In January, FASB issued new guidelines for valuing Goodwill, an intangible asset found on the balance sheet. Goodwill is difficult to quantify, making many accounting experts question its informative usefulness. Further, companies were required to take an annual “impairment test” to accurately quantify Goodwill. In January, GAAP 2014-2 allows private companies to discontinue this practice, but instead amortize impairment over a ten-year period on a straight-line basis.
What is Goodwill?
Goodwill is classified as an intangible asset. It is defined as the value of a company that exceeds the value of its physical assets. Most often, Goodwill arises when a company is bought or sold. For example, a private business owner decides to sell his business. His balance sheet shows that his buildings, machinery, inventory, accounts receivable, etc. total $2.3 million. He sells his business for $3.0 million, indicating its market value. This means that the value of the company is actually $700,000 higher than its physical value. The new owner may have paid more for the company’s desirable location, its catchy brand name, or the belief that profits would explode in the next five years. Clearly, the new owner believes that he will recoup $700,000 and more. This $700,000 is now an asset on the new balance sheet called Goodwill.
Why Did FASB Issue a New GAAP Guideline?
Accounting for Goodwill presents a problem in the years following the sale. After the new owner has recouped his investment with a profitable business, it begs the question: Is Goodwill doubly-counted on the asset sheet? The answer is unclear. The only way to know for sure is to sell the company again. Perhaps the intangible value of the company has increased. Instead, US GAAP required a yearly impairment test to determine if Goodwill had been impaired, or decreased.
Previously, the U.S. GAAP required that private companies take an annual “impairment test” to test the accuracy of Goodwill on the balance sheet. This was a costly and time-consuming practice. Indeed, many investors, creditors, and vendors do not view goodwill as a reliable indicator of value. Therefore, the annual impairment test became a futile exercise. Amortizing Goodwill on a straight-line basis allows private companies to reduce the value of Goodwill over ten years. It is simpler and FASB states that the new method “still provides decision-useful information for lenders, investors and other users of private company financial statements.”
Accounting for Goodwill Impairment
Amortization works just like depreciation. For our example above, every year, the new business owner would reduce his Goodwill amount by $70,000. An offsetting entry would go on the income statement showing the amortization amount of $70,000 as an operating expense thus reducing profit.
Why would companies want to do this if it reduces profitability? One reason is that straight-line amortization is probably less costly than the annual impairment test. In addition, non-cash expenses such as amortization and depreciation are usually not considered significant. Indeed, many investors and lenders tend to weigh the cash flow statement as more reliable indicator of financial health. Another reason is that decreased profitability is beneficial for companies at tax time. Companies that show lower profits will find a lower tax burden.
At present this FASB guidance was only issued for private companies, however, because it is well-received by decision-makers that depend on financial statements, the FASB added a project to its agenda to consider the issue for public companies and not-for-profit organizations.
About Sara Huter
Sara Huter has over 15 years experience in the banking and energy industries, and over 10 years as an adjunct professor. Her work has been published for BusinessBee.com, the International Directory of Company Histories, the Encyclopedia of Business Insights: Global, EHow.com, and Examiner.com. Find out more about Sara at her Google+ Profile.