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The balance sheet being a major financial statement of a business draws a firm's financial standing at a specific point in time. Therefore, it is a snapshot of what is owned by a company and to whom does it owes. Items in a balance sheet are reported into three components which are: assets, liabilities and equity. Balance sheet also sums up the popular accounting equation that is:
Assets = Liabilities + Equity.
Thus, balance sheet should always have the value of assets equal to the value of the sum of liabilities and equity of a business. While scrutinizing a business and assessing its worth it is of almost importance to get a thorough and detailed understanding of the particulars recorded in the balance sheet and how are they measured . In the balance sheet, assets denotes the resources of a business that it has attained over a time and which have some economic value. Companies usually acquire assets through investing activities, operating activities or financing activities. Liquidity refers to the concept of how fast can an asset be converted into cash. Therefore, assets in a balance sheet are listed according to the order of liquidity. The category of assets section is divided in to two sub-categories namely, current assets and non-current assets. Currents Assets are those assets which are predicted to stay with the business for more than twelve months. Both current and non current assets belong to the tangible form of assets. This also, infers that the assets that are recorded in the balance sheet or any other financial statement are actually tangible asset that are those assets which have some physical form and value where as the assets that can not be evaluated and seen physically are called intangible assets. Such assets as intangible assets can not be recorded in any financial statement, particularly not in the balance sheet.
Goodwill of a company falls under the heading of an intangible asset and thus, it is not recorded in the books of the companies as it is defined in terms of the positive reputation of a firm that does not have a physical existence, but is of utmost importance for a business. Patents, copyrights, and trademarks are also other examples of intangible assets which are not recorded in the balance sheet.
Good customer relations, a strong brand name, good employee relations, any patents or propriety technology may define goodwill of a business. Goodwill usually have no liquidation value and is a non-tax-deductible asset. It can be obtained by designing a suitable and positive advertisement campaign, through creating a new/advanced product with the help of extensive market research and management skills. Goodwill can be assessed by taking out the difference between the actual market value of the assets and the 'asking price' of those assets. In the book, "Introduction to Financial Accounting" Horngren and Gary L. Sundem states, "the ability to command a premium price for the total business is goodwill."
At times, brand names, good location of a company, customer lists, business's reputation, operating methods , knowledge of new technology and special skills might fall under the criteria of goodwill. Although these factors do not enjoy the perks of a physical existence and monetary value, they still add great value to the business. During the sale out of a business goodwill persuades a buyer that the firm will yield high profit in the future. According to standard accounting procedures, goodwill should be amortized (written off) over the time period in use. During the instances of a buy-out of a company, the purchaser should amortize this particular intangible asset, using the Straight Line Method over a time span of 15 years.
When a business acquires an intangible asset, it not only pays the actual price of an asset but also the price of its goodwill / brand name and all the costs that are incurred for its acquisition. According to the accounting standard of SFAS 141, an intangible asset should be identified as an asset excluding any goodwill if it is originating from any contractual or other legal rights, if not, then it can be taken as an asset only if it can be separated from goodwill and can be transferred, rented, sold, and exchanged. Noncompetition agreements, customer lists, trademarks, Internet domain names, advertising contracts, use rights, employment contracts, secret formulas, construction permits, patented and unpatented technologies are all examples of intangible assets according to appendix A to SFAS 141.
SFAS 142 has introduced a major change in the treatment of all intangible assets, it has eliminated the amortization of goodwill and instead the SFAS 142 demands businesses to conduct annual or interim tests for impairment of goodwill. The test comprises of two steps, initially the fair value of a reporting unit is compared to the carrying amount, including goodwill previously recognized, then the implied fair value of the reporting unit's goodwill is compared to the carrying amount of the goodwill, if the fair value is lower, it is thought to be impaired. Dealing for other intangibles is quite straightforward, if other pattern is determined then SFAS 142 allows the Straight Line Method.
Despite of these two accounting standards some accountants argue that the recording of internally generated goodwill should be carried out at fair market value. But taking the required action will result in exuberant costs for the businesses. The treatment of goodwill has been subjected critically for some years. Firstly because the goodwill consists of a substantial chunk of a business's acquisition price, especially in the case of a public corporation, the goodwill amortization can have less favorable impact on the net income of the buyer. Secondly, the handling of goodwill is different under U.S. laws than that of other countries, therefore, putting American companies under a disadvantage in international mergers.
The concept of goodwill enjoys an abstract nature and is difficult to interpret. It is usually taken as an accounting filler or a paper entry. But goodwill depicts actual resources utilized during an acquisition, its impairment shows real costs that might be misused at the time of a merger.