If you want to master reading a balance sheet, you need to understand the term "goodwill." It usually appears on a balance sheet if a company has acquired another firm and paid more than the acquiree's appraised net worth, which is very close to its book value.

Imagine that Roadrunner Industries (ticker: BEEEP) acquires the Acme Explosives Co. (ticker: KBOOM). Let's say that Acme is considered a gem among explosives manufacturers and that other companies would be happy to acquire it. If so, Roadrunner probably can't get away with paying just what the company is worth -- an offer like that might trigger counterbids for Acme. So, Roadrunner pays a premium. This difference between the price paid and the book value of the acquiree is entered on the acquirer's balance sheet as "goodwill."

Let's say that Roadrunner's book value was $100 million before the acquisition. Acme was calculated to be worth $20 million, but Roadrunner paid a premium for it, offering $25 million in cash. Roadrunner's value won't change. It will still be worth $100 million, but it won't have that $25 million in cash it paid for Acme as an asset on its balance sheet anymore.

But the cash can't simply disappear. It was used to purchase a new asset. So, the $25 million in cash is replaced by the $20 million value of Acme and a new $5 million value designated as "goodwill." Before 2002, goodwill was amortized over a period of years. In other words, it was incrementally reduced to zero.

But that is no longer the case. Instead, companies must now perform an annual test to determine "impairment of value" for its acquisitions. In other words, a company must annually value all of its acquisitions as separate business units to determine whether their value has fallen or risen in relation to the price paid.

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