In your journey to analyze financial statements, you will need to understand the meaning of goodwill on the balance sheet. Goodwill is an accounting term that stems from purchase accounting. The topic can get complex, but you'll gain a decent grasp of the basics of the subject so that you have an idea of what you see when you spot goodwill in a Form 10-K, annual report, or balance sheet.
Definition and Examples of Goodwill
When one company buys another, the amount it pays is called the purchase price. Under generally accepted accounting principles (GAAP) and the Financial Accounting Standards Board (FASB) rules and guides, goodwill refers to any part of the purchase price that exceeds the total asset value of the business.
In other words, accountants take the purchase price and subtract it from the company's book value with some other purchase accounting adjustments, such as assigning a certain value to the firm's client relationships and mailing list.
For instance, let's say a business being sold has $1 million worth of assets, but the purchaser pays $1.5 million for it. That $500,000 beyond the $1 million is the "goodwill."
Whatever value or part of the purchase price that cannot be allocated to a tangible asset gets added to an account called goodwill. Many companies have intangible value. These might include patents, trademarks, brand-name equity, and trade secrets. Each can be valued and is put into a goodwill figure.
How Goodwill Accounting Works
Goodwill isn't easy to place a value on. For decades, people have debated what exactly to include and how to account for it. Also, there's the issue of testing it for impairment. That's when the fair implied value of the goodwill is less than the amount carried over from previous periods.
The Current Goodwill Impairment Model
Goodwill has transformed in the past generation. There have been at least three methods for finding it in recent decades. Under the current system, when goodwill is valued, it is placed on a balance sheet; then, it's continuously carried over into the next period. Any other acquisitions will be added to the balance carried over. As with many financial assets, goodwill can lose value over time. This is known as impairment.
There are three tests used to find goodwill impairment. The first is an assessment of qualitative factors. These could be increasing costs due to the acquisition, a constant decline in share prices, or downturns in the economy that may cause devaluation.
What if the qualitative factors reveal a possible impairment? Then, the second test is to identify the potential impairment by comparing the fair value to the carrying value. If the value is greater than the carrying value there is no impairment. But if the fair value is less than the carrying amount, then there is an impairment that needs to be calculated.
The impairment loss is calculated in the third step as the fair value subtracted from the carrying value. Then, it is included in the balance sheet.
If there is an impairment, the balance of goodwill cannot be recorded as less than zero (as a negative).
Testing for impairment is complex. It can involve things such as performing a discounted cash flow analysis of expected cash flows from patents, for instance. The idea behind the treatment of goodwill is that the value of a solid ongoing business with a lot of franchise value rarely declines.
The Hershey Company Example
Let's take a look at past goodwill treatment. Consider The Hershey Company, which has made generations of investors wealthy. When Hershey bought Reese's in June 1963, Reese's had sales of $14,000,000 per annum. Hershey paid $23.3 million for the transaction. In 2019, Reese's brand candies exceeded $2.5 billion in retail sales.
The acquisition of Reese's into Hershey allowed for economies of scale the company didn't previously have. This allowed for higher returns on capital. Far from being impaired, the real economic goodwill doesn't show up on the balance sheet. It is now much higher than it was at the time of the acquisition.
This acquisition took place under old rules for goodwill. That means that Hershey doesn't carry any goodwill for it. However, if Hershey were to acquire Reese's in the current market, there would be several intangibles to be accounted for.
What It Means for Individual Investors
As a value investor, proper goodwill accounting helps ensures that companies engaging in large acquisitions won't artificially depress earnings per share. Older accounting systems caused the reported net income applicable to common shares to be understated relative to owner earnings.
Current goodwill accounting helps smooth out quirks in specific sectors and industries; otherwise, they may be able to make their shares look much more expensive than they were. Proper accounting methods make it easier to compare businesses across industries.
- Goodwill accounting refers to the portion of the acquisition price that goes beyond what the business's assets are worth.
- Goodwill can account for intangible aspects of a business such as patents or brand names.
- Accounting for goodwill helps prevent manipulative practices that could make a stock appear cheaper or more costly than it actually is.