Importance of goodwill

Goodwill is a non-cash item, so there is a strong case for simply saying it does not matter and investors are usually well advised to ignore it, so why not simply eliminate it from the balance sheet?

There are two simple alternatives to goodwill:

  1. simply to subtract the amount by which the price paid for an acquisition exceeds its book value, or,
  2. Deduct the excess from the balance sheet without passing it through the P & L.

Neither of these is really satisfactory. The first creates an immediate loss on almost every acquisition, however successful it may prove to be. It also makes no attempt to match the cost of an acquisition to its benefits, entirely ignoring the accrual principle.

Deducting from the balance sheet without passing it through the P & L makes the cost of an acquisition far too low profile. A significant cost should have a proportionate effect on the profit numbers, especially if the expenditure turns out to be wasted or excessive.

By keeping the goodwill on the balance sheet, management are under-pressure to acknowledge mistakes by writing-down the goodwill. Even if this does not happen, the goodwill on the balance sheet lowers some rate of return calculations (those that include goodwill) and the cost of past acquisitions is shown in the current balance sheet.

Conversely, this also stops companies improving apparent rates of return by making acquisitions that have high returns on assets.

Including goodwill in returns calculations does not tell you how well a company is doing now, neither does deducting goodwill impairments from profits. It does tell you how good past decisions to make acquisitions have been. It may even be worth adding back impaired goodwill when using metrics designed to measure returns in this way, such as ROIC.