Definition
Goodwill amortization refers to the gradual reduction of the value of the intangible asset of goodwill on a company’s balance sheet over time. It’s a tax deduction that companies taken advantage of to account for the value of non-physical, but valuable, assets that a company holds. However, accounting practices have shifted to recording periodic impairment losses rather than regular amortization in most countries, following international accounting standards.
Key Takeaways
- Goodwill Amortization refers to the gradual reduction in the amount of the goodwill asset by recording an expense on the balance sheet over time. It reduces a company’s net income, hence lowering its taxable income.
- Since 2001, the Financial Accounting Standards Board (FASB) stipulated that goodwill no longer needs to be amortized. Instead, goodwill is required to be tested annually for impairment, thus changing the process of goodwill amortization.
- Goodwill Amortization can affect a company’s financial statements significantly, particularly affecting the company’s earnings and therefore, potentially, its stock price. It is crucial for both investors and companies to understand how and why goodwill amortization is adjusted.
Importance
Goodwill Amortization is a crucial financial aspect that plays a significant role in corporate accounting.
It involves gradually writing off the value of a company’s goodwill over a specific period.
This concept is important because it aids businesses in the gradual and systematic reduction of the amount of goodwill that a firm records in its books after a merger or acquisition.
This helps to spread out the costs associated with the purchase of another business over a longer time period, thereby reducing sudden impacts on the company’s financial reporting.
It also provides a more accurate reflection of the company’s financial health by providing a methodical way of accounting for the intangible value of the business entity it purchased.
Explanation
Goodwill amortization refers to a systematic method that businesses implement to progressively reduce the value of goodwill, a non-tangible asset on the balance sheet, over a certain period. Goodwill commonly arises during the acquisition of one company by another, when the purchase price exceeds the net asset value of the acquired company.
The purpose of goodwill amortization, similarly to the depreciation of tangible assets, is to gradually decrease and eventually eliminate the amount of goodwill carried on a company’s balance sheet to better reflect the reducing value of this intangible asset over time. As for what it is used for, goodwill amortization provides a realistic demonstration of a company’s financial status.
It allows businesses to account for the dwindling value of the bought-out company’s goodwill gradually rather than having a drastic drop in a single point in time, which might misrepresent a company’s true financial health. By amortizing goodwill, the company ensures that the costs associated with the acquired goodwill are spread out throughout its useful lifetime, better matching revenue and expenses.
However, it should be noted that under current accounting standards, most companies performed an impairment test for goodwill annually instead of amortizing it, as per U.S. GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).
Examples of Goodwill Amortization
AT&T’s Acquisition of Time Warner: In 2018, telecommunications conglomerate AT&T acquired Time Warner, which includes assets such as CNN, HBO, and Warner Bros. AT&T had to record Goodwill and other intangible assets due to the difference between the purchase cost and the actual fair market value of Time Warner’s net assets. Over time, AT&T may need to amortize this goodwill through their income statement if the value of these acquired assets decreases over time.
Facebook’s Acquisition of WhatsApp: In 2014, Facebook acquired WhatsApp for $19 billion, which was significantly more than WhatsApp’s book value at the time. The excess amount was recorded as goodwill and other intangibles on Facebook’s balance sheet. Facebook is then required to test this goodwill for impairment annually, which could lead to goodwill amortization.
Disney’s Acquisition of Pixar: Disney’s purchase of Pixar back in 2006 is another famous example of the creation of goodwill. The acquisition deal was worth about $
4 billion while the book value of Pixar’s net assets at the time was significantly less. Disney was willing to pay such excess due to the value they perceived in Pixar’s innovation, reputation, and intellectual property. This perceived value was reflected as goodwill in Disney’s financial statements, part of which is amortized over time. Remember, as per the US GAAP, goodwill is not amortized but is tested for impairment annually. However, other international accounting standards, like IFRS, do provide for amortization of goodwill under specific conditions.
FAQs on Goodwill Amortization
1. What is Goodwill Amortization?
Goodwill Amortization refers to the gradual reduction or write-off of the accounting value of goodwill. Goodwill is an intangible asset that comes up when a company acquires another company for a price higher than its fair market value. However, it’s worth noting that under current U.S. Generally Accepted Accounting Principles (GAAP), goodwill is no longer amortized, but tested annually for impairment.
2. How is Goodwill Amortization calculated?
In the past, when goodwill was amortized, it was typically done so on a straight-line basis over a period of up to 40 years. This means that equal amounts were expensed each year over the amortization period. However, the current practice is to conduct annual impairment tests rather than automatically reducing the value of goodwill through amortizations.
3. What is an impairment test?
An impairment test is performed to determine if the value of the goodwill asset has decreased and is now less than the recorded cost on the company’s books. If the fair value is less, an impairment loss must be recorded to reduce the carrying value of the goodwill asset to its fair value.
4. Why did the accounting rules on Goodwill Amortization change?
The change from amortizing goodwill to testing for impairment was based on a shift in understanding of the nature of goodwill. Previously, goodwill was seen as a wasting asset that naturally lost value over time. However, currently, goodwill is seen as having an indefinite life that doesn’t reduce in value unless there is an impairment triggering event.
5. How does Goodwill Amortization affect a company’s financial statement?
When goodwill was amortized, the annual amortization expense reduced the company’s recorded net income. Now, under the impairment model, a company’s earnings are not affected unless there is an impairment loss. However, a substantial impairment loss can result in a large deduction from the company’s reported net income, which can have a significant impact on the company’s overall financial performance.
Related Entrepreneurship Terms
- Intangible Assets
- Amortization Schedule
- Impairment Test
- Non-cash Expense
- Balance Sheet
Sources for More Information
- Investopedia – A leading source that specializes in finance and investing education.
- AccountingTools – Provides clear explanations of accounting and finance concepts.
- Corporate Finance Institute (CFI) – Offers online courses and resources about corporate finance topics.
- Financial Accounting Standards Board (FASB) – The organization responsible for establishing accounting and financial reporting standards in the U.S.
