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What is goodwill in accounting?
Goodwill refers to an intangible asset that has to do with purchasing one company by another. On a specific basis, goodwill is part of the purchase price that is greater than the sum of the fair value (net) of every asset a company purchases in the acquisition as well as the liabilities it assumed or incurred in the process. In essence, it accounts for the excess purchase price of another company. This means that if a company’s purchase price is less than the target’s book value, the goodwill gained is negative. In other words, this company purchased the target company at a bargain is a distress sale.
The term has to do with the brand name/good name of a company, its solid customer base, reputation, connection with other companies, organizations operating within an industry, and proprietary technology. These components represent some of the reasons why goodwill exists. This intangible asset helps a company to be distinguished among its counterparts thereby helping it to remain competitive. It is a factor that helps in pulling new customers into the company, this sustains its competitive edge. With this, a company is able to distinguish itself as an established and well-trusted firm. This is what new companies/firms struggle with. It is, therefore, an intangible asset that helps contribute to the company’s earning potential in the long run.
It is a critical concept in financial accounting that describes an intangible asset that a company creates when it acquires another company for a price greater than its net fair asset value.
Goodwill evaluation is a critical skill for many investors though it is challenging. When analyzing the balance sheet of a company, it tends to be very difficult for a company to state whether the goodwill it possesses is justifiable in fact. For instance, it is possible for a company to claim that its goodwill is on the basis of its brand recognition and the customer loyalty it acquired. In analyzing a company’s balance sheet, investors will have to crosscheck the factors behind its goodwill. The aim of this scrutiny is to determine if they may need to write off this component in the future. In some instances, the case may be contrary when investors believe that the goodwill of a company is greater than it is recorded in its balance sheet.
Also, it is important to a company. It is critical for every company to review their goodwill value in their financial statements. It is a basic requirement to do this on a periodic basis, either quarterly or yearly in order to detect and record any impairments. Goodwill is unique among other assets that are intangible, that is, it has an indefinite life. Many other assets that are intangible have a finite life as well as a useful life.
This implies the accounting record that companies keep when the goodwill value in the financial statement exceeds the fair value. Usually, accountants record goodwill after a company has acquired assets and liabilities, and paid a price exceeding the identifiable net value.
So now, impairment with regard to this takes place when deterioration takes place in the capabilities of acquired assets to generate cash flows. Also, it takes place when the goodwill’s fair value goes below its book value. Impairment may surface if the assets a company acquires are no longer yielding the expected financial results at the time of purchase. That is, the earnings charge a company records on its income statement after identifying that there is evidence that the related assets no longer demonstrate the initial financial results.
As we have seen above, goodwill is an intangible asset that usually has to do with a company purchasing another company. On a specific basis, companies record it in situations whereby the purchase price exceeds the net fair value of all tangible and intangible assets as well as liabilities that are identifiable, which a company assumes in the course of acquisition. The difference between the face value and the purchase price of these assets and liabilities is what we record as goodwill. This is because many companies acquire other firms and pay a higher price than the fair value of all identifiable assets and liabilities of the acquired firm.
So, if uncertain events occur such that there is a decrease in the expected cash flows from these acquired assets, then the company has to record goodwill impairment. That is when the current value goes below the initial fair value.
Testing goodwill impairment
Carrying out this test should align with the generally accepted accounting principles (GAAP). This exercise should take place periodically, the minimum should be on an annual basis.
There are two common methods of testing impairments;
- Income approach
- Market approach
Using the income approach, a company discounts the estimated future cash flows to the present value.
Under this approach, the company analyzes the assets and liabilities of similar firms that operate within the same industry.
The effect of the impairment on goodwill is that it results in a decrease in the goodwill account on the balance sheet. On the income statement, it is treated as a loss which has a direct effect, that is it reduces the net income of the year.
Goodwill accounting treatment
In accounting, we treat goodwill as an intangible asset just as it has been highlighted above. It does not include identifiable assets that are capable of being separated from the acquired company and sold, transferred, exchanged, licensed, or rented. In essence, goodwill is a representation of assets that are not separately identifiable. This intangible asset does not include legal and contractual rights. This is regardless of whether one can transfer or separate the recognizable assets from the company, or other rights and obligations.
A company can only acquire goodwill through acquisition, that is, you cannot self-create it. Now, examples of these identifiable assets include the brand name of a company, patents, customer relationships, proprietary technology, etc.
In essence, goodwill amounts to the surplus of the purchase consideration. The purchase consideration is simply the money a company pays to purchase an asset or the entity/business. In the balance sheet, it is an intangible asset. That is, you cannot see or touch the asset. It usually appears on the credit side of the balance sheet. There is usually no amortization of goodwill on the income statement.
