Welcome, in the last video,
we discussed the concept of goodwill,
and we saw that it does present some challenges
to accountants since we're buying a whole bunch
of items in a bundle and we're going to have to
figure out how to put value on each one of those items.
In this video, I'm going to do the bookkeeping for goodwill.
Hopefully as we work through the bookkeeping,
it will clarify what goodwill actually represents a little more for you.
Now, to do this I'm going to use an example.
Imagine that company A buys company B,
the owners of company A give a 100,000 of cash to the owner of company B.
They get assets with a fair value of $80,000.
By fair value what I mean is they go out and they identify each of these assets,
and say, "What would it cost if I bought
each one of these assets individually on the market?"
Now, company B's books actually had these with a book value of $57,000,
but we don't really care what they had it on their books for.
What we're trying to figure out is if we purchased each one of these items individually,
what would it have cost us?
That's the $80,000.
Company A also agreed to pay off the remaining debts of company B.
Those had a book value of $13,000,
but in today's market it would cost about $15,000 to satisfy those liabilities.
The question becomes how does Company A account for this transaction?
Well, if you look in the accounting standards,
they'll tell you the first thing to do is calculate goodwill,
and they'll tell you to calculate it this way.
First, you list the cash consideration you gave up, the $100,000.
Then you go out and you identify
the fair value of all the assets that you got, the $80,000.
You then net that against the fair value of the liabilities you're taken on,
the 15,000 to come up with a net identifiable asset number of $65,000.
That's the net value that you think you're getting,
and by net we mean net of the liabilities that you are paying off.
You then compare that net value to the a 100,000 cash consideration you gave up and say,
"There's $35,000 more that I gave up in
cash than net I think I'm getting so goodwill must be 35,000."
Did that seem confusing?
I have to admit it's always seem confusing to me when it's laid out this way.
Here's a way that I think is much more
intuitive to think about it and come to the same number.
Let's start with the cash consideration just like they did.
You gave up a $100,000 of cash,
but let's add to that the other consideration you're giving up.
That's the $15,000 of liabilities you've taken on.
That's value that you're going to give up in
the future for the right of having had this company.
That means in total,
you've given up a $115,000 worth of value.
Now, this is actually what you've paid for the company.
At this point, students often stop me and say,
"No, that's not right.
We've only paid a 100,000 because that's the cash."
But I want you to think about the fact that what you
pay is actually the total value you're giving up.
A 100,000 of cash today and a value
of $15,000 today for cash you're going to have to give up in the future.
If this still doesn't seem right to you, think of it this way,
what if we're giving up the a $100,000 of cash today,
and that 15,000 we're going to pay one day later.
If I asked you how much did we pay then you'd say 115,000.
Well, what if it's not one day?
What if it's two days?
Or seven days later?
You still would say, "Yeah that's 115,000."
Now, we can keep extending that out and at any point
adding just one more day doesn't seem to make the big difference.
Now, I do want to remind you this $15,000 is the fair value as of the transaction day.
It's taken into account present value.
So, you may be paying $30,000 in two or three years,
but as we discount that back, we say, well,
today that's the equivalent of $15,000.
In any case, the point is,
you've given up a $115,000 of value to get this new company.
What did you get in return?
Well, you can identify $80,000.
Those are the things that your accountant can go through and say "Yes,
from an accounting standpoint I can see that these are assets."
So, now we compare the 115,000 of value you gave
up to the 80,000 we can identify that you got,
and we say, "Well, there's another 35,000."
That's the excess that you paid beyond what
your accountant can identify as an accounting asset,
and we call that goodwill.
Maybe an even clearer way to do this is with the journal entries.
So, what we're going to do is we're going to compute and
record the difference between what we got and what we gave up.
This is no different than any other journal entry that you've done
when we purchase something like equipment or inventory.
So, the first thing we do is list everything we're giving up.
We no longer have that cash 100,000,
so we're going to credit that.
We also have taken on future obligations of 15,000.
Those are identifiable liabilities.
Then what did we get?
Well, we have identifiable assets that our accountant can see and count and say,
"Yes, these have value of $80,000."
Now, when we put this together,
we can see from the journal entry we have a problem.
Our total credits everything we gave up is a 115,000,
but our total debits are only 80,000.
We know that we need another $35,000 debit.
Those are the non-identifiable assets.
The things that we believe had value when we did this transaction.
If we go back to our restaurant example,
it would be the extra value of our restaurant from owning our own vineyard.
But the accountants can't identify through those accounting definitions.
Now, another way to think of this is,
this is a plug to get the debits equal the credits.
Because we wouldn't have paid more for this company than we think it's worth.
There's some sort of asset that we have
there our accountants just can't put a name to it.
Now, about now you're thinking "Wait a minute.
I've never seen the word non-identifiable assets on a balance sheet anywhere."
Well, that's true because accountants
decided non-identifiable assets wasn't a great name.
It sounds a lot better to say it's goodwill,
and so, they do the same journal entry.
Just instead of saying non-identifiable assets, they say goodwill.
Now that we've put it on our books,
you're probably asking yourself,
"Okay, I see where it comes from,
it's just the difference between what the accountant can identify
we gave up and what the accountant can identify that we got.
But what really is this goodwill?"
Well, it's things of value that accounting can't identify.
It could be the extra value of a brand name, synergies.
Perhaps it's getting a workforce that's
really well-trained and will help push your company forward.
None of these things meet the definition of an asset under accounting,
but you can still see where they have a lot of value in a business.
Now, of course, there is another potential answer.
Which is that we overpaid.
That when we acquired this company,
we got really excited about it or we overvalued some assets,
and really we've just paid more than we should have.
That brings us to the next question which is,
okay, then how do you use up goodwill?
Now, this is a really difficult question to answer
because since accounting can't even identify what it is that's making up the goodwill,
how can accountants figure out how it's used up?
Because of this, the current US rule say,
you're just going to assess it once a year to
determine whether the value has been impaired.
You're not going to try to do some sort of
systematic allocation like we did with all those other long lived assets.
The basic idea here is that it's like any other asset.
So, we're just going to look at it each year and see whether it's been impaired.
That is, does it still have
probable future value at least equal to what we put it on our books for?
If it does, then it hasn't been impaired and there's no charge.
If it doesn't, we will have to take an impairment charge.
The actual computations to do that are very technical and follow multiple steps.
We're not going to get into them.
Now, since I've brought up impairments,
in the next video,
I will talk to you a little more about what an impairment is and what that means.