Under Chapter 33: Intangible Assets

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Quiz T or F & Solving (add at least 1 question per person)

1.Goodwill can influence decisions like choosing between stores that sell similar products or choosing a
bank to entrust your money to. T
2. Under current accounting standards, goodwill can be recognized if it is internally generated. F
3. The measurement is known as the "direct approach" because goodwill is simply the residual after
deducting the fair value of net assets from the purchase price. F
4. An impairment loss on goodwill can be reversed if the recoverable amount increases in
future periods. F
5. The negative goodwill (NGW) amount, also known as the “gain on bargain purchase” amount T
6-10. ILY pare Co. purchases Abarico & Bernales Company for 13,000,000.

The assets and liabilities of purchased company measured at fair value are:

Cash 3,000,000

Accounts Receivable 10,000,000

Property, Plant, and Equipment 2,000,000

Accounts Payable 6,000,000

Unearned Revenue 1,000,000

Requirement: Determine the amount of goodwill (5,000,000)

Purchase Price 13,000,000

Net assets at FV (8,000,000)

Goodwill 5,000,000

1.​ What is goodwill? Discuss.

Goodwill is a key concept in business that represents the value of a company’s reputation and
other intangible factors that contribute to its ability to earn above-average profits. It arises when
a company's earnings surpass what is typical for its industry, due to factors like a good name,
skilled staff, strong financial standing, fair business practices, superior products or services, a
prime location, and a loyal customer base.

To explain this in simpler terms, consider two stores selling similar products or two banks
offering similar services. If one is known for having a great reputation, excellent customer
service, and a long history of reliability, customers are more likely to choose it, even if the other
store or bank offers comparable products. This extra value, driven by reputation and trust, is
what constitutes goodwill.

Goodwill is an intangible asset, meaning it does not have a physical presence like buildings or
machinery. It is, in fact, the most intangible of all intangible assets. While other intangible assets,
such as patents or trademarks, can be clearly identified and valued, goodwill cannot be directly
measured or separated from the business as a whole. It is tied to the entire entity, not a specific
asset or department, and is built over time through consistent positive experiences and a strong
public image.

Additionally, goodwill does not have a defined lifespan. Unlike tangible assets, which can
depreciate over time, the value of goodwill is indefinite, and its impact is woven into the ongoing
operations and overall image of the company. This makes it difficult to sell or transfer
independently from the business itself. Essentially, goodwill is the long-term value of the
company's reputation and how the public perceives its ability to deliver quality products or
services reliably.

In summary, goodwill is the sum of a company's intangible qualities that make it more valuable
than just its physical assets, and it is fundamentally tied to the company's image, reputation, and
overall success in the market.

2.​ When do we recognize goodwill as an intangible asset per definition of PAS 38?

The key point is that under the current accounting framework, goodwill is only recognized when
it is part of an acquisition, not when it is generated internally by the company itself. This change
aligns accounting practices with the principle that only actual transactions and purchases should
be recognized as assets, rather than intangible values that develop organically within a
company.

​ When recognizing goodwill, it is essential to differentiate between developed (or internal)

goodwill and purchased goodwill. Developed goodwill arises naturally within a company due to
factors like its strong reputation, skilled staff, high-quality products, favorable location, and good
credit standing. However, this type of goodwill is not recorded on the balance sheet because
measuring its value is subjective, difficult, and prone to misrepresentation. According to PAS 38,
developed goodwill should not be recognized as an asset. On the other hand, purchased
goodwill occurs when a company acquires another business. In this case, the buyer not only
acquires the tangible assets—such as property, equipment, and inventory—but also intangible
assets, including goodwill. Purchased goodwill is recognized as an asset because it represents
the actual cost paid for the acquisition of the business and reflects intangible qualities such as
brand recognition, customer loyalty, and management expertise, which contribute to the future
success of the company.

A company's overall value includes both tangible and intangible assets. The intangible assets,
like its brand and loyal customer base, play a significant role in its worth but cannot be
physically measured. When one company acquires another, it typically pays more than the book
value of the tangible assets because of the added value of the intangible qualities, which are
captured as goodwill. For example, if Elle Fashions were to buy Dior, a smaller clothing
retailer, it would acquire Dior's tangible assets—such as inventory and real estate, valued at
P750,000. However, if the purchase price was P850,000, the extra P100,000 would represent
the goodwill attributed to Teal Orchid’s strong brand and reputation. This P100,000 would be
recorded as goodwill on the balance sheet.

