Amortization & Goodwill in Accounting

The term Amortization is used to describe the write-off to expense of the cost of an intangible asset over its useful life. The usual accounting entry for amortization consists of a debit to Amortization Expense and a credit to the intangible asset account.

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Although it is difficult to estimate the useful life of an intangible such as a trademark, it is highly probable that such an asset will not contribute to future earnings on a permanent basis. The cost of the intangible asset should, therefore, be deducted from revenue during the years in which it may be expected to aid in producing revenue. Under the current rules of the Financial Accounting Standards Board, the maximum period for amortization of an intangible asset cannot exceed more than 40 years. The straight-line method normally is used for amortizing intangible assets.

Goodwill

Business executives used the term Goodwill in a variety of  meanings before it became part of accounting terminology. One of the most common meanings of goodwill in a non accounting sense concerns the benefits derived from a favorable reputation among customers. To accountants, however, goodwill has a very specific meaning not necessarily limited to customer relations. It means the present value of future earnings in excess of the normal return on net identifiable assets. Above-average earnings may arise not only from favorable customer relations but also from such factors as superior management, manufacturing efficiency, and weak competition.

The phrase normal return on net identifiable assets requires explanation. 'Net assets' means the owners' equity in a business, or assets minus liabilities. Goodwill, however, is not an identifiable asset. The existence of goodwill is implied by the ability of a business to earn an above-average return; however, the cause and precise dollar value of goodwill are largely matters of personal opinion. Therefore, net identifiable assets mean all assets except goodwill, minus liabilities. A normal return on net identifiable assets is the rate of return which investors demand in a particular industry to justify their buying a business at the fair market value of its net identifiable assets. A business has goodwill when investors will pay a higher price because the business earns more than the normal rate of return.

Recording Goodwill in the Accounting Records

Goodwill is recorded in the accounting records only when it is purchased; this situation usually occurs only' when a going business is purchased in its entirety. After the fair market values of all identifiable assets have been recorded in the accounting records of the new owners, any additional amount paid for the business may properly be debited to an asset account entitled Goodwill. This intangible asset must then be amortized over a period not to exceed 40 years, although a much shorter amortization period is usually appropriate.

Many businesses have never purchased goodwill but have generated it internally through developing good customer relations, superior management, or other factors which result in above-average earnings. Because there is no objective means of determining the dollar value of goodwill unless the business is sold, internally developed goodwill is nol recorded in the accounting records. Thus, goodwill may be a very important asset of a successful business but may not even appear in the company's balance sheet.

Goodwill is perhaps the most misunderstood asset in financial accounting and reporting. A primary reason for this misunderstanding is that most discussions of goodwill fail to distinguish clearly between the definition and the measurement of goodwill. Goodwill consists of the favorable characteristics of a business enterprise that are intangible and that cannot be separately identified and valued. Examples of favorable characteristics that often comprise goodwill include the following:

• 1. Superior management team.
• 2. Outstanding sales manager or organization.
• 3. Weakness in the management of a competitor.
• 4. Effective advertising.
• 5. Secret manufacturing process.
• 6. Good labor relations.
• 7. Outstanding credit rating.
• 8. Top-flight training program for employees.
• 9. High standing in the community.
• 10. Unfavorable developments in operations of a competitor.
• 11. Favorable association with another company.
• 12. Strategic location.
• 13. Discovery of talents or resources.
• 14. Favorable tax conditions.
• 15. Favorable government regulation.

           Unlike inventory, property, and even specifically identifiable intangibles, such as patents and copyrights, the components of goodwill cannot be sold separately because they cannot exist apart from the company to which they belong. By increasing earning power, these components increase the value of the entity; they are, then, assets. We record goodwill as an asset, however, only when we can identify part of a company's acquisition cost with goodwill, A company may generate goodwill in its normal business operations, such as when it develops resources or gains a favorable image in the community. But to value this goodwill without a market transaction is so difficult, and the results are so subjective, that the company generating the goodwill cannot record it as an asset. Only by acquiring another entity may a company record goodwill as an asset.

Amortization of Goodwill

There are two schools of thought with respect to the amortization of goodwill:

(1) Since it has an indefinite life, it should not be written off unless there is Clear evidence that it no longer exists, In this case, a large amount could be deducted as a lump-sum write-off.

(2) Because goodwill is essentially the purchase of excess earnings for a limited time period, it should be amortized over that period.

While both arguments concur that goodwill should be written off or down at some point in time, the one for periodic amortization is more realistic since it prevents the distortion of asset and capital balances and presents excess earnings as a return on capital rather than income;"