Goodwill represents the price in excess of the value of tangible assets that one business pays when it acquires another business. Say that you own a pizza parlor, and you want to expand your business by purchasing a competitor's pizza shack. You hire an appraiser to perform a valuation analysis on the pizza shack business, which assigns a total value of $500,000 for the pizza shack and all of its assets.
The price you pay for the current value of the tangible assets such as real estate, food equipment, appliances, tables, chairs, or other goods, adds up to $450,000. The remaining, unallocated $50,000 gets put on your balance sheet as goodwill. For more than one hundred years, small business owners have often referred to goodwill as "blue sky."
In the past, companies were required to show a portion of goodwill on their income statement, which reduced their reported earnings. The theory made sense on the surface: If you bought an asset, you had to depreciate it so why, then, wouldn't you have to do the same when you bought an entire company?
For all intents and purposes, these goodwill charges on company income statements were ignored by investors because, unlike buying assets that were needed to operate, acquiring a competitor or merger likely increased your profits if done wisely. The goodwill charges were causing managers to report lower earnings, which was against the accounting goal of providing an accurate picture of economic reality.
Accounting Rule Changes for Goodwill
In June 2001, the Financial Accounting Standards Board (FASB), the folks who make accounting rules in the United States by determining GAAP, changed the guidelines, no longer requiring companies to take these goodwill and amortization charges. Instead, a company was required to periodically determine, through cash-flow analysis and other means, whether the goodwill was impaired.
In practical terms, this meant that the goodwill would sit as an asset on the balance sheet forever unless something happened to the acquired business that caused management to realize they overpaid. In the event they did overpay, the business would record a goodwill impairment expense on the income statement, causing reported profits to fall. The goodwill "asset" could then be removed from the balance sheet.
The Exception: Patents
The one exception to this new goodwill policy was intangible assets that do not have indefinite lives, such as patents. These need to continue to be amortized off as an expense because when the patent expires, it is effectively worthless and so it would be misleading to list it on the balance sheet as an asset indefinitely.
In simple terms, if the pizza shack you bought had a licensing agreement with a local sports team that ran out in five years, you would have to continue to charge that asset off on the income statement through amortization, until it reached $0 at the end of the five years.
The most important thing for you to know when you look at goodwill is that it is a non-cash charge. That means that if a company has a goodwill expense of $10 million, not a penny is coming out of the company's pocket in most cases because it is just representing a loss that has already occurred.
If the pizza shack you bought went bankrupt three years from now after the building burned to the ground, you would record a goodwill impairment charge o your income statement, and your profits would be lower. The money you spent on the building was paid out three years before when you bought the place, not when the goodwill charge hit the income statement.