Goodwill on the Balance Sheet
Analyzing a Balance Sheet
In your journey to analyze financial statements, you will need to understand the meaning of goodwill on the balance sheet. Goodwill is an accounting term that stems from purchase accounting. The topic can get complex but you'll gain a decent grasp of the basics of the subject so that you have an idea of what you're seeing when you spot goodwill in a Form 10-K or annual report.
Under GAAP accounting rules, goodwill on the balance sheet represents the premium for buying a business for a higher price than that supported by the identifiable assets of that business. When one company buys another, the amount it pays is called the purchase price.
Accountants take the purchase price and subtract it from the company's book value with some other purchase accounting adjustments, such as assigning a certain value to the firm's client relationships and mailing list.
Whatever value or part of the purchase price that cannot be allocated to a tangible asset gets added to an account called goodwill. If companies have intangible value in patents, trademarks or brand-name equity, this often supports the value of the goodwill number.
In past generations, and especially among smaller entrepreneurs, this was also known as "blue sky," to signify what you paid for a business beyond its inventory, building, fixtures, and cash.
Different Accounting Methods
Goodwill has undergone a transformation over the past generation. When a company bought another company, it used to have the option of choosing one of two accounting methods: the pooling of interest method or the purchase method. When the pooling of interest method was used, the balance sheets of the two businesses were combined and no goodwill was created.
When the purchase method was used, the acquiring company put the premium it paid for the other company on its balance sheet under the goodwill asset account. The accounting rules in place at that time required goodwill to be written off over 40 years, much in the same way depreciation and amortization is expensed.
Goodwill Is No Longer Amortized on the Income Statement
These days, that isn't the case. Major lobbying was undertaken by certain parties who felt that writing off goodwill had the effect of distorting economic reality and making earnings appear worse than they really were. Many see the change to no longer amortizing goodwill as a more rational accounting philosophy. Goodwill now remains on the balance sheet as an asset, with no annual write-offs, unless it is deemed to be impaired.
Goodwill impairment testing is complex, and can involve things such as performing a discounted cash flow analysis of expected cash flows from patents, for example, but the idea behind the new goodwill treatment is that the value of an ongoing business, a solid business with a lot of franchise value, rarely declines and, in fact, grows.
As an example of the past goodwill treatment, consider The Hershey Company, which has made generations of investors wealthy. When Hershey bought Reese's in June 1963, Reese's had sales of $14,000,000 per annum. Hershey paid $23,300,000 for the transaction. Today, Reese's peanut butter cups alone produce more than $500,000,000 in annual sales.
With the scope and integration of Hershey, it has all kinds of economies of scale it didn't otherwise have, a development that allowed for higher returns on capital. Far from being impaired, the real economic goodwill, which doesn't show up anywhere on the balance sheet, is now exponentially higher than it was at the time of the acquisition. Due to the old accounting rules, though, Hershey doesn't carry any goodwill for Reese's on the balance sheet.
As a value investor, the loss of the goodwill write-offs would be upsetting because companies that had engaged in large acquisitions under the old method tended to have artificially depressed earnings per share. This caused the reported net income applicable to common to be significantly understated relative to owner earnings.
Combined with certain quirks in the treatment of accounting in specific sectors and industries, such as pharmaceuticals, you were confronted with a strange situation in which the actual earning power was materially above the reported earnings, making the shares look much more expensive than they were. It wasn't an accident that these forces played a role in the sectors and industries that produced the greatest investment opportunities of the past century.