Goodwill is an accounting concept that comes into play whenever a firm is looking to acquire another company. Below, we are going to take a closer look at how goodwill is calculated, what are the different types of goodwill, and why goodwill accounting is an important consideration during mergers and acquisitions.
Highlights/ Key Takeaways
- Goodwill describes the value of certain intangible assets that are embedded within a company - like brand names, business reputation, and managerial talent.
- Goodwill must be considered during mergers and acquisitions and recorded on a balance sheet accordingly.
- Goodwill accounting involves determining the difference between a company’s purchase price and its fair value.
- The four types of goodwill are business goodwill, professional practice goodwill, inherent goodwill, and purchased goodwill.
What Is Goodwill Accounting?
Goodwill accounting is the accounting process that involves calculating and recording the value of a company’s goodwill - a specific type of intangible asset. The goodwill value is often considered during mergers and acquisitions (M&A) and can be calculated by subtracting a business’s fair market value from its purchase price.
How Does Goodwill Work?
General goodwill meaning describes certain intangible assets like a business’s branding, reputation, trade secrets, managerial talent, and customer base. To qualify as goodwill, an asset must have the following characteristics:
- The asset is intangible (more on that below!).
- The asset cannot be separated from the business.
- The asset value is not relative to any investment costs or amounts.
- The asset value is subjective and depends on the person judging it.
- The asset value is subject to unpredictable fluctuations in response to external events.
Goodwill accounting helps to estimate the value of intangible assets that fall under the goodwill category. Note that, unlike some other kinds of intangible assets, goodwill has value for an indefinite amount of time.
Understanding Intangible Assets
All types of business assets can be classified as either tangible or intangible. A tangible asset is a physical object that belongs to a business, - for example, a building, a piece of equipment, or sales inventory. The value of tangible assets can be calculated relatively easily and is always recorded on financial statements.
In contrast, an intangible asset is something of value that cannot be seen or touched. Common examples of these non-physical resources include copyrights, trademarks, domain names, and goodwill assets like business branding and reputation.
Different Types of Goodwill
In accounting, four common categories of goodwill are recognized: business goodwill, inherent goodwill, professional practice goodwill, and purchased goodwill.
Business Goodwill
Business goodwill takes into account an entire business, including factors like customers, brand, and the business’s overall position in the industry. It describes the value of a company’s good name and reputation, as well as other intangible assets that give the company an advantage over its competitors.
For example, the amount that franchise contracts, licenses, royalty agreements, and distributorship rights are valued over their purchased costs is considered business goodwill.
Inherent Goodwill
Inherent goodwill is the value of a business above the fair value of its separable net assets. Inherent goodwill is generated within a company due to its reputation and can fluctuate over time, taking on either a positive or a negative value.
Inherent goodwill costs nothing but can take a long time to build. For example, if you are providing consistently excellent service and building close customer relations, you are building inherent goodwill
Professional Practice Goodwill
As the name suggests, professional practice goodwill applies to professional practices, such as a law firm or a medical clinic. This type of goodwill is more personal in nature, as it may exist for an individual rather than a business. For example, doctors, dentists, pharmacists, and accountants can all generate professional practice goodwill.
The value of professional practice goodwill can be affected by a multitude of factors, such as the practitioner’s skills, health, age, reputation in the community, past earning power, and his or her relative professional success.
Purchased Goodwill
Purchased goodwill is the only type of goodwill that is recognized on a company’s goodwill financial statements.
The concept of purchased goodwill is used when a company is purchased for an amount above its fair market value, which is calculated as total assets minus total liabilities. This value difference appears as an additional asset on the balance sheet, denoted simply as “Goodwill.”
Examples of Goodwill
Common examples of goodwill assets include:
- Industry reputation. A company’s reputation within the industry helps it reach new markets, win customer trust, hire new talent, and produce good feedback.
- Brand power. Some businesses have so much brand recognition that they are nearly synonymous with their corresponding industries. For example, when one thinks of bandages, the first brand that comes to mind is Band-Aid.
- Trade secrets. Some companies, especially those in technical fields, are able to develop a deep working knowledge or technique that the average worker might not know.
- Customer loyalty. Customer loyalty helps to increase the goodwill value of a company, - whether the brand has a stable base of repeat customers or a rabid group of fans.
- Workforce talent. A competent and innovative workforce helps to improve the chances of the long-term success of the organization, therefore increasing its goodwill value.
How Does Goodwill Differ from Other Intangible Assets?
While goodwill technically falls under intangible assets, it is recorded on financial statements and treated differently than other types of intangibles. Goodwill earns its own line on a balance sheet, partly because it only appears on the financial statement only when one company purchases another.
Not all intangible assets are goodwill, but all goodwill assets are intangible. For example, goodwill assets like customer loyalty, brand name, and business reputation are, indeed, intangible. However, assets like copyrights are considered intangible but not goodwill.
If an intangible asset can be sold independently of the business (proprietary technology, for example), it is not considered goodwill. Plus, non-goodwill intangible assets can lose value over time, while goodwill will remain useful for indefinite periods of time.
“Not all intangible assets are goodwill, but all goodwill assets are intangible.”
Goodwill vs. Other Intangible Assets: Comparison
Here is a quick summary of how goodwill compares to other intangible assets on a balance sheet:
| Goodwill Assets | Other Intangible Assets |
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How to Calculate Goodwill
Accountants and financial analysts use residual analysis when calculating goodwill. This means finding the residual value of the business left when subtracting its fair market value from its purchase price.
