On The Importance of Goodwill
Information in financial markets evolves over time. Items that were historically not meaningful may take on a first-order level of relevance as firms change and disclosure improves. Historically, goodwill accounted for only a small fraction of most companies’ book equity, so many investors felt comfortable overlooking it. We believe that investors can no longer afford to ignore goodwill because more companies today carry goodwill, and its size relative to book equity is meaningful. In this paper, we discuss the evolution of goodwill and its impact on investment decisions and performance.
What Is Goodwill?
Under current accounting rules, when one firm acquires another, the difference between the purchase price and the fair value of the net identifiable assets of the target firm is included as goodwill in the acquiror’s accounting statements. This goodwill is recorded as an asset for the acquiror and incorporated into the book value of equity.
Historical Accounting Treatment of Goodwill
Before 2001, firms engaged in acquisitions could choose between the pooling-of-interests method or purchase method to consolidate assets. Under the pooling method, assets and liabilities of the target firm are transferred to the acquiror at book value and no goodwill is recorded. Under the purchase method, the difference between the purchase price and book value of the target firm is recorded as goodwill. Financial Accounting Standards Board (FASB) Statement 141 ended the pooling method effective June 30, 2001.
Goodwill is often regarded as the most important intangible asset on a firm’s balance sheet. The Accounting Principles Board (APB) Opinion No. 17, issued in 1970, required goodwill to be properly recorded and then amortized over its life (for historical details about APB 17, see Andrews, 1981, 37-49). In 1995, the Statement of Financial Accounting Standards (SFAS) 121 added more precision to the recognition and amortization guidance but retained the amortization rule. The most significant change to goodwill accounting took place in 2001 with issuance of SFAS 142. Under SFAS 142, instead of amortizing goodwill, firms were required to conduct an annual impairment test: If the fair value of the assets is lower than the carrying value, the firm is required to take an impairment charge.
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This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
The opinions expressed are those of the investment portfolio team and are no guarantee of the future performance of any Avantis Investors portfolio. This information is not intended as a personalized recommendation or fiduciary advice and should not be relied upon for investment, accounting, legal or tax advice. References to specific securities are for illustrative purposes only and are not intended as recommendations to purchase or sell securities.
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