What is Goodwill?
Goodwill is an intangible asset representing the future economic benefit arising from assets that are not recognised separately.
It constitutes an essential part of assets, especially for companies operating in high technology industries.
Goodwill is a simple concept to explain but a complex one to define. It benefits and advantages a business’s excellent name, reputation, and connections. It is the enticing power that attracts new clients.
It is one of the characteristics that separates an established firm from a start-up. Goodwill is comprised of several components. It varies in composition across trades and between enterprises within the same trade.
From a legal standpoint, goodwill is defined as “the benefit that a firm obtains above the worth of its capital, stock, and cash legitimately invested therein, as a result of the broad public favour and encouragement gained from regular or habitual consumers.”
Goodwill is defined in accounting as the portion of the value of the acquiring company that is not included in accounts receivable and inventories. It is based on what the company may someday be able to sell, and therefore its value changes with the business’s success. The total value of the business represents the price at which the acquired company’s stock is bought plus the book value of the remaining assets in the acquired company.
Due to the growing importance of intangible assets, there has also been a significant change in the standards associated with the accounting treatment of goodwill or goodwill accounting.
International Accounting Standard Board issued International Financial Reporting Standard (IFRS) 3- Business and Combination in 2004. This new standard provides significant changes for the accounting treatment of intangible assets, goodwill and business combinations.
According to new standards, firms must not amortise the goodwill, but it must be tested for annual impairment. The new accounting rule moved the head American General Accepted Accounting Principal (US GAAP), which introduced such an approach a few years earlier for the accounting treatment of Goodwill.
On July 20, 2001, the Financial Accounting Standard Board (FASB) issued the standard statements such as; Standard -141 Business Combination and 142- Goodwill and Other Intangible. Under the US GAAP, goodwill is not amortised but must be tested for impairment. A firm does not consider goodwill as a separate asset, so it is evaluated for impairment as a part of the cash-generating unit under IFRS or reporting unit in US GAAP.
U.S. GAAP Treatment of Goodwill Impairment
U.S. GAAP (Statement of Financial Standard Accounting Board -142 business Combinations and 142- Goodwill and Other Intangible assets) laid down the rules for the accounting treatment of Goodwill in the books of account.
Under U.S. GAAP, the value of goodwill is recorded as the excess of the cost of an acquisition price over the fair value of acquired net assets. It will be recorded only when the carrying amount of goodwill exceeds its implied fair value.
Before the new accounting standards, companies generally recorded the total amount of goodwill in the books. They did not assign the value of goodwill to the individual reporting unit of business.
A reporting unit is defined in the Statement of Financial Accounting Standard 142.30 as an operating unit or its component. Companies assign the value of goodwill to reporting units by comparing the estimated value of the operating unit with the fair value of the reporting unit’s identifiable net assets. Two-step impairment should be followed to identify potential goodwill impairment and measure the amount of impairment loss to be recognised, if any.
Step 1:-Test for Impairment Goodwill
The companies should follow the first step to identify the reporting unit’s fair value that has goodwill.
Compare the fair value of the reporting unit with its carrying amount.
If the carrying value of the reporting units exceeds its fair value (carrying value > fair value), continue to the next step; else stop.
Step 2:- Measures the Amount of Goodwill Impairment Loss
To calculate the impairment loss of goodwill, the companies should follow the rules of accounting standards.
(a) Allocate the fair value of reporting unit step 1 to identifiable assets and liabilities of the reporting unit based on their current fair value;
(b) Allocate any excess fair value to goodwill;
(c) compare the amount allocated to goodwill In step 2(b) with the balance sheet carrying the value of goodwill
(d) An organisation can recognise an impairment loss on goodwill by reducing the carrying value to its fair value computed in step 2b.
Treatment of Goodwill as Per IFRS
Under IFRS, the value of goodwill is measured as the difference between recoverable amounts over the balance sheet carrying value (including identifiable assets, liabilities and contingent liabilities).
An organisation requires the valuation of the fair value of all identifiable fair value of all tangible and intangible assets of the business for recognition of goodwill.
On the day of the goodwill acquisition, the impairment test is applied at the cash-generating unit level. The term cash-generating unit has been defined in IFRS. The smallest identifiable group of assets generates cash inflows that are largely independent of the cash inflows from other assets and the group of assets.
An organisation recognises an impairment loss if the unit’s recoverable amount is less than the balance sheet carrying value.
As above the Same example proceed: –
|Assets||Carrying value||Recoverable value|
|Land, Building, and Equipment (Tangible assets)||$15||$15|
Philips recognises an impairment loss of $40 million because the carrying value of the cash-generating unit exceeds its recoverable amount of $60 million.