What is Goodwill and How Does it Work in Accounting?

Goodwill is an essential finance and accounting term that refers to the excess of the purchase price paid for an acquired firm over the fair value of its separately identifiable net assets. In simpler terms, goodwill reflects the perceived superior earnings capacity of a business combination.

If you want to better understand a company's financial statements, recognizing the concept of goodwill is essential. Some companies have goodwill in the top three largest categories of assets on their balance sheets.

Illustrating Goodwill

An example of goodwill could be a factory transfer. A business man in blue agrees with another in red that blue will pay a substantial amount of money to transfer ownership of a factory to him. If the purchase price is $3B and the net assets are $2B, then the difference of $1B is goodwill. Goodwill helps make the journal entry balance, and it represents the difference between what a company pays to buy an acquisition target and what the company is worth "on paper."

Goodwill is recognized only in a business combination, and it's not amortized.

Microsoft-LinkedIn Acquisition

The Microsoft-LinkedIn acquisition, which occurred in 2016, is an excellent example of how the accounting for goodwill works. After months of negotiation, Microsoft announced the acquisition of LinkedIn for $196 per share, translating to a purchase price of $26.2B. The acquisition was unanimously approved by both boards of directors, and regulatory approvals were obtained.

The main reason Microsoft paid a premium for LinkedIn above its net assets was because goodwill reflects the perceived superior earnings capacity of the business combination.

The accounting for this specific acquisition is available in Microsoft's filing with the SEC of its FY17 Q2 quarterly report. In this filing, goodwill was recorded as an asset on the balance sheet, making it a non-current or long-term asset.

The Purchase Price Allocation

Microsoft’s valuation of the tangible assets it obtained was $5.7B, while the liabilities it took on were $3.4B. Given that Microsoft paid $27B, its net tangible assets from the acquisition were only $2.3B. However, Microsoft also had to assess the fair value of the intangible assets that it acquired, which were valued at $7.9B. The purchase price allocation is $5.7B + $7.9B - $3.4B = $10.2B.

Therefore, the goodwill amount is simply the purchase price ($27B) minus the fair value of the net assets ($10.2B), which gives us a goodwill value of $16.8B.

Impairment Test

Microsoft and other companies must carry out an annual impairment test on both goodwill and intangible assets. This test assesses whether the carrying value of goodwill and intangible assets is recoverable – that is, whether they can generate revenue and profits in the future.

Sometimes, a company may write off all or part of its goodwill and intangible assets if the financial results and future prospects of the business that it has acquired are dramatically dropping.

For instance, Microsoft's acquisition of Nokia's Devices and Services business in 2014 resulted in almost all of its goodwill and roughly 50% of its intangible assets being written off during the fourth quarter of fiscal year 2015.

Conclusion

Goodwill is an essential concept in finance and accounting that reflects the perceived superior earnings capacity of a business combination. Understanding its workings makes it easier to analyze a company's financial statement.

The Microsoft-LinkedIn acquisition serves as a great example of how goodwill accounting works. The purchase price allocation helped Microsoft determine the fair value of its net assets, supporting goodwill as an asset on the balance sheet.

Performing an annual impairment test on goodwill and intangible assets proves to be an essential step in ensuring that the carrying value of these assets is recoverable.