What’s in This Article:
Understanding Goodwill in Business Acquisitions
How Does Goodwill Accounting Work Under U.S. GAAP?
What Is the Private-Company Goodwill Accounting Alternative?
When Must Goodwill Be Tested for Impairment?
What Happens if a Public Company Acquires Your Business?
How Does Goodwill Affect Financial Statements?
What About the Tax Treatment of Goodwill
What Should Businesses Consider Before an Acquisition?
Understanding Goodwill Before Your Next Business Transaction
Understanding Goodwill in Business Acquisitions
Buying or merging with another business can create exciting opportunities for growth. But once the deal is complete, there’s more to consider than the purchase price.
One important accounting consideration is goodwill.
Goodwill may represent a significant portion of an acquisition’s recorded value, particularly when a buyer pays for an established reputation, customer relationships, or other expected benefits that cannot be recognized as separate assets.
For eligible private companies, U.S. Generally Accepted Accounting Principles (GAAP) offer an accounting alternative that can simplify how goodwill is reported after an acquisition.
However, that decision can have implications for future financial reporting, especially if the company plans to pursue another merger, acquisition, or public offering.
Understanding the options before making a decision can help avoid unexpected accounting complications later.
What Is Goodwill?
Goodwill is an intangible asset that may arise when one company acquires another business.
It generally represents the amount paid above the fair value of the identifiable net assets acquired, after applying the relevant business combination accounting requirements.
A buyer may be willing to pay more for a company because of its reputation, established workforce, customer relationships, or expected future growth.
Some of these benefits qualify as separately identifiable intangible assets. Others may contribute to goodwill.
Unlike equipment or inventory, goodwill cannot generally be sold independently of the business.
How Is Goodwill Calculated?
Under Accounting Standards Codification (ASC) 805, Business Combinations, goodwill is determined through acquisition accounting.
For a straightforward acquisition, the calculation can be illustrated as follows:
Goodwill = Purchase Consideration − Fair Value of Identifiable Net Assets Acquired
This simplified formula assumes a 100% acquisition with no previously held ownership interests or noncontrolling interests.
Example:
A company purchases another business for $1,500,000.
The acquired company’s identifiable assets have a fair value of $1,200,000, and its assumed liabilities have a fair value of $200,000.
Fair Value of Identifiable Net Assets:
$1,200,000 − $200,000 = $1,000,000
Goodwill:
$1,500,000 − $1,000,000 = $500,000
In this example, the acquiring company would recognize $500,000 in goodwill, assuming the transaction qualifies as a business combination and the acquisition accounting is otherwise complete.
How Does Goodwill Accounting Work Under U.S. GAAP?
Under the general U.S. GAAP goodwill accounting model, goodwill is not amortized over time.
Instead, companies must test goodwill for impairment at least annually and whenever events or circumstances indicate that impairment may have occurred.
An impairment loss is generally recognized when a reporting unit’s carrying amount exceeds its fair value, limited to the amount of goodwill assigned to that reporting unit.
This process may involve business valuations, financial forecasts, and professional judgment.
In 2017, the Financial Accounting Standards Board (FASB) simplified goodwill impairment testing through Accounting Standards Update (ASU) 2017-04, eliminating the former second step of the impairment test.
For eligible private companies, another accounting approach is available.
What Is the Private-Company Goodwill Accounting Alternative?
In 2014, FASB issued ASU 2014-02, introducing an optional goodwill accounting alternative for private companies.
The alternative remains available under ASC 350, Intangibles, Goodwill and Other.
Eligible private companies may elect to amortize goodwill on a straight-line basis over 10 years, or a shorter period when the company can demonstrate that another useful life is more appropriate.
Example:
Using the $500,000 goodwill balance from our earlier example:
$500,000 ÷ 10 years = $50,000 annually
Assuming a full year of amortization, the company would recognize $50,000 in goodwill amortization expense each year.
This expense reduces reported earnings but does not require an annual cash payment.
The alternative also simplifies impairment testing. Instead of performing an annual impairment test, a company generally evaluates goodwill for impairment when a triggering event occurs.
Eligible companies using this alternative may also elect to perform impairment testing at the entity level rather than the reporting-unit level.
Although this approach can reduce accounting complexity, it isn’t necessarily the best choice for every business.
When Must Goodwill Be Tested for Impairment?
The requirements depend on the goodwill accounting model a company follows.
Under the general U.S. GAAP model:
Goodwill must be tested at least annually and when events or circumstances indicate potential impairment.
Under the private-company amortization alternative:
Goodwill is amortized and tested for impairment when a triggering event occurs.
A separate accounting alternative introduced through ASU 2021-03 also allows eligible private companies to evaluate goodwill impairment triggering events as of the end of each reporting period, rather than throughout the period.
