When companies acquire other companies but pay in excess of the fair market value of the assets and liabilities acquired, the excess of the purchase price over the fair value of the assets and liabilities is accounted for (or “allocated to”) a purely conceptual asset called goodwill.
Goodwill is the amount by which the purchase price for a company exceeds its fair market value (FMV), representing the intangible value unaccounted for in other assets stemming from the acquired (like the company’s business name, customer relations, employee morale, etc.). It is important to remember that goodwill is created (Exhibit 6.9) only after all identifiable physical and intangible assets (patents, licenses) have been assigned fair market value.
Big-Time Acquires Johnny’s Interiors
The fair market value of a local New York furniture company, Johnny’s Interiors, is determined to be $5 million in 2007.
A national furniture company, Big-Time Furniture, believes that under its proven management and expertise, Johnny’s Interiors would be worth much more than the fair market value (FMV) implies and thus decides to acquire Johnny’s Interiors for $8 million, $3 million above the fair market value.