Goodwill is an intangible asset, meaning it has no physical value. It is only recognized as a result of a business acquisition and represents the difference between what a company pays to acquire another company and the market value of that targets company’s individual assets.
This premium arises because the investing company is prepared to pay in excess of the net assets acquired. The excess value typically represents brands, customer loyalty, future synergies, talented workforce, among other things. These items are assets but are not physical (tangible) and their value is very difficult to accurately quantify.
Under IFRS and US GAAP standards, goodwill must be capitalized and tested annually for impairment. Historically, the asset was amortized but this is no longer the case.
The Coca-Cola Company – Extract from Balance Sheet 2019
Goodwill – Accounting for M&As
Goodwill emerges in the financial statements if there has been an acquisition. It is calculated as the difference between the equity purchase price and the sum of the identifiable net assets (or shareholders’ equity) purchased. In most cases, the former is higher than the latter resulting in goodwill being recorded.
In most deals, the equity purchase price will be a mix of cash and securities used as consideration.
The shareholders equity purchased at fair value is not always the same as the book or carrying value reported in the target’s balance sheet. A large part of the goodwill calculation involves restating the target’s identifiable assets and liabilities to fair value.
Only identifiable assets and liabilities, or those that can be bought or sold separately from the business, can have a fair value.
If the equity purchase price is less than the fair value of equity purchased, then negative goodwill is created. Under IFRS, the treatment of negative goodwill has been significantly simplified. It is now recognized immediately in the income statement, after its calculation has been reviewed to ensure it exists.
Impairment of Goodwill
The value of goodwill must be reviewed annually for any impairment. This occurs when the market value of the asset significantly decreases below its historical cost. Such a reduction in value can be triggered by specific events or changes in circumstances specific to the subsidiary. A decline in cash flows, increased competition or an economic depression are all other potential contributing factors to a decrease in value.
Undertaking an impairment for something as ‘intangible’ as goodwill is not straightforward. It is difficult to isolate and test an asset which is not separable, so a different approach is required.
Goodwill must be valued as part of a larger group of assets, termed a cash generating unit (CGU). Impairments on a CGU are then allocated back to specific assets in the CGU, such as goodwill.