Goodwill

Definition

Goodwill is an intangible asset representing the premium paid in an acquisition over the Fair Value of the target company’s identifiable Net Assets (identifiable Assets less identifiable Liabilities). It is recorded on the acquirer’s Balance Sheet.

Represents

• It captures non-identifiable intangible value expected to contribute to future earnings, such as:
  • Brand reputation and recognition
  • Customer relationships and loyalty
  • Skilled workforce / Intellectual capital
  • Expected Synergies from the combination

Creation

• Goodwill arises only through Mergers & Acquisitions (M&A) transactions.
• Calculation: $Goodwill=PurchasePrice-FairValueofIdentifiableNetAssets$

Subsequent Accounting Treatment (US GAAP / IFRS)

• No Amortization: Unlike most other intangible assets, Goodwill is not amortized systematically over time.
• Impairment Testing: Goodwill must be tested for Impairment at least annually (or more frequently if indicators of impairment exist). This test assesses whether the fair value of the reporting unit (to which goodwill is assigned) is less than its carrying amount on the Balance Sheet.
• Impairment Loss: If the carrying amount exceeds the fair value, an Impairment loss is recognized as an expense on the Income Statement, reducing Net Income. This loss reduces the Goodwill asset balance on the Balance Sheet. Impairment losses cannot be reversed later if value recovers.
• Investor Impact: Impairment losses directly reduce reported earnings and can negatively impact investor perception and the investment’s return profile.

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Modeling in M&A

In transaction models, goodwill is calculated post-acquisition:

1. Purchase Equity Value: Start with the price paid for the target’s equity (from Enterprise Value to Equity Value Bridge).
2. (-) Target Book Value of Equity: Subtract the target’s existing Shareholders’ Equity (or Net Assets) from their Balance Sheet.
3. (-) Existing Goodwill: Subtract any goodwill already on the target’s balance sheet.
4. (=) Excess Purchase Price over Book Value
5. (-) Write-up of Assets: Subtract write-ups of identifiable assets to their fair value.
6. (+) Deferred Tax Liability Creation: Add the DTL created from the asset write-ups ($DTL=WriteUp\times TaxRate$).
7. (=) Pro Forma Goodwill: The result is the new goodwill created in the transaction.

This calculation isolates the premium paid over the fair value of identifiable net assets.

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See also: Intangible Assets, Balance Sheet, Mergers & Acquisitions (M&A), Impairment, Fair Value, Net Assets