Since goodwill is an intangible asset, it is listed on the balance sheet as a noncurrent asset,
similar to fixed assets. The value of goodwill is determined by the amount paid during the
acquisition, reflecting the premium paid for the intangible qualities of the business, which cannot
be touched or measured in a physical sense. In summary, purchased goodwill is recognized on
the balance sheet as a valuable asset, while developed goodwill, despite being an essential
component of a business’s value, is not recognized due to its internal and subjective nature.

3.​ Discuss the amortization and impairment of goodwill.

Under PAS 38, goodwill is not amortized because it has an indefinite useful life. Unlike
intangible assets with finite lives, goodwill does not decline predictably over time. Instead, its
value comes from how well the business continues to operate and the benefits it gains from
combining its assets and resources effectively.

Therefore, goodwill must be tested for impairment at least annually or when there are
indications of impairment.

According to PAS 36, goodwill is tested for impairment at the level of the cash-generating unit
(CGU) or a group of CGUs to which it has been allocated. The impairment test involves
comparing the carrying amount of the CGU, including goodwill, to its recoverable amount, which
is the higher of:
 1.​ Fair value less costs of disposal, or
2.​ Value in use (the present value of future cash flows expected from the CGU).

●​ If the recoverable amount exceeds the carrying amount, goodwill is not impaired.
●​ If the carrying amount exceeds the recoverable amount, an impairment loss is
recognized, first against goodwill. Any remaining loss is allocated to other assets within
the CGU.

An impairment loss on goodwill is permanent and cannot be reversed, even if the recoverable
amount increases in future periods. This approach ensures that financial statements remain
reliable and that goodwill is not overstated. Regular impairment testing provides stakeholders
with a true and fair view of the company's financial health.

4.​ Explain the measurement of goodwill – Residual Approach. Discuss the

illustrative problem.

Under the residual approach, goodwill is measured by comparing the purchase price for the
entity with the net tangible and identifiable assets, meaning total assets excluding goodwill
minus liabilities assumed.

The net assets acquired must be measured at fair value.

The excess of the purchase price over the fair value of net tangible and identifiable assets is
considered as goodwill.

The measurement is known as the "residual approach" because goodwill is simply the residual
after deducting the fair value of net tangible and identifiable assets from the purchase price
agreed upon between the buyer and the seller.

Illustration – Residual approach

Babes Company purchased an ongoing business for P9,000,000 cash.

The assets and liabilities of the acquired business measured at fair value are:

Assets:

Cash 500,000

Accounts receivable 1,500,000

Inventory 2,500,000
 Property, plant and equipment 4,000,000

Patent 1,300,000 9,800,000

Liabilities:

Accounts payable 1,600,000

Notes payable 1,000,000

Accrued expenses 200,000 2,800,000

Net assets at fair value 7,000,000

Purchase Price 9,000,000

Net assets at fair value (7,000,000)

Goodwill 2,000,000

Journal Entry:

Cash 500,000

Accounts Receivable 1,500,000

Inventory 2,500,000

Property, Plant and Equipment 4,000,000

Patent 1,300,000

Goodwill 2,000,000

Accounts Payable 1,600,000

Notes Payable 1,000,000

Accrued Expenses 200,000

Cash 9,000,000

5.​ Discuss negative goodwill and the illustrative problem.

The negative goodwill (NGW) amount, also known as the “bargain purchase” amount, is the
difference between the purchase price paid for an asset and its actual fair market value.

Negative goodwill is an accounting principle that occurs when the price paid for an asset is lower
than its value in the market and can be thought of as a “discount” to the buyer. In contrast,
goodwill occurs when the purchase price is higher than its market value – i.e., the goodwill
amount is the premium paid by the buyer for the intangible value of the company’s assets.

While negative goodwill is an indicator of unfavorable circumstances, the presence of goodwill

(i.e., “positive” goodwill) implies that the intangible value of assets is high, and the company is
under relatively low pressure to sell – this situation favors the seller.
Negative goodwill usually arises due to one of the following:

1.​ Forced or financially distressed sale of the company

Companies that are financially distressed and under pressure to sell may be willing to sell the
company at a discount in the form of negative goodwill since the value of intangible assets for a
distressed firm is likely to be lower.

