Goodwill

Goodwill is an intangible asset recognized in the parent company's financial statements to reflect the excess of the the price paid for the acquiree (by the parent and the minority shareholders) over the fair value of net identifiable assets of the acquiree.

Any successful business is almost always worth more than the fair value of its net identifiable assets. If it were not so, no company would need to fight long and costly battles with rivals to acquire a company. This is because the fair value of net assets represents only such assets and liabilities which can be expressed in terms of a number. It does not capture the quality of a company's management, the customer and vendor relationships that it has cultivated, its human capital, etc.

In a business combination, the fair value of the acquiree's assets and liabilities is determined (including any identifiable assets not appearing in the acquiree's books), and combined with the parent company's assets and liabilities in the consolidated financial statements. If the purchase consideration paid is greater than the fair value of net identifiable assets, the elimination of investment in subsidiaries in the consolidation process would involve recognition of the difference as goodwill.

Goodwill = Purchase consideration - Fair value of net identifiable assets

Goodwill is an intangible asset because it has no physical existence but it represents the economic value which is not captured by other assets. It is not amortized like other intangible assets must must be tested annually for impairment.

Example

Company A purchases all voting shares of Company B for $15 Million. The statements of financial positions of Company A and Company B with their book values and fair values are given below (all amounts are in thousands US$).

 Book ValueFair Value
 Company ACompany BCompany ACompany B
Assets    
PPE30,00015,00035,00017,000
Trade Receivables5,0004,5004,9004,000
Cash18,0002,00018,0002,000
Total53,00021,50057,90023,000
Liabilities and Equity    
Long-term Liabilities19,0008,00018,0007,500
Current Liabilities8,0004,0007,5004,500
Equity26,0009,50032,40011,000
Total53,00021,50057,90023,000

The goodwill on acquisition of Company B is calculated below:

Price paid for Company B 15,000
Fair value of Company B's net assets:  
PPE17,000 
Trade Receivables4,000 
Cash2,000 
Long-term liabilities(7,500) 
Current liabilities(4,500) 
  (11,000)
Goodwill 4,000

The statement of financial position of Company A after acquisition would show the goodwill $4 million as an asset.

Assets: 
Goodwill4,000
PPE47,000
Trade Receivables9,000
Cash5,000
Total65,000
Liabilities and Equity: 
Long-term Liabilities26,500
Current Liabilities12,500
Equity26,000
Total65,000

by Obaidullah Jan, ACA, CFA and last modified on

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