Amortization of goodwill

Amortization of goodwill is an accounting concept that refers to the systematic reduction of the value of goodwill on a company's balance sheet over a specified period. While it was once a common practice under various accounting standards, amortization of goodwill is no longer permitted for financial reporting under current U.S. GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards). Instead, goodwill is now subject to annual impairment testing. This change reflects a shift in how financial assets are valued and presented in financial statements.

History and Origin

Historically, amortization of goodwill was a standard practice, treating goodwill much like other intangible assets with a finite useful life. Before 2001, U.S. accounting rules, specifically APB Opinion No. 17, mandated that goodwill acquired in a business acquisition be amortized over its estimated useful life, not exceeding 40 years. The rationale was that even goodwill eventually diminishes in value or is replaced. This changed significantly with the issuance of FASB Statements No. 141 and 142 in June 2001. Statement 142, "Goodwill and Other Intangible Assets," eliminated the amortization of goodwill, requiring instead that it be reviewed for impairment at least annually.⁶, ⁷, ⁸ This overhaul was prompted by criticisms that goodwill amortization did not accurately reflect economic reality and that users of financial statements found the amortization expense unhelpful in analyzing investments.⁴, ⁵ The Financial Accounting Standards Board (FASB) aimed to provide investors with greater transparency regarding the economic value of goodwill and its impact on earnings per share.³ A New York Times article from the period highlighted how these changes aimed to align accounting with the actual business activities, particularly in the booming M&A landscape of the time. The move was seen as a major shift, with the FASB stating that "straight-line amortization of goodwill over an arbitrary period does not reflect economic reality and thus does not provide useful information."

Key Takeaways

• Amortization of goodwill is the process of systematically reducing the reported value of goodwill over time.
• Under current U.S. GAAP and IFRS, goodwill is no longer amortized but is instead tested for impairment annually.
• The shift from amortization to impairment testing for goodwill occurred to provide a more accurate reflection of goodwill's economic value.
• The tax treatment of goodwill can differ from financial reporting, with the IRS sometimes allowing a form of amortization.

Formula and Calculation

While amortization of goodwill is no longer applied for financial reporting under major accounting standards for goodwill itself, understanding the concept requires looking at how amortization generally applies to other intangible assets or how goodwill was historically amortized.

If goodwill were still amortized, the simplest method would be straight-line amortization, calculated as follows:

$\text{Annual Amortization Expense} = \frac{\text{Goodwill Value}}{\text{Useful Life (in years)}}$

For instance, if a company acquired goodwill with a purchase price that resulted in $10 million of recognized goodwill and an assumed useful life of 20 years, the annual amortization expense would have been:

$\text{Annual Amortization Expense} = \frac{\$10,000,000}{20 \text{ years}} = \$500,000$

This annual expense would have been recorded on the income statement, reducing reported net income. The corresponding amount would have reduced the carrying value of goodwill on the balance sheet. This method is conceptually similar to how depreciation is calculated for tangible assets.

Interpreting the Amortization of Goodwill

The interpretation of amortization of goodwill has evolved significantly. When goodwill was amortized, the annual expense reduced a company's reported profits. This often led to a steady drag on earnings per share even if the underlying value of the acquired business was stable or growing. Critics argued that this systematic reduction failed to acknowledge that goodwill, representing factors like brand reputation or customer loyalty, could indefinitely retain or even increase its fair value.

The shift to impairment testing means that goodwill's value on the books is only reduced when its fair value falls below its carrying amount. This change was intended to provide a more economically relevant picture of an entity's financial health, as it ties reductions in goodwill more directly to actual declines in the value of the acquired business, rather than an arbitrary time-based write-off.

Hypothetical Example

Consider Company A acquiring Company B for $50 million. The fair value of Company B's identifiable net assets (tangible assets and separable intangible assets) is determined to be $40 million. This results in $10 million of goodwill recognized on Company A's balance sheet (Purchase Price - Fair Value of Net Identifiable Assets = Goodwill; $50M - $40M = $10M).

