Final answer:
Goodwill is the term used when a company's purchase price is higher than the fair value of the net assets acquired. It includes unidentifiable intangible assets like a company's brand, customer base, or proprietary technology. Goodwill is recorded as an intangible asset on the balance sheet and is tested annually for impairment.
Step-by-step explanation:
When a company purchases another company and the purchase price is greater than the fair value of the net assets acquired, this excess is referred to as goodwill. Goodwill is an intangible asset that arises when a buyer acquires an existing business. It represents the value of the company's brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology. Goodwill is not amortized but is tested annually for impairment. If an impairment is found, the value of goodwill must be written down.
Goodwill only occurs in cases where the purchase price is higher than the sum of the fair value of the identifiable net assets of the company being acquired. This situation can arise because these identifiable assets do not include certain intangible assets that have value, such as the reputation or intellectual property of the company, which can lead the purchasing company to pay a premium over the fair value of identified net assets. In the simplest terms, goodwill is the extra value that a company is willing to pay for a company over the value of its tangible and identifiable intangible assets.
For example, if Company A buys Company B for $1 million and the fair value of Company B's net assets is $800,000, the goodwill recorded on the acquisition would be $200,000. This $200,000 represents the potential for Company A to benefit from Company B's existing operations, brand, customer base, and potentially other benefits that are not recognized as separate identifiable assets. It is this potential for future economic benefits that makes goodwill an asset on Company A's balance sheet after the acquisition.