In short, a company’s goodwill can be found according to the goodwill formula:
Goodwill = Purchase Price of a Company - Fair Market Value of a Company, where
Fair Market Value of a Company = Fair Market Value of Assets - Fair Market Value of Liabilities
Here, Purchase Price of a Company stands for the monetary amount that another company is willing to pay to acquire the business in question.
The Fair Market Value of a Company can be found by subtracting the total value of a company’s quantifiable liabilities from the total value of its quantifiable assets.
While the goodwill formula may seem simple, goodwill calculation can be quite complex in practice. That’s why most companies use dedicated accounting software to calculate goodwill and other accounting values like EBITDA.
Example
Company A owns $335,000 in quantifiable assets. Its total liabilities amount to $146,000. Company B purchases Company A for $240,000. Company A’s goodwill can be calculated as:
Company A’s Fair Market Value = $335,000 - $146,000 = $189,000
Goodwill = $240,000 - ($335,000 - $146,000) = $51,000
This means that during the M&A transaction, Company B has paid $51,000 on top of Company A’s fair market value.
Goodwill Impairment
The International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) require companies to evaluate goodwill at least once a year and record impairments in their financial statements.
Goodwill impairment relates to changes in a company’s fair market value. It is an accounting charge that must be recorded when the goodwill asset value on financial statements exceeds its fair value.
Goodwill impairment typically arises when acquired assets fail to generate enough cash flow, and the fair value of goodwill falls below its book value, which was recorded at the time of acquisition. Businesses need to test for impairment each year and following events like acquisitions and layoffs.
“Goodwill impairment … is an accounting charge that must be recorded when the goodwill asset value on financial statements exceeds its fair value.”
Goodwill on the Balance Sheet
The goodwill value must be recorded on a company’s balance sheet whenever it acquires another company, - but where exactly does goodwill go on the balance sheet?
Goodwill assets cannot be touched and have value for an indefinite period of time, meaning that they fall under the long-term intangible asset category. Goodwill is therefore recorded on a separate line on the balance sheet, under the long-term assets account. It is separated from other types of intangible assets, as it appears only as a result of a company being purchased by another company.
Note that the goodwill value can fluctuate, - so the balance sheet can be updated accordingly when a goodwill impairment changes its value.
Why Goodwill Matters in Accounting
There are many reasons why goodwill is used in accounting. Goodwill assets can affect the purchase price of a company, which makes goodwill accounting an important step in the M&A process. From there, companies need to periodically conduct goodwill impairment testing to evaluate their fair market value changes.
In a nutshell, calculating goodwill allows one to account for a premium purchase price in a company’s financial statements. Investors also commonly review the goodwill value on a company’s balance sheet when trying to determine which factors (like brand image and customer loyalty) provide added value to the company.
“Goodwill assets can affect the purchase price of a company, which makes goodwill accounting an important step in the M&A process.”
How Do Companies Accumulate Goodwill?
Many factors play a role in the way a company accumulates goodwill. Some examples include:
- Type of business. A company that offers products or services that are in high demand might accumulate more goodwill faster, as compared to a company that works in a saturated market.
- Business location. Similarly, a business located somewhere where its services are in demand and the market perfumes well will be able to earn goodwill faster.
- Management. If a company has an excellent managerial team, it is likely to see an increase in goodwill related to the way it is managed.
- Quality of products. A company that consistently delivers high-quality products will earn more goodwill as compared to an average company.
- Trademarks and patents. Owning patents and trademarks can help a company increase its profit and accumulate more goodwill.
- Contracts. Once a company is sold, the contracts it holds with customers are considered goodwill to the new owner of the company.
- Business risk. Finally, fewer business risks faced by a company can help it to build goodwill faster.
How Does Goodwill Affect a Company’s Value?
Goodwill can make up a significant percentage of a company’s purchase price. This is because intangible assets, including goodwill, contribute to business profitability, - just like typical tangible assets like equipment and machinery do.
The value of a company and, therefore, its purchase price, is largely determined by its ability to generate cash flow on a consistent basis and the associated risks. Goodwill assets are embedded within a company. As such, they reduce the risk that a company’s profitability will fall once the company ownership changes. This reduction in risk then naturally translates into a higher sale or purchase price.
Goodwill and Other M&A Considerations
Goodwill is one important factor that comes into play during Merger & Acquisition transactions. Other important M&A considerations include:
- Deal structure. There are several ways in which a seller can be compensated during an M&A transaction. The payment methods usually include company stock, cash, notes payable, or a combination of all three.
- Accounting implications. These include the Purchase Price Allocation, or the allocation of the purchase price to the liabilities and assets included in the transaction. This process is used for financial reporting and, in some cases, tax purposes.
- Tax implications. If an M&A transaction is treated as a stock sale rather than an asset sale, taxes will be minimized for the seller. Asset sales, on the other hand, are more favorable to buyers when it comes to taxes.
- Potential synergies. Synergy is the added value produced by combining two companies. Synergies allow the creation of opportunities that would not have been available to the two companies operating separately, - this is why companies merge in the first place
Final Word
All in all, the goodwill accounting concept is an important part of determining a company’s overall value, which is used in Merger and Acquisition transactions. Goodwill includes certain types of a company’s intangible assets, which are embedded within the company and cannot be sold separately - like a company’s brand, customer loyalty, or managerial talent.
