–Warren Buffett<\/a><\/p>\n\n\n\n Goodwill is controversial; many companies make up most of their assets with goodwill. Take, for example, the recent Amazon purchase of Whole Foods in 2017. Amazon paid $13.7 billion for the grocer, worth $9 billion more than the value of Whole Foods and its other net asset.<\/p>\n\n\n\n The issue is the $9 billion Amazon added to its assets as goodwill. By accounting rules, Amazon expects to evaluate or test that $9 billion yearly for any impairments or see if the value still holds. If they find a change in value, the impairment reduces the profits of Amazon.<\/p>\n\n\n\n All of the above remains perfectly legal, and there is no shadiness to the accounting. Still, companies can “pay” for purchases with intangible assets such as goodwill, putting the profits and shareholders at possible risk.<\/p>\n\n\n\n The valuation of goodwill remains a process that any purchase undergoes to determine the value of the assets and intangibles of that business. Understanding that process helps us understand any purchase and the possible ramifications, not only today, but in the future as well.<\/p>\n\n\n\n In today’s post, we will learn:<\/p>\n\n\n\n Ok, let’s dive in and learn more about goodwill valuation.<\/p>\n\n\n\n Goodwill, as defined by Investopedia<\/a>:<\/p>\n\n\n\n “Goodwill is an intangible asset for a company. It comes in various forms, including reputation, brand, domain names, intellectual property, and commercial secrets<\/em>.”<\/p>\n\n\n <\/p>\n\n\n\n The construct of goodwill comes into play when one company, such as Amazon, is contemplating purchasing another, such as Whole Foods.<\/p>\n\n\n\n Goodwill enters the picture when the other company pays significantly higher prices than its net assets’ fair market value of the purchased company.<\/p>\n\n\n\n\n\n\n\n The elements that make up the intangible assets of goodwill consist of the company’s good reputation, a loyal customer base, brand identity or recognition, a talented workforce, and proprietary technology.<\/p>\n\n\n\n Of course, these items are extremely valuable assets of any company, but they are not tangible or physical assets, and therein lies the problem. The intangible nature of those assets makes them difficult to value precisely.<\/p>\n\n\n\n The idea of goodwill goes back time, at least a century, and one of the first recorded definitions comes from 1907, in Halsbury’s Laws of England<\/em>:<\/a><\/p>\n\n\n\n “The <\/em>goodwill<\/em><\/strong> of a business is the whole advantage of the reputation and connection with customers together with the circumstances, whether of habit or otherwise, which tend to make that connection permanent<\/em>.”<\/p>\n\n\n\n In the next sections, we will uncover more about goodwill accounting.<\/p>\n\n\n\n But first, here is another example of goodwill and its impact on a balance sheet.<\/p>\n\n\n\n In 2010, Facebook purchased the domain name fb.com for $8.5 million from the American Farm Bureau Federation. A domain’s name remains the sole value, or in this case, the initials.<\/p>\n\n\n\n The total Facebook paid for the domain name “Facebook” could recognize on its balance sheet as goodwill. But, before the transaction, the American Farm Bureau Federation didn’t recognize fb.com on its balance sheet as goodwill.<\/p>\n\n\n\n The trick here is Facebook paid $8.5 million for a series of initials. this was chump change for Facebook, but the bigger issue remains: instead of expensing the purchase and reducing earnings, the purchase adds to Facebook’s balance sheet as an asset.<\/p>\n\n\n\n Goodwill is sometimes mistakenly categorized as economic, business, goodwill, and goodwill in accounting.<\/p>\n\n\n <\/p>\n\n\n\n Most refer to “accounting goodwill” as just recognizing the company’s accounting of “economic goodwill.”<\/p>\n\n\n\n Accounting goodwill defines an intangible asset created when one company purchases another for a price higher than the target company’s established fair market value.<\/p>\n\n\n\n Referring to the intangible asset as “created” is a bit misleading; creating an actual accounting journal entry, but that intangible asset already exists.<\/p>\n\n\n\n The entry of goodwill in the balance sheet as an asset is not genuinely creating an asset but merely recognizing the asset’s existence.<\/p>\n\n\n\n Economic, or business, goodwill remains an intangible asset, as previously defined, for example, Nike or McDonald’s strong brand identity. Those strong brand identities offer both companies a competitive advantage in their markets.<\/p>\n\n\n\n Addressing this intangible asset’s existence and estimating its value are often deduced from examining Nike’s return on assets ratio.<\/p>\n\n\n\n\n
What is Goodwill?<\/h2>\n\n\n\n
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<\/figure><\/div>\n\n\nAccounting vs. Economic Goodwill<\/h2>\n\n\n\n
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