Purchased goodwill is normally the balancing figure between the purchase price of an acquired entity and the total fair value of the acquired assets, both tangible and intangible, and liabilities. Frequently, however, the goodwill represents over half of the total purchase price. (This is especially true when the recognised intangible assets are undervalued, but that's another story...) so shareholders and other stakeholders are entitled to ask what goodwill represents and whether a fair price is being paid for it.

While UK GAAP and US GAAP do not require any explanation of the goodwill purchased, under IFRS rules which now apply to all UK and European quoted companies, an explanation is required. IFRS 3, Business Combinations, defines goodwill as follows "..a payment made by the acquirer in anticipation of future economic benefits from assets that are not capable of being individually identified and separately recognised" (IFRS 3, paragraph 52). It also requires disclosure of the nature of goodwill with "...a description of each intangible asset that was not recognised separately from goodwill and an explanation of why the intangible asset's fair value could not be measured reliably..." (IFRS 3, paragraph 66(h)).

In fact, research carried out by Intangible Business on the reporting of business combinations by FTSE100 companies in 2006, the first under IFRS, "IFRS 3: The First Year", indicates a very poor level of compliance with the disclosure requirements of IFRS 3 with respect to the components of goodwill. Whether this is due to reluctance to divulge what management consider to be sensitive information or because the management simply doesn't know what the goodwill represents is unclear.

More important, however, than compliance with disclosure requirements, is the need for an acquirer to identify the sources of value underlying goodwill as both a cross check on whether the purchase price represents good value and also to create benchmarks for future performance to ensure that those sources are exploited in full. Goodwill can and must be broken down into its component parts or the acquisition is highly likely to erode value as lack of measurability leads to lack of attention.

While it is difficult to generalise about the sources of goodwill, there are a number of typical sources that should be considered, including:

Workforce
Both US GAAP and IFRS specifically exclude workforce from the intangible assets that can be recognised and reliably valued on the basis that an acquired workforce can vote with its feet if they don't like the acquirer. For this reason, any payment for the workforce will fall into goodwill. It is possible to assign a value to the workforce, based on assumptions about the retention rate post acquisition. Where the skills of the workforce are critical to success, the acquirer had better recognise this and ensure that the acquired workforce is enticed to remain on board.

Synergies
These come in many forms and can be quantitatively evaluated relatively easily. The addition of a strong brand will allow the sales force to leverage the strengthened portfolio to grow sales of the acquirer's existing brands and, by the way, the beneficiary of the synergy may be either an acquired brand or one of the acquirer's brands. Additional purchasing power may lead to improved purchase prices of raw materials. Distribution costs can be shared by loading new products onto an existing fleet of trucks.

Cost Savings
Usually one company's head office disappears and part, at least, of the overhead costs of the two separate entities can be saved.

The value of the various identified components of goodwill should be determined in terms of future projected cash flows, discounted at the appropriate weighted cost of capital. This can then form the basis of allocation of goodwill to reporting unit (US GAAP) or cash generating unit (IFRS). This is critical in order to avoid problems with future impairment testing, so that the goodwill is correctly allocated to the reporting or cash generating unit where the cash flows will be generated. The same principle applies if the acquirer is required to "push down" the goodwill to a subsidiary.

Analysis of goodwill at the time of acquisition will help to identify risk of overpayment for an acquired entity leading, ultimately, to an impairment charge to profit. Numerous studies have indicated that many acquisitions fail to deliver shareholder value and a full evaluation of the components of goodwill helps to minimise the risk. The goodwill evaluation process forces management to identify and quantify the sources of cash flows that support the value of goodwill. If this is a struggle, or the assumptions about the cash flows are unrealistic, it probably means that the price is too high and its time to re-negotiate or walk away. Vodafone's acquisition of Mannesmann in 2001 for £101bn might have benefited from a closer analysis of the resulting goodwill (£83bn). Five years later, Vodafone reported a goodwill impairment charge to £23bn.