Goodwill

From Wikicpa

Goodwill is also an important accounting concept that describes the value of a business entity not directly attributable to its tangible assets and liabilities.

For example, a software company may have physical assets of some desktop PCs, servers, office equipment etc valued at $1 million, but the company's overall value (including brand, customer, intellectual capital) is valued at $10 million. Anybody buying that company would show $10 million total assets comprising $1 million physical assets, and $9 million in goodwill.

However the value of goodwill is very difficult to assess especially in cases where personal contact is important. A CPA who sells his practice would not be able to guarantee that all of his clients would transfer to the buyer. When purchasing a business of this nature it is very important to be sure that provisions are made for an adjustment in the sales price after an initial trial period to see if the client base has eroded.

Goodwill is often included on a balance sheet as an asset, but its valuation may be suspected if supporting evidence like an independent survey is missing. Goodwill is forced onto the balance sheet when a company is purchased for more than the sum of the value of the assets of the company. The difference between the purchase price and the sum of the assets is by definition the value of the "goodwill" of the company.

For example:

• A quality provider of goods or services builds up a good reputation (IBM, L.L. Bean).
• A brand name controlled by the business becomes recognizable by a large part of the population (Tide, Cheerios).

Goodwill is no longer amortized under United States generally accepted accounting principles(GAAP) (FAS 142). As of January 1st, 2005, it is also forbidden under International Accounting Standards. Goodwill can now only be impaired (impairment-only approach).

Goodwill is amortized over fifteen years for United States taxes, regardless of when the actual benefit is recognized by the organization or firm. Internally generated goodwill can not be amortized.

Since, in general, intellectual property (IP) is part of goodwill, one of the most important assets of knowledge-based companies does not appear at all on formal balance sheets. As for these companies it is the IP that generates profit, not the buildings or the cash they hold, this may lead to a misleading valuation, discouraging investors who do not understand the company's true value. However, as this intangible asset is hard to value in the first place, this is perhaps a good thing; over-valuation due to goodwill was one of the biggest factors of the dot-com bust.

There are many preferences to leaving goodwill unamortized and instead testing for impairment annually. First of all, when you are amortizing an intangible asset, you compare its fair value (often determined through present value of future cash flows) and its book value. While it is easy to grab the number for the book value of goodwill, it can be quite difficult to predict future cash flows associated with goodwill. For example if under the assumption that goodwill has an indefinite life, how can we come up with a limit of when those cash flows will cease? It is more appropriate to consider the business as a whole yearly. By first looking at the fair value vs. book value of the entire business, we can then better understand how to value goodwill.

Business

Goodwill is a concept used to refer to an individuals or a businesses ability to exert influence within a community, club, market or another type of group, without having to resort to the use of an asset (such as money or property). Different entities will have different amounts of goodwill within the group.

An entity typically has goodwill because of the others trust that it will act in the common interest or, more generally, that it will live up to its claims. Sometimes, the trust needs only extend to that the entity will act a bona fide way and thus is not broken in the eventuality that the entity failed to comply with its promises due to external factors.

For example,

• A bank has goodwill within the banking system and a particular market because of the others faith that it will honor all debts, refrain from unjustifiably issuing new currency and that it will, in general, perform all transactions in a correct manner. It can, as a consequence, attract financial capital from the market by borrowing without having to secure such loans with real-estate or other type of guarantees.

The concept of goodwill also applies on a smaller scale, with regard to, for example, customer-vendor relations and even ones standing (or respect) within his or her group of acquaintances.

Source: wikipedia adapted