Accounting Says Maybe, But Tax Laws Say
Presenting unidentifiable intangible assets in financial statements
By Bart A. Basi
This year is the first full year in which the Financial Accounting Standards Board's (FASB) guidance on how to account for goodwill and other unidentifiable intangible assets is in effect for presentation in financial statements.
On the other hand, the rules for goodwill have not changed when it comes
to deducting this cost on your tax return. This article presents both
the implication of goodwill on your financial statements as well as the
impact on your tax returns.
This article addresses the unidentifiable intangibles, such as goodwill,
attained through an acquisition of another company. This is because, under
the rules from both the FASB and the IRS, this is the only time that goodwill
can be recorded on a company's books. You cannot record goodwill or intangible
assets when they are self-created. Remember, first you must buy another
company before these rules apply to your financial statements. However,
if you purchased a company in the past, the rules apply to goodwill that
is presently on your books.
There is a laundry list of items that qualify for this special accounting.
Following are the most common intangibles included in goodwill (unidentifiable
- company customer list,
- key employees,
- covenant not to compete,
- market location, and
- business location.
These categories are lumped together under goodwill because no specific
value can be assigned to each category. Therefore, when making a purchase
of another company, look to see if there is goodwill.
Prior to 2002, companies were allowed to record an acquisition using one
of two different methods. One method was called the pooling of interest
method. According to this method, when two companies merge, they simply
add the historical cost of the assets and the amount of the liabilities
together. This method did not allow the new company to record any goodwill
on the company's books.
The other method, previously available to account for an acquisition,
was called the purchase method. Under the purchase method,
the purchasing company adds the purchased assets at fair market value
and the liabilities to the acquiring company's books. If there is any
extra purchase price over the amount assigned to the net assets (assets
at fair market value minus liabilities), then the company assigns this
premium to an account called goodwill. It was up to the company
to decide which method was the appropriate one.
The problem with the two options was that it allowed individuals to record
essentially the same transaction differently. This led to the FASB eliminating
one of the methods. Now, when an acquisition of a company occurs, you
are only allowed to use the purchase method. This means you must account
The FASB rules might allow an expense deduction
against the income of the company, while the Tax Code definitely allows
a deduction against your taxable income for the year. This difference
can mean a lot.
To determine the amount of goodwill to account for on your books, you
first must determine the fair market value of the assets purchased. This
amount is reduced by the amount of any liabilities assumed. Then you take
the purchase price and subtract the value you determined for the assets
minus the liabilities. The difference is the amount of goodwill you will
record on your company's books.
To illustrate how this works, assume that your company buys company X
for a total of $1,000,000. The assets of company X are on its books for
a total of $250,000, but have a fair market value of $750,000. The liabilities
of company X are recorded at $150,000. To calculate goodwill, you would
take the purchase price of $1,000,000 minus the net assets of $600,000
($750,000 FMV of the assets minus the $150,000 of liabilities). The total
amount of goodwill to be recorded for your acquisition of company X is
$400,000. This calculation is the same for accounting and tax purposes.
Difference between FASB and the Tax Code
Now that goodwill is on your books, the difference between what the FASB
and the Internal Revenue Tax Code want you to do arises. The FASB rules
might allow an expense deduction against the income of the company, while
the Tax Code definitely allows a deduction against your taxable
income for the year. This difference can mean a lot to you.
Under the present FASB statements, goodwill must be examined for each
year to see if the value has changed. This means that you can no longer
amortize goodwill over the previously ambiguous forty-year period. FASB
defines a value change as the carrying value of the intangible
asset being less than that of the fair market value of the intangible
asset that was originally recorded.
Returning to the example above, let us look at the end of the first year
after the transaction was recorded. At this time, you discover the amount
of goodwill that should be recorded is still $400,000 and that there would
not be a write-down of goodwill because goodwill has decreased in value.
If it were uncovered that the amount of goodwill should be $200,000, then
your company would have to record a loss due to an impairment of goodwill
of $200,000. The $200,000 is equal to the difference between the carrying
value of goodwill ($400,000) and the amount of goodwill determined under
the testing for impairment ($200,000). The impairment testing of unidentifiable
intangible assets must be done every year.
A loss due to impairment can hurt your company. The impairment losses
on these types of assets are written off against your company's earnings,
the bottom-line, in the year in which the impairment is discovered. This
could lead to problems for your company. Suppose your company had the
Sales Revenue: $1,500,000
Cost of Goods Sold: $ 500,000
Other Expenses: $ 250,000
due to Goodwill: $1,000,000
Using the information above, your company would show a loss for the year
of $250,000 on your financial statements ($1.5 million in sales minus
the total of $1.75 million in expenses and impairment loss). This could
lead to a loan being denied because your financial records do not look
as good as the bank wants them to be. A potential investor in your company
might be scared off since the earnings per share are down. If you are
looking to sell the company, this could reduce the selling price you could
obtain because your earnings have dropped. The potential losses associated
with this method of decreasing goodwill could injure your company's position.
The Tax Code allows you to take a deduction for the amount of goodwill
written off each year. As everyone knows, the more deductions you have,
the lower your profits and the lower your taxes for that year. The rules
that allow a deduction for goodwill are different from the new FASB rules,
but are very simple.
Once you have determined that you have goodwill and capitalized it for
tax purposes, the amount to be deducted is determined by using a simple
amortization schedule. Amortization is a process in which the costs of
intangible assets are allocated over a certain period of time, much the
same as depreciation. The Tax Code allows the cost of goodwill to be amortized
over a period of fifteen years. This begins in the month in which the
goodwill is acquired.
Take the example in which your company had goodwill of $400,000. Applying
the rules for goodwill, this would mean that your company would be able
to deduct a total of $26,667 per year for the next fifteen years. Your
profit will decrease each year by $26,667, thus lowering your income taxes.
The larger the amount of goodwill and the higher your tax bracket, the
more benefit you will receive from deducting goodwill for tax purposes,
even if you are not deducting it for accounting purposes.
Worth the Effort?
Keeping track of what is allowable on your financial statements and your
tax return can be cumbersome, but for financial presentation purposes,
you must go through and determine if your purchased goodwill has been
impaired. Then, and only then, are you allowed to reduce the amount of
goodwill on your accounting records.
For your tax returns, you are allowed a deduction of one fifteenth of the amount of goodwill for which you paid. The effects of these methods are substantial depending on whether it is a matter of financial presentation or a question of taxation.