Sometimes a retail business is more than the sum of it's parts. It's not uncommon for a business owner to sell his business for more than the value derived from experts and analysts. The difference between what a buyer pays for a business and the fair value of the business is considered goodwill. Retail businesses with a strong brand, great employees and strong customer relations often have goodwill. Accountants need to evaluate goodwill on a periodic basis to make sure it's not impaired.
Initial Goodwill Calculation
Under U.S. generally accepted accounting principles, goodwill can only be generated through an acquisition. An accountant calculates goodwill by subtracting the purchase price from the fair value of the company's net assets. The fair value of the net assets is the value of assets less liabilities. For instance, say that Company X bought Retailer A for $10,000. Retailer A's assets are valued at $7,000 and liabilities are valued at $1,000. In this situation, the purchase generated $2,000 of goodwill for Retailer A. The accountant will debit the goodwill intangible asset account for $2,000 when recording the journal entry for the purchase.
Why Goodwill is Different
Goodwill is considered an intangible asset with an indefinite life. A retail business could potentially have intangible assets other than goodwill, such as patents and trademarks. U.S. generally accepted accounting principles instruct accountants to amortize intangible assets, such as patents and trademarks, that have a definite life. For example, an accountant might amortize a 10-year, $10,000 patent at $1,000 per year. Since it's difficult to define the useful life of goodwill, accountants write down goodwill when it's impaired rather than amortizing it.
The Impairment Test
U.S. generally accepted accounting principles instruct accountants to put goodwill through a two-part test before writing it down. First, the accountant compares the fair value of the company with the book value of the retail company. If the fair value is lower, the goodwill is probably not impaired and the accountant doesn't write down the asset. If the book value is higher than the fair value, the accountant considers goodwill impaired. For example, an accountant would need to write down goodwill on a retail business with a fair value of $6,000 and a book value of $4,000.
The Impairment Amount
If goodwill is deemed impaired, the accountant performs a separate calculation to determine the new value of the goodwill. This is referred to as implied goodwill. To determine implied goodwill, subtract the fair value of the company's net assets excluding goodwill from the fair value of the company. For example, a company with a fair value of $6,000, net assets valued at $4,000 and goodwill of $2,000 has implied goodwill of zero. Since the implied goodwill is less than the current goodwill, the accountant would write the goodwill down from $2,000 to zero. If the implied goodwill is more than the current goodwill, no action is necessary.
- Intermediate Accounting, 6th Edition; Property, Plant, and Equipment and Intangible Assets -- Utilization and Impairment; David Spiceland
- Accounting Explained: Intangible Assets
- Financial Accounting Series: Intangibles - Goodwill and Other
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