the goodwill accounting

the goodwill accounting

Understanding Goodwill in Accounting

1. Introduction to Goodwill

According to the business dictionary, goodwill is: ‘an intangible asset, such as the advantage or benefit which is expected to be derived from a favorable reputation, business location, or business custom’. Goodwill is the excess of purchase consideration – the purchase price (cash and non-cash adjustments) and the value of equity interest acquired when purchasing a business – over the fair market value of the acquired company’s identifiable net assets. Business combination under FASB 141(R) states that the purchase price cannot include costs incurred to effect the acquisition; rather, it is the price that the purchaser actually pays. The fair value of the acquired company’s identifiable net assets is also its book value. IFRS 3R Business Combination (2008) says the same thing but uses the term ‘acquiring cost’ instead of purchase price.”

“For companies such as Coca-Cola and IBM to exist for over a century is impressive. How did they achieve this feat? By having an excellent product is important, but I opine that goodwill is what keeps such companies in top position. This leads to the question – What is goodwill and how is it determined from an accounting perspective?

2. Importance of Goodwill in Accounting

At the moment, it has been determined that the method deployed by private and open market transactions to estimate the purchase of goodwill by an acquiring company is not precise at all. Private sales are tiny in number, pertinent only to expensive corporations, or need some level of responsibility on part of the analyst compared to listed purchases. Open market sales encompass businesses with less significant effect over enormous billion-value corporations. It is because of these reasons that some stock price determination should be made before purchase. A Bayes’ weighted average percentage of errors and a FileStream ratio comprises a formula that sufficiently determines the overall payment for an entire company. Optimism concerning the company’s growth rates might end up consuming a percentage equal to the entire premium.

Goodwill is an economic concept that is adopted by the accounting profession. Accountants have come up with a means of measuring and capitalizing on this concept by considering any noncash expense paid by a business on top of an asset’s listed value as goodwill. Goodwill is deployed by businesses to acquire other potential companies or businesses. The acquiring companies typically assign a portion or a number of all the non-cash expenses to acquired assets, a balance is considered as a purchase price for the opportunity to generate the acquired business’s future gains. Goodwill is said to serve as proof of the acquiring company’s capacity to pay for what it has learned or for the building up of a strong effect caused by the purchase. This premium will be termed as an economic or accounting goodwill based upon alternatives to measuring the overall goodwill of an acquisition.

3. Factors Affecting Goodwill Valuation

Both standards and accounting valuations are dependent on stock market values and, as a consequence, on the market’s needs at particular periods of time. If the accounting systems as we know them had originally considered the critical factors that really determine goodwill valuation, basically the necessary information would not be obtained on required inputs to the traditional valuation models. This information would be measured in financial terms that lack economic and accounting significance. The definition of financial statements as “instrumentation of processes going on the accounting subject” imposes the search for reflection on reality as the basis for work to transform concrete data that reflect this reality into intangible information, according to the requirements of potential users. It is not possible to produce data from obsolete concepts that no longer represent value to decision-making. Each model alone has its limits, but the hypothesis of perspectives existing value synthesis models, allowing combinations of inputs that might even be qualitative, could eliminate previous criticisms.

This complexity arises from different factors that affect goodwill calculations. As has already been mentioned, goodwill measures the essence of a firm like brand recognition, customer loyalty, and proprietary images, all of them intangible. However, at the same time, goodwill is impacted by other factors that are capable of modifying its potential value, such as firm size, purchasing premiums, or the business acquisition costs for patent-pending new technologies. Unfortunately, the traditional methods of valuing goodwill are not able to take these factors into account as they are based on economic theories developed before accounting incorporated most of them. When the traditional valuation methods of goodwill were developed, it was thought that they would be long-lived accounting systems, as reports. Instead, existing accounting valuation and disclosure systems are actually short-lived.

4. Methods of Calculating Goodwill

Capitalization method: This method of goodwill valuation is useful in the case when the relationship between the share capital and the actual total profit of the business is given. This method is based on the number of years returns on capital at the current rate. When the amount of capital is known and the amount of average annual profits is given, goodwill can be measured by the following formula, Goodwill = Average Profits x Years Purchase Method. This method is used under situations where value is based on the capitalization of average profits and in such cases, goodwill’s value is calculated at the same amount as that of the actual profit of the business. Under such circumstances, the existing capital must bring normal profits.

Super Profit Method: This method is based on the capitalization of super profits. Here, the super-profit is calculated by using the formula as, Super profits = actual profits – profit of normal capital. Here, normal profit is calculated by multiplying the average profit by the rate of interest as well as on the price of shares. In actual, super-profit = Average profit – minimum profit. Here, this difference can be regarded as super profit. The goodwill is then calculated by the formula as, Goodwill = Normal Profits x Number of years.

Average Profit Method: This is the simplest and easier method to calculate goodwill, which is based on the average profit of previous years. According to this method, the goodwill is calculated on the basis of average profit. To calculate this, add the actual profits of the past few years (at least five years), then take an average of it by dividing the total by the number of years. In the next period, profit should be forecasted, and the method would be the same as in the annuity method, i.e. goodwill = average profit (A) x Number of Annuity year (R) / 100. The number of years is selected based on the company’s policy regarding the number of years of the purchase of goodwill.

1. Average Profit Method 2. Super-Profit Method 3. Capitalisation Method 4. Annuity Method

Goodwill can be calculated and measured using 4 different methods. They are based on how one views goodwill. The four methods are:

5. Implications of Goodwill on Financial Statements

The implications of goodwill are widespread. Products of business combinations and financial statements issued by companies having goodwill; financial analysts, institutional investors, auditors, creditors, managers, and financial markets increasingly rely on goodwill. Business combinations are a major part of many businesses, often changing fundamentally the way their financial positions are interpreted. The financial performance in the post-combination period is crucial to the success of a business combination. Therefore, analysts, investors, managers, and other contract writers who use financial statements to assess and reward the performance of companies often see short-term movements and have a short-term effect. An indication of the unexpected changes in accounting profitability often contributes to the business value by providing a useful framework to interpret the implications of financial reporting decisions. For example, an unexpected increase in the book return on assets may suggest the earnings generation that uses extreme efforts in an exceptionally good year, lowering the expected return on assets in the future.

Goodwill impairment is widely spread in banking companies today, so it’s really important to understand it well. To the best of our knowledge, a discussion of goodwill impairment is still very limited. Some literatures that discuss goodwill impairment include Riano (2018) which discusses the effect of accounting standard convergence on financial statements of business combinations, but the study does not take into account the effect of prospective circumstances or management beliefs in the consideration of goodwill impairment, and there is no need for goodwill that do not need to be subject to testing for impairment. Holthausen and Watts (2001) also stated the factors that cause reporting failure are debt covenants, management remuneration contracts, specific reputations, and security resource level covenants. However, other potential factors are still being examined. This research aims to determine whether prospective circumstances can explain the recognition and value of goodwill impairment losses and the termination of the existence of goodwill that do not need to be subject to testing for impairment.