Accounting for goodwill
The goodwill accounting treatment also includes the fact that it is not accounted for until it is written off against profits or accumulated reserves. We still retain it as an asset without any write-off until there is a drop in value.
In companies like the limited liability company and corporations, they deduct it from the shareholders’ funds. Or treat it as an asset and write it off over a certain period through the profit and loss account.
As a result of these factors, it is important to state that one should only record and recognize goodwill in business accounts where there are considerations in terms of money. Or when payment has taken place such as invoice payment.
There is absolutely no need to account for inherent goodwill at all. This is because it is not transactional in nature and it comes about as a result of the image of a company.
To calculate goodwill, we deduct the fair market value of identifiable assets from the purchase price. For instance, if I acquired 100% of your company and I pay more than the net value of your company, then goodwill occurs. To effectively calculate this component, it is a necessity for me to have a list of all the assets and liabilities of your company at fair market value.
Principally, carrying out this calculation is fairly straightforward but it is practically complex. So, if you want to determine goodwill in a simplistic formula, take the company’s purchase price and subtract it from the net fair market value of identifiable assets and liabilities.
How to calculate goodwill
The formula for calculating goodwill is as follows;
Goodwill = P-(A-L) where,
P = Purchase price of the target company
A = Fair market value of assets
L = Fair market value of liabilities
Goodwill = Consideration paid + Fair value of non-controlling interests + Fair value of equity previous interests – Fair value of net assets recognized.
The step-by-step method of calculating goodwill is as follows;
- Determine the consideration the acquirer paid to the seller, this will form part of the deal contract. Valuing this consideration can be by a fair valuation method or the share-based payment method. The payment of consideration can take place in form of cash, stocks, or cash-in-kind.
- Secondly, determine the fair value of the non-controlling interest that is in the acquired company. This implies the equity ownership in a subsidiary that one cannot attribute to the parent company.
- Thirdly, determine the fair value of equity in previous interests.
- Fourthly, figure out the net assets’ fair value recognizable in the acquired company. Basically, this is the net of the assets’ fair value as well as the fair value of liabilities. Usually, it is easy to access it in the balance sheet.
- The final step is to calculate the goodwill equation by adding the consideration paid, non-controlling interests, and the fair value of the previous equity. Then, deduct the company’s net assets. In other words, substitute the variables in the formula.
For instance, company A agreed to acquire company B. In order to obtain a 95% stake in company B, The purchase consideration is $100 million. Based on the esteemed valuation company, the non-controlling interest’s fair value is $12 million. Also, the estimation of the fair value of identifiable assets and liabilities to be acquired is $200 million and $90 million, respectively. There are no equity interests. Based on the above information, calculate the goodwill.
Consideration paid = $100 million
Non-controlling interests fair value = $12 million
The fair value of equity previous interests = $0
Now, we will calculate the net identifiable assets thus;
Net identifiable assets (NIA) = Fair value of identifiable assets – Fair value of identifiable liabilities
NIA = $200 million – $90 million
Net Identifiable Assets = $110 million
Using the formula;
Goodwill = $100 million + $12 million + $0 – $110 million
= $2 million
Types of goodwill
There are two basic types of goodwill namely;
- Purchased goodwill
- Inherent goodwill
This comes about when a company acquires another entity through purchase for an amount higher than the fair value of the separable acquired net assets. This is why it appears on the balance sheet as an asset. These are the only types of goodwill that are recognizable in the company’s books of account.
This is the opposite of purchased goodwill. It is the representation of the fair value of a company/business, rather than its separable net assets’ fair value. So, inherent in this case, a company generates it internally and it rises over time as a result of reputation.
Inherent goodwill is the best thing for a company to have. Though it costs nothing, a company can gain a lot from it. It takes a lot of time to build it, there are certain factors that influence its growth.
An example is when a company sells an outstanding product or consistently provides excellent service. This is a major factor that influences the speedy growth of inherent goodwill. Other factors include the firm’s age, favorable location, good relationship with customers, hard work ethics, etc. So one can conclude that public relations can help in building inherent goodwill.
Features of goodwill
The following are the features of goodwill;
- Because it is an intangible asset, you can not see or touch it.
- One cannot separate it from the company unlike it is with the physical assets.
- The value of this intangible asset is not relative to any investment costs or amounts.
- Its value can be subjective and dependent on the customer judging it.
- Also, the value is prone or subject to wild and unpredictable fluctuations, responding to externalities.
- It is untransferable, it forms a vital part of the company, therefore, one cannot separate it from the company. In essence, it can only move with the company.
