Purchased Goodwill: Calculation, Accounting, and Tax

Purchased goodwill is an intangible asset that arises during a business acquisition, representing the premium paid over the fair market value of an acquired company’s identifiable assets and liabilities. This value captures non-physical attributes such as brand reputation, a loyal customer base, and proprietary technology. It is the monetary worth of the factors that allow a business to generate superior earnings. This asset is unique because it is not created internally or purchased on its own; it only comes into existence as part of a business combination.

Calculating Purchased Goodwill

Purchased goodwill is calculated by taking the total purchase price for an acquisition and subtracting the fair market value (FMV) of the net identifiable assets acquired. The purchase price is the total consideration transferred to the seller, which includes cash paid, the fair value of any stock issued, and the present value of any deferred or contingent payments. Net identifiable assets are the aggregate FMV of all assets acquired, such as inventory and property, less the FMV of all liabilities assumed, like debt.

For a practical example, consider Company A acquiring Company B for a total price of $2 million. After a detailed analysis, the fair market value of Company B’s assets is determined to be $1.5 million, and the fair market value of its liabilities is $300,000. The net identifiable assets are therefore $1.2 million ($1,500,000 – $300,000).

The purchased goodwill is then calculated as the purchase price minus these net assets. In this case, the goodwill would be $800,000 ($2,000,000 – $1,200,000), which Company A would record on its balance sheet.

Accounting Treatment and Reporting

Once calculated, purchased goodwill is recorded as a non-current, intangible asset on the acquirer’s balance sheet. Its subsequent accounting treatment under U.S. Generally Accepted Accounting Principles (GAAP) depends on whether the acquiring entity is public or private.

For public companies, goodwill is not amortized. Instead, it must be tested for impairment at least annually. An impairment loss occurs when the carrying amount of the goodwill on the balance sheet exceeds its fair value. If an impairment is identified, the company must write down the goodwill asset, which results in a loss being recognized on the income statement.

Private companies are offered an alternative to the annual impairment test. They can elect to amortize goodwill on a straight-line basis for a period not to exceed 10 years. This option was introduced to reduce the complexity and cost associated with performing annual impairment evaluations. If a private company chooses this accounting policy, it must apply it consistently. The notes to the financial statements will provide additional detail on the amount of goodwill and the accounting policy being used.

Tax Treatment of Purchased Goodwill

The tax treatment of purchased goodwill is governed by Section 197 of the Internal Revenue Code and is distinct from its accounting treatment. For federal income tax purposes, the rules are uniform for all types of businesses, whether public or private.

Under Section 197, the cost of purchased goodwill must be amortized on a straight-line basis over a fixed period of 15 years. This amortization begins in the month the goodwill is acquired. The 15-year life applies regardless of the asset’s actual expected useful life or the amortization period used for financial reporting under GAAP.

This tax-deductible amortization provides a benefit to the acquiring company by reducing its taxable income over the 15-year span. The structure of the acquisition, specifically whether it is treated as an asset sale or a stock sale for tax purposes, determines if the goodwill is tax-deductible. In transactions structured as asset sales, the buyer can create new, tax-deductible goodwill.

Both the buyer and seller in an asset acquisition must file Form 8594, Asset Acquisition Statement, with the IRS. This form reports the allocation of the purchase price among the various asset classes, including goodwill.