2.​ Incorrect valuation of assets

Valuation of assets, especially long-term fixed assets, may be incorrect – given that
macroeconomic factors are constantly changing – and result in inaccurate market values.
Similarly, an inaccurate valuation of intangible assets may also result in lower market values and
negative goodwill.

Accounting for Negative Goodwill:

According to US GAAP and IFRS, both goodwill and negative goodwill must be recognized and
accounted for in the acquiring company’s financial statements.

NGW in the Income Statement: Negative goodwill must be recognized as a “gain on acquisition”
in the acquirer’s income statement, under non-cash sources of income.
NGW in the Balance Sheet: In the balance sheet of the selling company, goodwill is recorded as
an asset, whereas negative goodwill is part of the liabilities since it reduces the valuation.
Alternatively, goodwill may be recorded as a contra-asset, or a reduction to assets to indicate the
amount of NGW.
NGW in the Statement of Cash Flows: In the statement of cash flows, negative goodwill is
usually recorded as a “gain on acquisition” or “gain on bargain purchase” to indicate the additional
value acquired in the form of NGW.

Illustrative problem: Buncraft company faced growing competition and incurred debt obligations
that it could not cover. They decided to sell the company to Company Baks for 8,000,000 cash.

The assets and liabilities of the acquired company measured at fair value are:

Cash 500,000

Accounts receivable 2,000,000

Inventory 2,500,000

Land 3,000,000

Plant and equipment 6,000,000

Accounts payable (1,000,000)

Bonds payable (4,000,000)

Net assets at fair value 9,000,000

Purchase price 8,000,000

Net assets acquired at fair value 9,000,000

 Gain on Bargain purchase (1,000,000)

Journal entry:

Cash 500,000

Accounts receivable 2,000,000

Inventory 2,500,000

Land 3,000,000

Plant and equipment 6,000,000

Accounts payable 1,000,000

Bonds payable 4,000,000

Cash 8,000,000

Gain on bargain purchase 1,000,000

6.​ Explain the measurement of goodwill – Direct Approach. Discuss the illustrative
problems.

An attempt made to value the anticipated excess earnings which are the essential component of goodwill.

It is a systematic approach to be a systematic and logical way of measuring goodwill because if future earnings
exceed normal earnings, the excess earnings are indicative of the fact that there is an unidentifiable intangible
asset that is causing the excess earnings.

The following data are available in relation to the computation of goodwill:

Net assets (Excluding Goodwill) 7,500,000
Normal rate of return in the industry 12%

Past earnings for 5 years preceding the sale:

2019 950,000

2020 975,000

2021 950,000

2022 1,075,000

2023 1,050,000

Total 5,000,000
Average earnings of the 5-year period (5,000,000/5) 1,000,000

Method 1- Purchase of “average excess earnings”

The goodwill is measured at average excess earnings for 5 years.

Average earnings 1,000,000

Normal earnings (12% x 7,500,000 (900,000)

Average excess earnings 100,000

Goodwill (100,000 x 5) 500,000

The normal rate of 12% is applied on net assets, excluding goodwill (total assets before goodwill minus liabilities)

Method 2- Capitalization of “average excess earnings”

The goodwill is measured at the average excess earnings capitalized at 25%

Average excess earnings 100,000

Divide by capitalization rate 25%

Goodwill 400,000

Method 3- Capitalization of “average earnings”

The goodwill is measured at average earnings capitalized at 10%

Average earnings 1,000,000

Divide by capitalization rate 10%

Net assets, including goodwill or purchase price 10,000,000

Net assets, excluding goodwill (7,500,000)

Goodwill 2,500,000

Method 4 - present value method

Under this method, the goodwill is the discounted value or the present value of the average excess earnings that are
expected to become available in future periods.

For example if the average excess earnings of 100,000 are expected to be received annually in 5 years, the goodwill
assuming a discount rate of 12% is computed by simply multiplying the average excess earnings by the present value
of an ordinary annuity factor.

Average excess earnings 100,000

Multiply by the present value of an ordinary 3.605

annuity of 1 for 5 years at 12%

Goodwill 360,500