Goodwill on the Balance Sheet
Analyzing a Balance Sheet
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.
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 represents the premium for buying a business for a higher price due to the intangible assets that may justify a higher price than that supported by the identifiable assets of that business.
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.
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 in patents, trademarks, brand-name equity, and trade secrets. These can all be valued, and are put into a goodwill figure.
Goodwill is difficult to place a value on; there is an on-going debate about what to include, how to account for it, and how to test it for impairment—when the fair implied value of the goodwill is less than the amount carried over from previous periods.
Different Goodwill Testing Methods
Goodwill has undergone a transformation over the past generation. In 2020, when a company buys another company, the company accounts for goodwill by subtracting the net identifiable assets of a company from the sum of a company's non-controlling interest, considerations, and the fair value of equity interests.
When goodwill is valued, it is placed on a balance sheet and continuously carried over into the next period, added to by additional acquisitions that add more goodwill. As with many financial assets, goodwill can lose value over time. Determining this value is complicated and under much scrutiny from regulatory agencies and scholars.
There are three tests used to determine goodwill impairment. The first is an assessment of qualitative factors, such as increasing costs due to the acquisition, a constant decline in share prices or downturns in economic conditions that may cause devaluation.
If the qualitative factors reveal a possible impairment, the second step 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. However, 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, which is then included in the balance sheet.
If there is an impairment, the balance of goodwill cannot be recorded as less than zero, or a negative.
Goodwill remains on the balance sheet as an asset, with no annual write-offs, unless it is deemed to be impaired. Testing for impairment is complex and can involve things such as performing a discounted cash flow analysis of expected cash flows from patents, for example, but the idea behind the treatment of goodwill is that the value of a solid ongoing business with a lot of franchise value rarely declines.
As an example of the 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 $23,300,000 for the transaction. In 2019, Reese's brand candies exceeded $2.5 billion in retail sales.
The acquisition of Reeses into Hershey allowed for economies of scale the company didn't previously have, a development that allowed for higher returns on capital. Far from being impaired, the real economic goodwill, which doesn't show up anywhere on the balance sheet, is now exponentially higher than it was at the time of the acquisition.
Since this acquisition took place under old rules for goodwill, Hershey doesn't carry any goodwill for it. However, if Hershey were to acquire Reeses in the current market, there would be a number of intangibles to be accounted for.
Goodwill For Investors
As a value investor, the loss of the goodwill write-offs would be upsetting because companies that had engaged in large acquisitions under the old method tended to have artificially depressed earnings per share. It caused the reported net income applicable to common to be significantly understated relative to owner earnings.
Combined with certain quirks in the treatment of accounting in specific sectors and industries, such as pharmaceuticals, you were confronted with a strange situation in which the actual earning power was materially above the reported earnings, making the shares look much more expensive than they were. It wasn't an accident that these forces played a role in the sectors and industries that produced the greatest investment opportunities of the past century.