Under the historical amortization of goodwill method (pre-2001 GAAP):
If Company A had adopted a 20-year useful life for goodwill, it would have recorded an annual amortization expense of $500,000 ($10,000,000 / 20 years). This expense would have been reflected on its income statement each year for two decades.

Under current accounting standards (GAAP/IFRS):
Company A would not amortize the $10 million of goodwill. Instead, it would perform an annual impairment test (or more frequently if triggering events occur). If, in a subsequent year, the fair value of the acquired Company B (specifically the reporting unit to which goodwill is assigned) drops significantly—say, due to a downturn in its industry or a loss of key customers—Company A would assess if an impairment has occurred. If the carrying amount of the reporting unit (including goodwill) exceeds its fair value, and the implied fair value of the goodwill is less than its carrying amount, an impairment loss would be recognized on the income statement, reducing the goodwill's carrying value to its new implied fair value. This could result in a one-time, potentially large, write-down.

Practical Applications

While direct amortization of goodwill is largely a historical concept for financial reporting, the principles of amortization remain highly relevant for other intangible assets that have a finite useful life, such as patents, copyrights, and customer lists.

In the context of goodwill, current practical applications primarily revolve around its impairment testing. Companies engaged in acquisition activities must meticulously assess the goodwill recognized and perform regular impairment tests. This involves complex valuations, often using discounted cash flow models, to determine if the carrying value of goodwill on the balance sheet is still supported by the underlying economic value of the acquired business. Reuters has reported on goodwill write-downs and their impact on corporate earnings. Tax regulations, however, can treat goodwill differently. For U.S. tax purposes, certain acquired intangible assets, including goodwill, may be amortized over 15 years under Section 197 of the Internal Revenue Code. Thi¹, ²s means that while a company may not amortize goodwill for financial reporting, it might do so for tax purposes, creating deferred tax assets or liabilities.

Limitations and Criticisms

The shift away from amortization of goodwill was spurred by criticisms that it was arbitrary and did not reflect economic reality. However, the current impairment model also faces limitations and criticisms. One major critique is the subjectivity inherent in impairment testing, which relies heavily on management's estimates of future cash flow and fair value. This can open the door to management discretion, potentially delaying the recognition of losses or even manipulating earnings per share.

Another concern is the "big bath" phenomenon, where companies might choose to take a large impairment charge in a year with already poor performance to clear the decks for future periods. Financial Executives International (FEI) has historically weighed in on the challenges of goodwill accounting. Furthermore, impairment losses, when recognized, can be substantial and volatile, leading to significant swings in reported net income, which can make financial analysis challenging. The non-amortization of goodwill also means that its carrying value on the balance sheet can remain inflated for extended periods, even if the underlying business subtly deteriorates, until a formal impairment event occurs.

Amortization of Goodwill vs. Impairment of Goodwill

The primary difference between amortization of goodwill and impairment of goodwill lies in their nature and timing.

While amortization was a routine accounting procedure, impairment testing is a periodic assessment of the actual economic value. This means that under current standards, goodwill remains on the balance sheet at its initial value unless a specific event or annual review indicates that its fair value has fallen below its carrying amount, necessitating an impairment loss.

FAQs

Why is goodwill no longer amortized in financial reporting?

Goodwill is no longer amortized under GAAP or IFRS because accounting standard setters concluded that its useful life is often indefinite, and amortization over an arbitrary period did not accurately reflect its economic value. Instead, impairment testing is used to reflect decreases in goodwill's value only when they truly occur.

What is the difference between amortization and depreciation?

Amortization refers to the systematic expensing of intangible assets with a finite useful life, such as patents or copyrights. Depreciation, conversely, refers to the systematic expensing of tangible assets, like buildings or machinery, over their useful lives. Both methods aim to allocate the cost of an asset over the periods it benefits.

Can goodwill still be amortized for tax purposes?

Yes, in some jurisdictions, goodwill and certain other intangible assets acquired in a business transaction can be amortized for tax purposes, even if they are not amortized for financial reporting. In the U.S., Section 197 of the Internal Revenue Code generally allows for the amortization of acquired goodwill over 15 years. This difference can lead to variations between a company's financial accounting income and its taxable income.