When we mention goodwill in the finance and accounting world, we’re not referring to a second-hand retail store. Goodwill is an intriguing concept with significant implications for companies involved in merger and acquisition (M&A) transactions. Goodwill is an intangible asset created for accounting purposes when a company acquires another business (target) and pays a purchase price greater than the target’s net assets.

What is Goodwill?

Goodwill, as an intangible asset, refers to the value of a business beyond its tangible assets and liabilities. It includes a company's reputation, brand recognition, customer loyalty, a skilled workforce, and favorable supplier relationships. It represents the difference between the purchase price paid for the acquired company and the fair market value of its identifiable net assets. Goodwill is not separately identifiable and is only recognized when an entire business, or a substantial portion of it, is acquired.

How to Calculate Goodwill

After acquiring a business, the buyer compares the purchase price paid to the fair market value of the target's net assets, which typically include identifiable assets like cash, accounts receivable, inventory, and fixed assets. In this simplified example, the difference between these two amounts represents goodwill. The calculation below is straightforward if goodwill is the only intangible asset acquired.

Purchase price                                                         $1,000,000

Less: Fair value of net assets acquired                ($900,000)

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Goodwill                                                                      $100,000

Financial Impact on M&A Transactions

Understanding the financial impact of Goodwill is crucial for both buyers and sellers in M&A transactions.

Financial Reporting

Goodwill needs to be calculated and accurately reported on the opening balance sheet post-acquisition. Since businesses are commonly purchased at prices higher than their net asset value, the overall value of the business acquisition needs to be reported. Therefore, this is how goodwill is created – the intangible asset that was acquired.

Seller’s Tax Impact

Generally, the amount of the purchase price which is allocated to goodwill is considered favorable for the seller. As long as the seller has owned the business for more than a year, goodwill is taxed at capital gain rates rather than ordinary income rates. Consequently, sellers tend to advocate for a high goodwill allocation compared to other assets.

Buyer’s Tax Impact

Business acquisitions are commonly structured as asset sales (rather than stock sales). With an asset sale, acquired goodwill is tax-deductible and amortizable over 15 years. This means the acquirer will be able to reduce its taxable income by deducting goodwill amortization for 15 years post-acquisition. Buyers typically consider the tax impact of an acquisition, and goodwill amortization may help to reduce the buyer’s tax burden post-deal.

Annual Test for Goodwill Impairment

Generally accepted accounting principles (GAAP) require companies to review goodwill for impairment annually. Certain events may trigger goodwill impairment, such as current economic conditions, loss of key customers or personnel, or changes to industry regulations that diminish the company’s goodwill value. The nuances of goodwill impairment testing are beyond the scope of this article. However, goodwill may be impaired if the fair value of goodwill is less than the carrying value.

Goodwill is a key aspect of business acquisitions, representing the intangible value attributed to a company's reputation, brand, and other intangible assets. By grasping goodwill’s nuances, buyers and sellers can ensure they are making informed decisions when navigating an M&A transaction. Please contact us if you have any questions.