In accounting, goodwill is an intangible asset and refers to the difference between the book value of a company and its purchase price.
Generally speaking, goodwill is an accounting charge that a company takes when it makes an acquisition. The value of a company can include more than merely its hard-asset value. Goodwill is usually considered that "intangible" aspect of a company's worth: think of stuff like a well-known and respected name or brand image, the value of a customer base and good customer relations with that base, etc. These are items for which there is no independent and objectively verifiable value, but which add a subjective value to the sale price of the company.
When the acquiring company enters the value of the acquired company onto its balance sheet, the difference between the value of the hard assets acquired and the purchase price is entered as an asset called "goodwill" on the balance sheet. Note that if the purchase price is greater than the book value, goodwill is a positive number in the asset column. If, however, book value exceeds the purchase price, goodwill will be entered as a negative number.
Given that goodwill is a subjective factor and may not hold up well in certain economic environments, Fools tend to ignore these charges from intangibles and focus on earnings from operations to help value a company. This is because in the case of positive goodwill, the acquisition may have simply been overpriced; that would create a huge amount of goodwill that will evaporate on a re-sale of the acquired company in a less-than-favorable economy.
Goodwill and book value
For companies that have acquired several others over a year, goodwill can become a large portion of their total assets. When using metrics that rely on book value or shareholders' equity, a ton of goodwill can throw off the reliability of these metrics. In such situations, use tangible book value (book value without intangible assets like goodwill).
Every year, the carrying value of goodwill must be tested for impairment, according to FASB 142. If goodwill is found to be impaired, then it must be reduced through a writedown as a charge against income for the year.
This impairment is done in two steps. The first is to check the carrying value of each operating unit. The carrying value of each unit is compared against its fair market value. If the fair value is higher than the carrying value, nothing happens. If, however, the carrying value is higher than the fair market value, then the excess is charged against goodwill to reduce the carrying value to that fair market value.
As long as the fair market value of the operating units remains above carrying value, goodwill remains unchanged. Theoretically this situation could last for many, many years. This is in direct contrast to earlier GAAP, in which goodwill was amortized (reduced in value) over time.
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