Goodwill is an intangible asset which arises from an acquisition and represents the positive difference between the purchase price and the fair market value of the acquiree’s identifiable assets.
Under U.S. GAAP, goodwill accounting can differ depending on whether the company is privately held or publicly owned – i.e., has its shares listed on a stock exchange. Public companies must test goodwill annually for impairment. If such an impairment occurs, the company must write down the goodwill to its estimated amount. The write-down involves the reduction of the goodwill asset to fair value with a corresponding impairment expense. U.S. GAAP allows private companies the option of amortizing goodwill on a straight-line basis. This option was introduced because annually impairment testing can be costly. Straight-line goodwill amortization involves the recognition of an equal amount of goodwill amortization expense over the asset’s life. Goodwill has no residual value, so the entirety of the goodwill asset will be written off the company’s balance sheet.
For tax purposes, companies may be able to recognize amortization expense depending on the structure of the acquisition.
Why do companies pay a premium over the identifiable assets? Companies value an acquisition based on the future cash flows which the acquisition is expected to produce. These projected cash flows are then discounted to the present using an appropriate discount rate. Often, this value will exceed the fair market value of the acquired assets.
A company can acquire another company and recognize negative goodwill. For example, if the company being acquired is in distress, the company may be bought for less than the fair market value of its identifiable assets.
