Goodwill

Whenever one business buys another, and pays more than the fair value of all the identifiable pieces, the excess is termed "goodwill." This has always struck me as an odd term - but I suppose it is easier to attach this odd name, in lieu of using a more descriptive account title like: Excess of Purchase Price Over Fair Value of Identifiable Assets Acquired in a Purchase Business Combination. So, when you see Goodwill in the corporate accounts, you now know what it means. It only arises from the purchase of one business by another. Many companies may have implicit goodwill, but it is not recorded until it arises from an actual acquisition (that is, it is bought and paid for in a arm's-length transaction).

Perhaps we should consider why someone would be willing to pay such a premium. There are many possible scenarios, but suffice it to say that many businesses are worth more than their identifiable pieces. A movie rental store, with its business location and established customer base, is perhaps worth more than the movies, display equipment, and check-out stands it holds. A law firm is hopefully worth more than its desks, books, and computers. An oil company is likely far more valuable than its drilling and pumping gear. Consider the value of a brand name that may not be on the books but has instead been established by years of marketing. And, let's not forget that a business combination may eliminate some amount of competition; some businesses will pay a lot to be rid of a competitor.

The Consolidated Balance Sheet

No matter how goodwill arises, the accountant's challenge is to measure and report it in the consolidated statements - along with all the other assets and liabilities of the parent and sub. Study the following consolidated balance sheet for Premier and Sledge:

In the above illustration, take note of several important points. First, the Investment in Sledge account is absent because it has effectively been replaced with the individual assets and liabilities of Sledge. Second, the assets acquired from Sledge, including goodwill, have been pulled into the consolidated balance sheet at the price paid for them (for example, take special note of the calculations relating to the Land account). Finally, note the consolidated stockholders' equity amounts are the same as from Premier's separate balance sheet. This result is expected since Premier's separate accounts include the ownership of Sledge via the Investment in Sledge account (which has now been replaced by the actual assets and liabilities of Sledge).

It may appear a bit mysterious as to how the preceding balance sheet "balances" - there is an orderly worksheet process that can be shown to explain how this consolidated balance sheet comes together, and that is best reserved for advanced accounting classes - for now simply understand that the consolidated balance sheet encompasses the assets (excluding the investment account), liabilities, and equity of the parent at their dollar amounts reflected on the parent's books, along with the assets (including goodwill) and liabilities of the sub adjusted to their values based on the price paid by the parent for its ownership in the sub.

The Consolidated Income Statement

Although it will not be illustrated here, it is important to know that the income statements of the parent and sub will be consolidated post-acquisition. That is, in future months, quarters, and years, the consolidated income statement will reflect the revenues and expenses of both the parent and sub added together. This process is ordinarily straightforward. But, an occasional wrinkle will arise. For instance, if the parent paid a premium in the acquisition for depreciable assets and/or inventory, the amount of consolidated depreciation expense and/or cost of goods sold may need to be tweaked to reflect alternative amounts from those reported in the separate statements. And, if the parent and sub have done business with one another, adjustments will be needed to avoid reporting intercompany transactions. We never want to report internal transactions between affiliates as actual sales. To do so can easily and rather obviously open the door to manipulated financial results.