Goodwill is an intangible asset, therefore it is a debit entry, so what you do is write it off as an expense over several years to the profit and loss account. Credit goodwill, debit expenses. Rather like depreciation of tangible assets. So like depreciation, there is an accounting standard that says you have to write off goodwill and gives rules on how to do it, otherwise you could make the whole thing up (then we would be in the realms of creative accountancy!) and different companies' financial statements wouldn't be comparable. The one thing a company is NOT allowed to do is just leave goodwill there forever. Writing it off will obviously reduce profit, but if the company was a good buy that's not going to bother you.
Which brings me on to the whole question of accruals v. cash. Company accounts have to be prepared on the accruals basis, which can give a very different result to just looking at how much cash comes in and how much cash goes out. A company can be making a loss if it has goodwill to write off but still have a positive cash flow so it can keep running. There are huge multinational corporations that make losses now and again but haven't collapsed. Which gives us another accounting standard - large companies have to prepare a cash flow statement. It's when a company doesn't actually have enough cash in the bank to pay its bills that it is officially insolvent.
Is this making some sense?
"But accounting standards require you to write it off as soon as possible rather than keep a fictional figure in the financial statements."
Huh? I can't imagine what this means but it isn't even true in England to say nothing of the US. Goodwill is only written off when it is impaired. An accounting requirement that you write it off would be completely bizarre as goodwill often reflects real value. (An accountant talking about something as "fictional figure" makes me giggle). Goodwill amortization is a decade dead. We now do impairment tests. If the answer to that test is "I have no idea" (which it usually is), the goodwill stays on the books. That is exactly the opposite of this silly statement.
The whole post above is one of those "I got a B in freshman accounting but will claim to be an accountant" posts.
Now we get "The one precise portion of valuation is book value (assets minus liabilities).". Uh no. When calculating goodwill you mark up asset and liabilities to current market value which may have nothing at all to do with book value.
Why do people answer questions when they don;t have a clue? Try the Baby Names section folks.
Goodwill and other long-lived assets are reviewed periodically for impairment. In your example, the company that paid $20MM would evaluate the related assets and if they concluded that they were only worth $15MM, then they would write the goodwill down accordingly.
Basically, some deals are good and some aren't. The goodwill doesn't go in the sense that you mean, but if the acquiring company overpaid (or if the acquired company doesn't perform) then they end up biting the bullet.
The one precise portion of valuation is book value (assets minus liabilities). It's not very interesting and usually not the most significant portion of the valuation. Next you have existing contracts and sales. Customers promised to buy this much stuff so it's valuable. Sometimes they default on contracts or payments, so existing sales usually gets discounted some amount. Next is future sales. A business has a history of selling so much goods and services, and likely some expectation or history of growth. Future sales get some multiple applied depending on how certain, how profitable, and how far into the future. The remaining valuation is goodwill. A company may have brand recognition, particularly important clients, patents or other intangibles making it more valuable than the sum of its parts. Putting a value on goodwill is somewhat subjective, as are multiples and discounts to sales, but certain industries and business deals set benchmarks for subjective comparisons. Ultimately is a willing buyer and seller negotiating price and terms. Look at the Pfizer AstraZeneca deal getting up to $118B that looks to be going down in flames.
Ok so im reading a book on financial statements (Ben graham - Financial statement analysis) . I understand what goodwill is. the premium your paying. e.g if you acquire TOOLSTOP for $20M and only 10M is tangibles then the other 10M will be goodwill? am i correct?
OK so the bit i dont understand is how can goodwill be written off to $1 ? how can goodwill ever go? so say if im looking at a company and it has goodwill now of 8M then in five years how would i even know that it acquired something that costed 8m? can someone please explain a bit more in depth as the book i have is very basic. Very basic!
thank you!