Factors affecting goodwill
The following are the factors affecting goodwill;
- Location of the business
- Quality of goods and services
- Efficiency of management
- Business risk
- Nature of business
- Favorable contracts
- Possession of trademark and patents
Location of the business
When a business is located in a favorable location, there will be a higher and more favorable chance of higher goodwill. On the other hand, if the business is in a remote location, the reverse will be the case.
Quality of goods and services
A company that provides a higher quality of goods or services stands a greater chance of acquiring a greater reputation. The reverse is the case with other competitors that provide inferior goods and services. For instance, an air transport company that has a history of poor services with frequent accidents/air disasters cannot build goodwill.
Efficiency of management
When a company is efficient in its management, it will result in an increase in profit. In turn, this helps to enhance the company’s business.
A company with lesser risk exposure has greater chances of building goodwill. The reverse is the case with companies that have higher risk exposure.
Nature of business
The nature of business implies the type of products a business/company, the level of competition in the market, the demand for the products, and the regulations that impact the business. When a company has a favorable outcome in these sensitive areas, then it will have greater goodwill.
When a firm/company has access to favorable contracts for the sale of products, it will enjoy a higher rate of goodwill.
Possession of trademark and patents
Firms that possess patents and trademarks will enjoy a monopoly in the market. This will contribute to the growth of goodwill of the firm.
A company that has a higher return on investment with less capital investment, many consider such a company as more profitable. This, in turn, will build more goodwill for the company.
Importance of goodwill
It is an important thing for a company to build goodwill. It makes customers feel good about a brand/company thereby spreading the reputation to others. This helps a company to build relationships that fuel its long-term success. Building goodwill can take place through creating customer appreciation programs, going the extra mile in providing services, etc.
Here are some benefits of creating goodwill with customers;
- Encourages brand loyalty
- Encourages forgiveness
- Greater competitive edge
- Improves the value of a company’s business
Encourages brand loyalty
When customers feel good about a company, they will want to do business with such continuously. Building goodwill helps in creating brand loyalty. This is by making customers feel good about doing business with a company. It does not only make people wish to do business with a company but also to recommend family and friends to contact the company when they are in need of a product or service that it offers. In turn, this helps a company to expand its customer base.
A company that creates goodwill with its customers by going the extra mile encourages forgiveness. In this sense, there is more likelihood of customers overlooking the company’s mistakes.
Greater competitive edge
When customers are facing struggles in choosing between companies offering products and services, goodwill will help in setting a company apart in its own favor. That is, it helps a company to stand out among its competitors and gain its customers’ business.
Improves the value of a company’s Business
Investors have an understanding of how important goodwill is. They also understand what it builds with customers. A company with a positive reputation as a result of this factor has a corresponding increase in its value. This helps a company to attract investors as well as secure credit more easily for business expansion. It helps a company to command more in sales if it chooses to sell its business. A company builds value through this. Through this, a company is able to secure its future.
Despite the importance of goodwill, it has some limitations. One of them is that the intangible asset is difficult to price. Negative goodwill may occur when the acquirer purchases a company less than its fair market value. Usually, this happens when a target company is unable to negotiate a fair price for its acquisition. Also, the risk of insolvency exists. That is, a previously successful company may be at risk of facing insolvency. when insolvency happens, investors will deduct goodwill from their residual equity determinations. This happens because, at the point of insolvency, the previously enjoyed goodwill possesses no resale value.
Frequently asked questions
What does having goodwill mean?
Goodwill refers to an intangible asset that has to do with purchasing one company by another. On a specific basis, goodwill is part of the purchase price that is greater than the sum of the fair value (net) of every asset a company purchases in the acquisition as well as the liabilities it assumed or incurred in the process (purchase goodwill).
In essence, it accounts for the excess purchase price of another company.
The term also has to do with the brand name/good name of a company, its solid customer base, reputation, connection with other companies, organizations operating within an industry, and proprietary technology (inherent goodwill).
Describing this in terms of acquiring a company and in terms of good reputation helps to describe the two types of goodwill.
What is the use of goodwill?
This intangible asset helps a company to be distinguished among its counterparts thereby helping it to remain competitive. It is a factor that helps in pulling new customers into the company, this sustains its competitive edge. With this, a company is able to distinguish itself as an established and well-trusted firm. This is what new companies/firms struggle with. It is, therefore, an intangible asset that helps contribute to the company’s earning potential in the long run.
What is an example of goodwill?
goodwill examples include the good reputation of a company, patent, trademarks, employee relationship, customer relationships, etc. They all contribute to the existence of this intangible asset.