What does 'goodwill' represent?

John W. Schoen Senior Producer • Profile • E-mail

Q: From time to time I see the term “goodwill” in reports. What is this? It seems to be whatever the CEO wants it to be to make the books balance. — Michael B.

A: That’s not a bad definition. Here’s a more “official” one: goodwill represents (roughly) the market value of a company over and above the net worth of all of its hard assets minus its liabilities. That “intangible” value is supposed to come from things like a strong brand name, a lucrative patent, a uniquely strong market position, the outstanding productivity of its employees, etc. Those are all reasons investors pay more for a stock than what they’d get if the company were liquidated and the proceeds distributed to shareholders.

So goodwill is basically a fudge factor: while a company is usually “worth” more than its tangible assets (like real estate, equipment, investments, etc.) minus what it owes — the exact reasons can be tough to nail down. In order to account for that “extra worth” - and make the books balance — accountants came up with a catchall label in the assets column called “goodwill.” Over time, that fudge factor also came to be used to represent the premium paid in a takeover — the extra money paid by a company beyond what stock market investors said the target company was worth.

Last year, the Financial Accounting Standards Board, the accounting industry’s rule makers, finally decided that the use of goodwill had gotten out of hand. The board ordered companies to “test” the value of goodwill every year, and “mark it down” if they could no longer justify it. That’s why a company like AOL Time Warner, which merged in at the peak of the dot-com bubble when AOL’s stock was hyperinflated, recently took a charge of over $50 billion. The charge was really an admission that the company’s accountants had been playing with funny money all along.

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