What is Goodwill Amortization?

Goodwill amortization is the process of gradually reducing the intangible goodwill asset by allocating an amortization expense.

The amortization cost is spread over the useful life of intangible assets, in this case, goodwill which is 10 years as per the guidelines of the Financial Accounting Standards Board (FASB).

An important concept linked to amortization is the calculation of the impairment expense that arises due to a difference between the carrying value and the fair market value of goodwill.

Let’s dive in to know what is goodwill amortization, how it is calculated, and what are the challenges in the calculations of amortization costs.

What is Goodwill Amortization?

Goodwill amortization refers to the periodic reduction of goodwill of a company over a defined period.

Goodwill arises from the acquisition of a company when its assets include intangible assets like patents, copyrights, significant customer base, brand value, etc. It is cumulatively referred to as the goodwill of a business.

Since goodwill does not come with a defined lifespan, companies must perform periodic reviews to assess its fair market value and adjust the financial statements accordingly.

Public companies must follow the GAAP or IFRS rules and conduct goodwill impairment tests annually.

However, private companies do not need to conduct annual impairment tests and they can choose to perform an impairment test if a trigger event occurs.

If a parent company once elects to perform goodwill amortization, it must continue to do so across all sections and for all accounting periods.

How Goodwill Amortization is Calculated?

Public companies must perform an annual goodwill impairment test to adjust the goodwill value in the financial statements.

The purpose is to avoid overvaluation or undervaluation of goodwill and other intangible assets and to avoid manipulation of accounting rules.

Therefore, there is no definitive lifespan of goodwill amortization for public companies. Instead, public companies report a goodwill impairment charge on their income statements.

Since conducting goodwill impairment tests requires specific skills, time, and financial resources, it isn’t viable for private companies as such.

So, the relaxation of accounting rules from the FASB allows private companies to amortize goodwill over a period of 10 years.

If a company can prove the useful life of goodwill is less than 10 years, it can do so as well.

It means private companies will calculate the fair market value of the goodwill and amortize this total cost over 10 years.

If a trigger event happens and the company feels impairment of goodwill arises, it must account for the impairment charge and adjust the goodwill fair market value accordingly.

Goodwill Impairment Test

Often when a company acquires another one the pricing is overvalued. The most common reason for that overvaluation process is inaccurate calculation of goodwill.

When there is a difference between the fair market value of an acquired entity and its perceived carrying value, the acquirer company must record an impairment loss on its financial statements.

The calculation of an impairment expense for an acquirer follows three steps.

The first step is the qualitative assessment of the goodwill recorded in the balance sheet of a company.

The company must analyze the carrying value and fair market value of the intangible assets including goodwill. If the entity assesses that the goodwill fair market value is less than the stated goodwill value in its books, then it must quantify the impairment.

The second step is to confirm the goodwill fair market value with accurate calculations.

During this step, an entity must consider the changing dynamics that affect the goodwill including copyrights, customer share, market share, new products, and so on.

If the entity’s calculated fair market value is lower than its carrying value, then it must quantify the impairment charge.

The third step is simply to calculate the difference between the fair value of the goodwill and compare it with the carrying value recorded earlier.

The difference will be recorded as an impairment charge to goodwill on the financial statements of the entity. If the fair market value is still higher than its carrying value, then there will be no entry.

Reporting of Goodwill Amortization

Goodwill is represented on the balance sheet as an intangible asset. It is presented cumulatively for all types of goodwill a company possesses as a separate line item.

The goodwill amortization or impairment expense is then represented on the income statement.

Thus, goodwill has a direct impact on the profitability of a company. Therefore, it’s pivotal to calculate goodwill accurately and also to calculate its amortization charge correctly.

The journal entry for goodwill amortization will be:

Amortization Expense                                 Debit

Goodwill Account                                         Credit

For accumulated amortization, the journal entry will be:

Amortization Expense                                 Debit

Accumulated Amortization                         Credit

At the end of the amortization period, the accumulated amortization will be written off with the following journal entry:

Accumulated Amortization                         Debit

Goodwill Account                                        Credit

Note: This final entry will be for the total amount of goodwill accumulated over a defined period (10 years as guided by the FASB).

Working Example

Suppose a company ABC Pvt. Limited acquires another company XYZ Pvt. Limited.

ABC Pvt. Limited paid a total of $730 million to acquire XYZ but the net assets of the acquired company were valued at only $680 million.

The difference between the fair market value of the assets owned by XYZ and the amount paid by ABC comes from Goodwill carried by XYZ.

Goodwill Amount = Total Consideration Paid – Fair Market Value

Goodwill Amount = $730 – $680 = $50 million.

ABC company can amortize this goodwill for up to 10 years. It will record a yearly entry of $5 million for the amortization cost with the following journal entry.

Account NameDebitCredit
Amortization Expense$5 million
Goodwill$5 million

For accumulated amortization:

Account NameDebitCredit
Amortization Expense$5 million
Accumulated Amortization$5 million

At the end of year 10, ABC will record the following journal entry:

Account NameDebitCredit
Accumulated Amortization$50 million
Goodwill$50 million

Goodwill Amortization vs Goodwill Impairment

The concept of amortization is usually linked to intangible assets. However, the FASB has re-allowed private companies to amortize goodwill as well.

Amortization of goodwill is the process of periodic allocation of the goodwill expense. It’s fairly difficult to assess the useful life of an intangible asset like goodwill.

The FASB guidelines now allow private companies to spread the goodwill amortization across 10 years or less if there is a reasonable justification.

An impairment charge is the difference between the recorded carrying value of the goodwill and its fair market value.

The market value of goodwill declines as time passes when a higher portion of its total value is already amortized. However, a difference in the values may arise due to several financial and macroeconomic factors for the company.

Problems with Goodwill Amortization

The first challenge is to quantify goodwill as there are no set rules for its calculations. It means the calculation of goodwill itself can be manipulated.

Then, the amortization period may differ depending on the nature of intangible assets and their net value calculated by an entity.

Again, the assessment of the amortization period and subsequently the amortization expense is subject to accounting manipulation.

Public companies usually own more resources and possess better expertise than private companies. It’s difficult for private companies to assess the fair value of goodwill and adjustments for the impairment charges.

Finally, the calculation of an impairment charge is once again subjective. There are no set rules to define the fair market value of goodwill at any stage. Therefore, the accounting practices can be manipulated to adjust the profit/loss of an entity through impairment charge calculations.

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