Potential impairment indicators include:
- Significant declines in business performance
- Adverse changes in economic or market conditions
- Loss of major customers or contracts
- Unexpected increases in operating costs
- Declining revenue, earnings, or expected cash flows
For government contractors, the loss of a significant federal contract could be an important consideration when evaluating goodwill impairment.
These circumstances don’t automatically mean goodwill is impaired. They indicate that further evaluation may be necessary under the applicable accounting model.
What Happens if a Public Company Acquires Your Business?
This is an important consideration for private companies evaluating the goodwill amortization alternative.
Public companies generally follow the goodwill impairment model rather than the private-company amortization alternative.
If a private company that elected goodwill amortization is later acquired by a public company, the buyer may need financial information prepared under accounting requirements applicable to public companies.
Depending on the transaction and reporting requirements, this could involve revising historical financial information to remove the effects of accounting alternatives that are not permitted for public-company reporting.
That process can require additional accounting work, valuations, and financial statement adjustments.
However, the specific requirements depend on the transaction structure, applicable SEC reporting rules, and whether the acquired company’s historical financial statements must be presented or reconciled.
Electing goodwill amortization does not automatically make a company less attractive to buyers.
Still, businesses considering a future sale, public offering, or acquisition by a public company should evaluate the potential reporting implications before choosing the alternative.
How Does Goodwill Affect Financial Statements?
Goodwill accounting can influence several areas of a company’s financial reporting.
Balance Sheet
Goodwill is generally recorded as an intangible asset. Under the private-company amortization alternative, its carrying amount decreases through accumulated amortization and any recognized impairment losses.
Income Statement
Goodwill amortization and impairment losses reduce reported earnings when recognized.
Cash Flow
Amortization and impairment are noncash expenses. Although they affect reported earnings, they do not directly represent cash payments in the periods recognized.
Financial Ratios
Goodwill balances and related expenses can influence profitability measures, return on assets, and other financial ratios.
For companies seeking financing or preparing for an acquisition, understanding these effects can help explain differences in reported financial performance.
What About the Tax Treatment of Goodwill?
Financial reporting and tax accounting for goodwill are not always the same.
For federal income tax purposes, qualifying acquired goodwill is generally amortized over 15 years under Internal Revenue Code Section 197.
However, the tax treatment depends on the structure of the acquisition and the applicable tax rules.
For example, an asset acquisition and a stock acquisition may produce different tax consequences.
A company using the 10-year private-company goodwill amortization alternative for financial reporting may therefore have a different amortization period for tax purposes.
These differences can affect tax reporting and deferred tax accounting.
Businesses should evaluate both the financial reporting and tax implications before completing an acquisition.
What Should Businesses Consider Before an Acquisition?
Goodwill accounting is only one part of evaluating a merger or acquisition.
Before completing a transaction, business owners should consider:
- Purchase price allocation: How much of the purchase price relates to identifiable assets, liabilities, and goodwill?
- Financial reporting: Which goodwill accounting model will apply after the acquisition?
- Future earnings: How could amortization or impairment affect reported results?
- Financing arrangements: Could goodwill accounting affect financial covenants or lender reporting?
- Future growth plans: Could the business eventually be acquired by a public company or pursue public-company reporting?
- Tax implications: How will the transaction structure affect the tax basis and amortization of acquired goodwill?
For government contractors, acquisitions may also introduce considerations involving contract transfers, indirect cost structures, and government contracting compliance.
Addressing these issues early can help business owners avoid unexpected financial reporting challenges after closing.
Understanding Goodwill Before Your Next Business Transaction
A merger or acquisition can create valuable growth opportunities, but it can also introduce accounting and financial reporting complexities.
Understanding how goodwill is recognized, amortized, and tested for impairment can help business owners evaluate the financial effects of a transaction and make more informed decisions.
At Cheryl Jefferson & Associates, we help growing businesses and government contractors navigate accounting requirements, financial reporting, and strategic financial planning.
Planning an acquisition or evaluating your company’s financial reporting needs? Contact CJA to discuss how our accounting and virtual CFO services can support your business.
Frequently Asked Questions
Do private companies have to amortize goodwill?
No. Eligible private companies may elect the goodwill amortization alternative under U.S. GAAP, but they are not required to do so.
Can goodwill be written off immediately?
Goodwill generally cannot be written off simply because a company prefers to recognize the expense immediately. An impairment loss must be recognized when required under the applicable accounting guidance.
Is goodwill amortization tax-deductible?
Qualifying acquired goodwill is generally amortized over 15 years for federal income tax purposes under IRC Section 197. The deduction depends on the transaction structure and applicable tax requirements.
