Purchased Goodwill

Definition

Purchased Goodwill is an intangible asset that arises when a company is acquired for more than the fair value of its identifiable tangible and intangible assets. This premium is often paid based on the target company’s brand strength, customer relationships, employee relations, technological advantages, and other non-physical assets. Unlike identifiable intangibles such as patents or licenses, goodwill cannot be separately identified and measured.

Examples

Company Acquisition Example: If Company A acquires Company B for $500 million, and the fair value of Company B’s identifiable net assets is $450 million, then the purchased goodwill is $50 million ($500M - $450M).
Brand Value Inclusion: When a technology giant acquires a startup, part of the purchase price might be attributed to the startup’s innovative technology and strong brand, resulting in significant purchased goodwill on the balance sheet of the acquiring company.

Frequently Asked Questions (FAQs)

What is the difference between purchased goodwill and internally generated goodwill?

Purchased goodwill is recorded when one company acquires another and pays more than the fair value of its net identifiable assets. Internally generated goodwill, on the other hand, represents the intangible value a company generates through its operations that is not recorded on the balance sheet because accounting standards prohibit its recognition unless it’s part of an acquisition.

How is purchased goodwill recorded in financial statements?

Purchased goodwill is recorded as an intangible asset on the acquiring company’s balance sheet. It is subject to impairment testing on at least an annual basis, and it is not amortized.

Can purchased goodwill be amortized?

Under U.S. GAAP, purchased goodwill is not amortized but is tested annually for impairment. However, under IFRS, goodwill is also tested for impairment but does not have provisions for amortization.

How does impairment of goodwill impact financial statements?

If an impairment test shows the carrying amount of goodwill exceeds its recoverable amount, an impairment loss is recognized in the income statement, reducing the value of both the goodwill and the equity of the company.

Why is goodwill important for investors?

Goodwill indicates the premium paid over a company’s fair value, representing future economic benefits arising from other assets acquired that are not individually identified and recognized. High levels of goodwill may indicate strong brands, market position, or exceptional customer relations.

Intangible Assets

These are non-physical assets such as intellectual property, patents, trademarks, copyrights, and goodwill that provide long-term value to a company.

Impairment

A permanent reduction in the value of an asset. For goodwill, this happens when its carrying amount exceeds fair value, necessitating a write-down.

Amortization

The allocation of the cost of an intangible asset over its useful life. Goodwill, however, is not amortized under current accounting standards but tested for impairment.

Fair Value

The estimated price at which an asset would trade hands between knowledgeable, willing parties in an arm’s-length transaction.

Online References

Suggested Books for Further Studies

“Financial Accounting: An Introduction” by Pauline Weetman - Comprehensive coverage of financial accounting principles, including the treatment of goodwill.
“Principles of Accounting” by Belverd E. Needles and Marian Powers - Detailed explanations of various accounting concepts including intangible assets.
“Advanced Accounting” by Joe Ben Hoyle, Thomas Schaefer, and Timothy Doupnik - A higher-level textbook providing deep insights into business combinations and goodwill.

Accounting Basics: “Purchased Goodwill” Fundamentals Quiz

### What does purchased goodwill represent in an acquisition? - [x] The premium amount paid over the fair value of the identifiable net assets. - [ ] The value of a company's fixed physical assets after acquisition. - [ ] The portion of equity paid in cash. - [ ] The stock issued during the acquisition. > **Explanation:** Purchased goodwill is the premium amount paid over the fair value of the identifiable net assets during a company's acquisition. ### Is purchased goodwill an intangible or tangible asset? - [x] Intangible asset - [ ] Tangible asset - [ ] Financial liability - [ ] Physical property > **Explanation:** Purchased goodwill is classified as an intangible asset because it represents non-physical factors such as brand reputation and customer relations. ### How is purchased goodwill recorded on the balance sheet? - [x] As an intangible asset - [ ] As a current liability - [ ] Within shareholder's equity - [ ] As a fixed asset > **Explanation:** Purchased goodwill is recorded as an intangible asset on the balance sheet of the acquiring company. ### How often must goodwill be tested for impairment? - [x] Annually - [ ] Quarterly - [ ] Semi-annually - [ ] During each financial statement update > **Explanation:** Goodwill must be tested for impairment on at least an annual basis. ### Does purchased goodwill undergo amortization? - [ ] Yes, purchased goodwill is amortized over its useful life. - [ ] Yes, but only under specific circumstances. - [ ] No, purchased goodwill is expensed immediately. - [x] No, purchased goodwill is tested for impairment, not amortized. > **Explanation:** Purchased goodwill is not amortized under U.S. GAAP but is subject to annual impairment testing. ### What potential effect does goodwill impairment have on financial statements? - [ ] It increases the value of the goodwill asset. - [ ] It results in the reporting of higher earnings. - [x] It reduces the value of goodwill and equity, and increases expenses. - [ ] It is recorded as revenue. > **Explanation:** Goodwill impairment reduces the value of goodwill and the equity, and it results in a loss recognized in the income statement. ### Can internally generated goodwill be found on the balance sheet? - [ ] Yes, it can be recorded if it meets specific criteria. - [ ] Yes, as long as it is significant. - [x] No, accounting standards do not allow the recognition of internally generated goodwill. - [ ] No, it is recorded in the income statement instead. > **Explanation:** Internally generated goodwill cannot be recognized on the balance sheet according to accounting standards. ### Why might a company have a high level of purchased goodwill? - [x] Due to strong brand value, customer relationships, and market position. - [ ] Because of large amounts of fixed assets. - [ ] Owing to high financial liabilities. - [ ] As a result of high immediate revenues. > **Explanation:** High levels of purchased goodwill are often due to the perceived value of intangible assets such as brand value, strong customer relationships, and a robust market position. ### What governs the impairment testing guidelines for purchased goodwill? - [ ] Local municipality regulations - [x] Accounting standards like U.S. GAAP and IFRS - [ ] Federal tax laws - [ ] Shareholder agreements > **Explanation:** The guidelines for impairment testing of purchased goodwill are governed by accounting standards like U.S. GAAP and IFRS. ### Which of the following is NOT a factor of purchased goodwill? - [ ] Brand reputation - [ ] Customer relationships - [ ] Employee relations - [x] Physical asset value > **Explanation:** Physical asset value is not a factor of purchased goodwill as these would be identifiable and measure separately. Goodwill includes intangible factors like brand reputation and customer relationships.

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