Goodwill accounting: A complicated part of mergers and acquisitions

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Quantifying the intangibles.

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When companies announce acquisitions, the executives throw around a number called goodwill, which is the difference between the price paid and the value of the company’s net assets on its balance sheet. Goodwill is almost always positive—and can sometimes be large. Goodwill accounting is a critical consideration for corporations who engage in mergers and acquisitions (M&A).

If you’re an investor or potential investor—in a company’s shares and/or its bonds—looking at goodwill can be one of those fundamental metrics that help you decide whether to buy, sell, or add to a position.

Goodwill is the benefit of a brand name, technology, or process that is generated when one company purchases another.

From an accounting perspective, goodwill is equal to the amount paid over and above the value of a company’s net assets. Goodwill is called an “intangible asset” because it’s not a physical item, and the value cannot be calculated easily. Goodwill includes intellectual property such as secret formulas, patents, and brand names, and it reflects balance sheet assets that have been written down (i.e., reduced in recorded value) but that still have plenty of value, such as real estate (carried at purchase price) or fully depreciated equipment.

A company purchase may be structured by the legal team as an asset sale or a stock sale.

Asset sale. Under this structure, a company’s assets (things like cash, furniture and equipment, and accounts receivable) and its liabilities (things like debt it owes) now belong to the new company. The assets are marked to fair market value at the time of purchase.

Suppose ABC company has $100,000 in fair market assets and $50,000 in liabilities. According to our formula, ABC’s owners’ equity (or net worth) would be $50,000. But what if company XYZ buys ABC for $100,000? Why were XYZ executives willing to pay more than it’s worth? They might believe that ABC’s products will help their current product line (or get rid of a competing product), or that the name brand is recognizable to customers, or that ABC has equipment or a distribution system that will grow XYZ’s business. These presumptions result in the creation of goodwill. In our example, the goodwill would be recorded as $50,000 ($100,000 in cash paid minus $50,000 in value).

Stock sale. Under this structure, the purchasing company buys all outstanding stock from its shareholders. The assets are kept at their book value (not fair market value).

Suppose CBA company’s net worth (owners’ equity) is $50,000. To make it simple, let’s say that $50,000 is stock: 1,000 shares outstanding, and each share is worth $50. But ZYX company is willing to pay $100,000 to acquire CBA. What happens? ZYX offers to buy all 1,000 shares of CBA at $100 a share. The extra $50 a share is recorded as goodwill on the combined books of CBA plus ZYX: $50,000 ($50 a share for 1,000 shares).

If you follow high-profile corporate M&A deals, you know that the acquirer typically must pay a premium to the prevailing share price to entice existing shareholders to sell. That premium sits on the acquirer’s books as goodwill.

The FASB accounting standard ASC 805 covers accounting for corporate mergers and acquisitions; Subtopic 350-20 covers accounting of amortization. For decades, companies were required to amortize goodwill, causing an ongoing expense even though there was no evidence that the acquired intangibles had become less valuable. In many cases, the goodwill actually became more valuable. Many acquirers revived old trademarks, expanded markets for intellectual property, and developed real estate. They turned the goodwill value into something more valuable, but they were required to treat it as though it had become less valuable.

When you amortize goodwill, no cash is paid out. But it’s shown on the income statement as an expense, so it lowers net income, which lowers earnings per share. In a financial world obsessed with earnings per share, companies that in the past had a lot of M&A often faced a “valuation penalty” for no other reason than goodwill amortization, which tended to be a drag on net income.

As of 2001, companies are not permitted to amortize goodwill on their nontax books (although in 2014 a new ruling permitted private companies to amortize instead of evaluate, if they choose). Instead, goodwill must be evaluated annually. If its value has declined, the company needs to write it down, i.e., lower the value of the asset. This write-down will result in a hit to the company’s quarterly and/or annual earnings. Otherwise, the goodwill stays on the balance sheet at the value assigned at the time of the transaction.

A merger is a combination of two original companies into a brand new company. Typically, the companies are similar in size. A merger implies that there is some operating control that is being shared, not simply trademarks, inventory, or equipment. In our example, if ABC and XYZ companies merged, the combined name might be AZ company.

The assets and liabilities of both ABC and XYZ are combined into one balance sheet. Because there is no cash paid out over and above the value of these assets, there is no goodwill recorded in a merger transaction. (If cash is paid in the business transaction over and above net asset value, the transaction is, in reality, an acquisition instead of a merger, and goodwill would be recorded.)

Goodwill describes the positive reputation that a business develops, which generates customer loyalty and gives marketing efforts extra juice. The accounting definition is simply the purchase price of an acquired business less the book value; the assumption is that the price difference is because of the target company’s good reputation.

If you own (or are thinking about buying) shares in a company, consider checking the value of the goodwill on its books as part of your due diligence .