This post explains what goodwill is in accounting. We look at what goodwill is, how it is calculated, the conditions for amortizing goodwill, and why goodwill arises in M&A deals. Here are some key takeaways about goodwill:
In accounting, goodwill comes into play when one business buys another. For more on how this process works, read our guide: The M&A Process Explained. In accounting, goodwill is the difference between the net assets acquired (fair market value of assets acquired minus any assumed liabilities) and the amount spent by the buyer to acquire the target business.
As an example, say Company A is willing to buy Company B for $15 million when the fair market value of Company B is only $10 million. The difference of $5 million goes on the buyer’s balance sheet as an intangible asset reflective of any perceived and agreed upon value not reflected in Company B’s tangible assets. Goodwill may reference value in things such as brand name, reputation, etc.
An oversimplified way of looking at fair market value is the price an asset would sell for in an open free market—where both the buyers and sellers have reasonable knowledge about the asset, and the buyer is willing to buy, and the seller is willing to sell. Additionally, there needs to be a reasonable amount of time for the execution of the sale.
For publicly traded companies, fair market value is already established. The stock market values these businesses every trading day through the price of the company's stock.
For privately held businesses, fair market value is usually determined by third party appraisers when the seller decides to sell. However, sometimes the buyer and seller will put together a quick deal where the buyer and seller will agree to a private transaction. In these circumstances, fair market value can also be established without third party appraisers. For fair market to be established, there are a few deal elements that need to be established. First, both parties need to know all of the relevant facts about the transaction. Additionally, the transaction needs to serve the best interests of both parties. Finally, there needs to be no pressure to make the trade and it can't be unreasonably rushed. Normally, however third party appraisers are involved in establishing fair market value for private companies.
Again, to summarize, we arrive at goodwill in an M&A transaction by looking at the difference between these net assets acquired and the purchase price the acquirer is willing to spend to buy the target company.
Whether or not goodwill is tax deductible and amortizable depends on two things. Whether the sale was structured as an asset purchase or a stock purchase (read more about asset purchases vs stock purchases here), and whether the company is public or private.
In addition to the distinctions above, we also have to understand the conditions surrounding how goodwill is tested for impairment.
What does this mean?
If Company A buys Company B for $5 million more than its fair market value, that $5 million goes on the acquiring company's balance sheet as goodwill. What if later on, after the acquisition the market value of the assets is deemed to be less in the future? In order to address this issue, goodwill is subject to annual impairment testing and if these assets acquired (goodwill) are found to be worth less in the future, then there will be a goodwill impairment charge to offset this.
Private companies are exempt from this impairment testing on the grounds that it would create a financial burden to them that may involve great cost. Private companies may elect to amortize goodwill over a ten-year period without the impairment testing that public companies are subject to.
At this point in the guide, you may be wondering: why would someone be willing to pay more than fair market value to acquire a business?
For the purpose of trying to understand goodwill for accounting, there are a few good reasons:
The first reason is to achieve financial synergies. There are both revenue (soft) and cost (hard) synergies in mergers and acquisitions deals. These synergies are benefits that the acquiring company receives when buying the business. An example of a revenue (soft) synergy would be gaining access to a new market by buying a local company. The logic being that now they can sell more products to people they otherwise would not have been able to reach without the acquisition. An example of a cost (hard) synergy may be negotiating power with a supplier that would come from being able to place larger orders. Maybe this acquisition allows them to purchase supplies from a supplier for a reduced cost (in greater bulk) or to negotiate more favorable accounts payable terms. So, from a synergy perspective, these savings may justify paying a larger purchase price than fair market value, because they may gain more in the long run.
Additionally, it is fairly obvious that powerful brands are worth more than just their tangible assets. It’s easy to understand how Apple, for example is worth more than their inventory, real estate, etc. Their brand name resonates with customers and those customers pay Apple premium prices because they trust the quality associated with the Apple brand name.
Another reason to pay more than fair market value for a target company, could be to eliminate a competitor. The logic being that they would greatly reduce external threats to their company by eliminating a rival business.
Additionally, by structuring the deal the right way (see above), they can potentially amortize goodwill over time, helping to offset the costs of paying more than fair market value to acquire another business, but they could start seeing the benefits sooner.
As a final point, it’s worth noting that overpaying is a big reason why M&A deals fail.