Goodwill arises when a company acquires another entire business. The amount of goodwill is the cost to purchase the business minus the fair market value of the tangible assets, the intangible assets that can be identified, and the liabilities obtained in the purchase.
What is Goodwill?
Goodwill is the excess of the purchase price paid for an acquired entity and the amount of the price not assigned to acquired assets and liabilities. It arises when an acquirer pays a high price to acquire another business.
This asset only arises from an acquisition; it cannot be generated internally. Goodwill is an intangible asset, and so is listed within the long-term assets section of the acquirer’s balance sheet.
The value of goodwill is highly subjective, especially since it does not independently generate cash flows. Consequently, the accounting standards require that an acquirer regularly test its goodwill asset for impairment, and to write down the asset if impairment can be proven.
Why is goodwill important?
Although they can’t easily be calculated, intangible assets significantly contribute to a company’s success and value.
During a business acquisition, it’s therefore important to consider factors such as brand identity, customer relations, customer loyalty, and staff satisfaction to ensure purchases are made at a fair price.
Goodwill doesn’t consider identifiable assets such as contracts, legal rights, or assets that can be separated, divided, transferred, or sold.
How to Calculate Goodwill
Financial advisors use residual analysis in the valuation of goodwill. In this case, goodwill represents the residual of the overall business value less the total value of all tangible assets and identifiable intangible assets used in the business enterprise.
- Get the book value of all the assets on the balance sheet
- Determine the fair value of the assets
- Find the fair value adjustment which is the difference between the fair value and the book value of the assets
- Calculate the excess purchase price by taking the difference between the price paid to acquire the target business and the net book value of the assets
- The goodwill is calculated by taking the excess purchase price and deducting the fair value adjustments
To calculate goodwill, we should take the purchase price of a company and subtract the fair market value of identifiable assets and liabilities.
Goodwill = P−(A+L)
P = Purchase price of the target company
A = Fair market value of assets
L = Fair market value of liabilities
Methods of Valuation
There are three methods used for the valuation of goodwill:
- Super Profits Method
- Average Profits Method
- Capitalization Method
Goodwill in business vs. other intangible assets
There’s a significant difference between goodwill and other intangible assets, such as a patent, intellectual property, or research and development. Essentially, goodwill only arises during an acquisition.
As such, it can’t be bought or sold independently, unlike intangible assets such as copyright, for example. In addition, other intangibles are classified as “definite” as there’s a foreseeable end to their useful lives, whereas goodwill is “indefinite”.
Types of Goodwill
There are two distinct types:
Purchased goodwill is a result when purchasing a business is done for a higher price than the fair value of the separated acquired assets. Due to this, goodwill is shown as an asset on the balance sheet, whereas other types cannot be recognized.
Non-Purchased or Inherent Goodwill
In contrast to purchased goodwill, inherent goodwill represents the business’s value in excess of its separable net assets. Developing inherent goodwill is an internal process that occurs over time as a result of reputation. It could go either way, positive or negative.
Goodwill takes time to build but it can bring you a lot of benefits. There are certain factors that can greatly impact it.
For example, suppose you are selling an outstanding product or providing excellent service consistently. In that case, there is a high chance of an increase in goodwill.
Goodwill should always be recorded in a separate line under the assets section of the buyer’s balance sheet; however, the treatment of goodwill varies between different accounting standards.
According to the IFRS Standards, businesses shouldn’t amortize goodwill. Instead, it’s the business’s responsibility to monitor the value of goodwill and apply impairment when necessary.
Under the UK GAAP, goodwill has a finite useful life and should therefore be amortized. If a company can’t accurately estimate the goodwill’s useful life, it can’t exceed five years. In the UK, the UK GAAP is much more commonly used than the IFRS Standards.
What Goodwill Tells You
The value of goodwill typically arises in an acquisition—when an acquirer purchases a target company. The amount the acquiring company pays for the target company over the target’s net assets at fair value usually accounts for the value of the target’s goodwill.
If the acquiring company pays less than the target’s book value, it gains negative goodwill, meaning that it purchased the company at a bargain in a distress sale.
Goodwill is recorded as an intangible asset on the acquiring company’s balance sheet under the long-term assets account. Under the generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS), companies are required to evaluate the value of goodwill on their financial statements at least once a year and record any impairments.
Goodwill is considered an intangible (or non-current) asset because it is not a physical asset like buildings or equipment.
Adding to a company’s value
In addition to a company’s reputation, there are many other factors that may be valuable when calculating goodwill. One could be if a company has a dedicated and solid customer base.
When customers have faith in and respect for a company, they can potentially spread positive word of mouth and recommend the company to others, ultimately bringing more capital to the firm.
A company has run a major advertising campaign; the effect of this can also influence a company’s goodwill. Value can also be added by new agreements, integrations, or partners, which are known to bring in new income.
Example of Goodwill
Let’s assume that Company A acquires Business X for $5 million based on Business X’s annual net income X 10. The fair value of Business X’s identifiable assets was $4 million and its liabilities were $1 million. Therefore, Company A is paying $5 million for identifiable assets and liabilities having a value of $3 million ($4 million of assets minus $1 million of liabilities). When Company A records the transaction, it will:
- Debit of various assets accounts for $4 million
- Credit various liability accounts for $1 million
- Credit Cash for $5 million
- Debit Goodwill for $2 million
The $2 million, which was over and above the fair value of the identifiable assets minus the liabilities, must have been for something else. We refer to that something else as goodwill.
Accounting vs. Economic Goodwill
Goodwill is sometimes separately categorized as economic, or business, goodwill, and goodwill in accounting, but to speak as if these were two separate things is an artificial and misleading construct. What is referred to as “accounting goodwill” is really just the recognition in the accounting of a company’s “economic goodwill.”
Accounting goodwill is sometimes defined as an intangible asset that is created when a company purchases another company for a price higher than the fair market value of the target company’s net assets. But referring to the intangible asset as being “created” is misleading – an accounting journal entry is created, but the intangible asset already exists.
Economic, or business, goodwill is defined as previously noted: an intangible asset – for example, strong brand identity or superior customer relations – that provides a company with competitive advantages in the marketplace. Both the existence of this intangible asset, as well as an indication or estimate of its value, is often drawn from examining a company’s return on assets ratio.
Frequently asked questions about goodwill
What does goodwill tell you about a company?
Goodwill supplements the net value of a company’s assets to provide a more balanced valuation. Once the fair value of all net assets has been deducted, what remains is goodwill. Likewise, when a company acquires a failing company in a distressed sale, it will likely have negative goodwill. In which case, the company will often be asset-stripped.
Can businesses claim tax relief on goodwill?
Yes. Companies can claim relief on acquisitions made on or after 1 April 2019 as long as the company is liable to corporation tax, and goodwill is included in the company accounts along with other intangible assets.
What are goodwill impairments?
Goodwill impairment is anything that results in a decrease in the goodwill account on a company’s balance sheet. Increased competition, economic downturns, or decreases in cash flow can all cause a company’s intangible assets to be impaired.
Under international financial reporting standards, companies must evaluate the value of their goodwill annually on their financial statements, and record any impairments.