There are several costs you incur when you acquire another company. You assume not only the target company's assets, but also its liabilities. Additionally, if you pay above the fair value price the transaction creates an intangible asset called goodwill. Intangible assets could also be patents and licenses with finite lives. At one time accounting rules permitted the amortization of all intangible assets. However, recent changes have eliminated the amortization of goodwill and similar intangible assets.
Goodwill and Intangible Assets
Goodwill and intangible assets represent a significant portion of many business acquisitions. Typically, the purchasing company records goodwill as an asset when it pays above the fair market value of the acquired company's net worth. Like other intangibles such as a patents and licenses, goodwill is an intangible asset. However, unlike a patent, goodwill has an indefinite life. Typically, you may carry goodwill and other intangible assets on your balance sheet.
Accounting Standards Codification 805
Accounting Standards Codification (ASC) 805 and ASC 350 address business combinations, goodwill and intangible assets. In essence, ASC requires all parties to the business combination to estimate the fair market value of the acquired company’s assets, categorizing intangible assets by type such as customer lists, trademarks, patents, intellectual property and software. Secondly, the acquiring company must separate intangible assets into those with identifiable useful lives, such as patents and trademarks, from intangible assets with indefinite useful lives, such as goodwill. ASC 805, which replaced Statements of Accounting Standards (SFAS) 141, requires companies to expense acquisition-related costs such as legal, investment banking and accounting fees rather than capitalize these costs.
Amortization of Goodwill
Under ASC 350 (formerly SFAS 142), intangible assets classified as having an indefinite useful life such as goodwill are subject to a two-step test for impairment. Companies must conduct an annual test for the impairment value of goodwill. Prior to this, SFAS allowed companies to amortize goodwill over its useful life up to 40 years. The new two-step process requires that a company first identify potential impairment and secondly compare the implied fair value goodwill with its carrying amount. Goodwill is not impaired so long as its fair market value is greater than its carrying value. Companies must perform a Transitional Impairment Test within six months of an acquisition using approved valuation methodologies. If there is impairment, the company must record a loss by year-end.
Amortization of Intangible Assets
Accounting rules allow for the amortization of intangible assets with useful lives such as patents. In this case, you record a patent as an asset and capitalize the cost each year over its useful life. As the patent nears expiration, it becomes worthless or zero, which justifies amortizing the cost over time.
In general, you must expense acquisition-related costs, with the main exceptions being intangible assets such as goodwill. If the intangible asset has a finite useful life, you should amortize rather than expense the cost. However, intangible assets with an unidentified useful life are subject to an impairment test. If impaired, you must remove them from your balance sheet and record the loss. Having an accountant assist with the valuation of business acquisition or using a business appraisal service protects you from overpaying in an acquisition. However, the process of acquiring another business is both an art and a science, as it involves qualitative and quantitative factors for deriving a “fair” purchase price.