How can you calculate goodwill of a company?

Answer 1

Business Combination and Goodwill Business combination are events or transactions in which two or more business enterprise or their net assets, are brought under common control as a single accounting entity. The term "Mergers and Acquisitions" are also referred to as business combination. Product diversification and integration are two of the more common reasons for business combinations. Diversification refers to the production or sale of many different products, while integration means production or sale of the same product. Integration may be horizontal,i.e, combining two companies selling the same product, or vertical, i.e, two businesses engaged in different of production or distribution of a common product. Diversification and integration can be accomplished by internal growth, but external acquisitions result in faster accomplishment of goals. ---- Accounting for business combination is a very complex and controversial issue but extremely important due to the magnitudes of transactions involved.A business combination is handled in either of the two basic ways: 1) as a Pooling of interest or 2) as a purchase. Pooling of Interest Method In this method, the consolidated balance sheet is constructed by simply adding together the balance sheets of the combined companies. In essence, the concept of a pooling of interest is that nothing of real economic substance has occurred in the combination. All the previous shareholders remain as shareholders, the assets of the combined companies are same as before. Canadian accounting requirements are such that the pooling of interests method is rarely used, but it is fairly common in the United States. There are two conditions to be met before the pooling of interest method may be used: # The transaction must be accomplished by an exchange of voting shares, and # It must be impossible to identify one of the combining firms as the acquirer. Purchase method The purchase method is based on the assumption that a business combination is a transaction in which one entity acquires the net assets of other combining companies. The acquiring company records net assets received at fair value at the date of combination. Any excess of cost over the fair value of net assets acquired is allocated to goodwill and amortized over a maximum period of 40 years. Comparison of the two methodsWhen business interest of two companies are combined under this method, there is no recording of goodwill. Under the purchase method, goodwill is recorded as a result of purchase of a going concern, if the purchase cost is greater or less than the fair value of net tangible and identifiable intangible assets acquired. The goodwill has to be amortized over the years and is a non-tax deductable expense. As a result, the earnings of the new entity reduces and lower earnings are recorded per share. For example, when Philip Morris acquired Kraft Inc. for $12.9 billion in 1988, the fair value of the Krafts assets was only $1.3 billion. The difference , a staggering $11.6 billion, or 90% of the purchase price was goodwill. Philip Morris has to amortize this amount in 40 years, deducting $290 million a year from earnings - about $1.25 a share. In the pooling of interest method, there is no goodwill and thus no amortization expense is involved resulting in higher EPS. Also, there is no uncertainties in determining the purchase price under the pooling of interest method. ---- Accounting Methods For Goodwill The three qualitative characteristics most directly concerned with goodwill are reliability, prudence (not deliberate understatement) and consistency. Although much has been written on the problem of accounting for goodwill during the past century, a solution remains elusive. The treatment of goodwill has changed over the years. The four different methods of accounting for goodwill are discussed in the following paragraphs. 1. Write-off Under this method, goodwill is immediately written off against an account in the stockholders' equity section, generally retained earnings. Advocates of this method argue that goodwill is not measurable and has no true future value. Thus, it should be written off against stockholders' equity. Another rationale for this method is that overpayment for the assets of an acquired company represents the expectation of superior future earnings. Since these earnings eventually endup in the stockholders' equity, they can be offset against the excess acquisition payment. Writing off goodwill immediately can lead to distorted results when tangible assets are undervalued allowing goodwill to be overstated. Even though there are some good arguments for write-off method, it appears that it was used because it was the easiest and most widely used and not because it was conceptually correct. 2. Capitalization This approach's proponents argue that if goodwill is as important as asset as many beleive, it belongs on the balance sheet. One problem with capitalization of goodwill is determining the proper amount to capitalize. Current practice follows the residuum approach. One way of correcting the misuse of goodwill is through the hidden assets approach. Under this approach, the excess purchase price that companies pay over fair market value of the assets is for assets that are hidden from the balance sheet. Hidden assets should be identified and recorded on the balance sheet, then amortized over their useful life. If they were, goodwill account would probably be much smaller than in current practice and financial statements would probably be more useful. 3. Non-AmortizationCapitalization of goodwill without amortization allows the most advantageous financial reporting figures. A company gets to record an asset instead of a decrease in stockholders' equity and net income is not periodically reduced. However, it probably would result in more abuse than any other method. The rationale for non-amortization is premised on the notion that goodwill does not decrease in value. High managerial ability, good name and reputation, and excellent staff generally do not decrease in value but they increase in value. Goodwill could be viewed as an investment and should stay on the balance sheet unamortized. But, without amortization, abuse may occur, and the goodwill account will lose what limited significance it has now. 4. Amortization Amortization enables companies to match the cost of intangible assets over the period deemed to benefit from their acquisition. Main arguments for amortization are the abuse of non-amortization and the unreliability of earnings without some attempt to recognize the impact. When amortization became required, the period for write-off became the focus. If the life of the asset is non determinable, which is normally the case with goodwill, amortization over a maximum of forty years should be used. This lengthy period was set to allow a minimum impact to the net income.

Answer 2

Goodwill is calculated retroactively when a company is sold, buys another company, or merges with another company. The goodwill is the difference between the purchase price of the company and the book value of the company described by its financial statements. When a large company acquires other smaller companies, the extra money that the larger company paid for the smaller company becomes the larger company's goodwill (since their assets are merged together). Goodwill can also be estimated by looking at market capitalization, license fees for the brand name/franchise, but these methods are inconsistent with GAAP and therefore are not used in formal financial statements. In practice, goodwill is recorded only when an entire business is sold or merged, in order to comply with GAAP.

Answer 3

A court has characterized this type of capitalization as "capitalization of excess earnings." Dugan v. Dugan, 92 N.J. 423 (1983).

To calculate goodwill by capitalization method under Dugan ask the following:

1. How much does the business or practice earn beyond that earned by others similarly situated -- in experience, expertise e.t.c. E.g. how much more does a dentist in Queens earn, compared to other Dentist in Queens -- say 100k a year compared to 40k a year.

2. Then calculate the average net income for 5 years

3. Adjust average net income for return on physical assets.

4. How much does average net income exceed similarly situated business (see 1 above)?

5. Multiply the excess amount by capitalization factor, which is perceived as the number of years another is willing to pay for the excess income -- between 0 and 5.

Obviously I doubt lawyer's understand the calculation part as well as Accountants, but this case represents the general idea.