At first blush, goodwill seems definable as the ethical score assigned to a company based on its company practices and principles. However, upon further exploration it can simplistically be defined as the purchase price minus the fair market value of a company. Due to the intangibility of the value of goodwill, unlike property or equipment for example, it is often estimated. In previous years, companies had two accounting options, pool interest or a flat out purchase. In the first accounting practice, both companies would combine their assets and liabilities on one balance sheet and there would be no goodwill created. The second option was where the company would list the premium paid for upon acquisition as “goodwill” on their balance sheet and be allowed an amortization period of forty years.
Here is an example: If Company A wanted to acquire Company B. If Company B’s book value of $20 per share but is trading on the stock market at $42 per share and has an outstanding 1 million shares. Company A purchases Company B for ($42 per share x 1,000,000 shares) so a total of $42,000,000. Now because Company B’s book value is ($20 x 1,000,000=20,000,000) Company A has then paid a premium of $22,000,000. Amortized over 40 years Company A would have to subtract $550,000 per year (1/40 x $22,000,000) from their earnings, until the entire goodwill amount is settled.
The FASB Changes and Goodwill.
The ‘blue sky’ as goodwill was known for a number of years, continued to be reported both ways until the Financial Accounting Standards board (the financial rule makers in America) decided in June of 2001 that there was no point in maintaining two reporting styles for business mergers. Until that point:
Businesses would use the interest pooling method which means no earnings reduction
Pay excessive amounts for mergers with no accountability on balance sheets
Once the purchase method was enforced, business executives complained that there would have been a reduction in mergers, as no company wanted to report a loss. So the FASB acquiesced and issued a statement that required goodwill to no longer be amortized instead record impairments if there is evidence that the acquirer had over paid.
Importance of Goodwill to Investors
Conscientious companies will be obliged to value the businesses they invest in and acquisitions provide this background. If earning statements are inflated and executives are happily overspending on their mergers, then their stock becomes risky.