Goodwill

Page written by AI. Reviewed internally on July 4, 2024.

Definition

Goodwill, in business and accounting, refers to the intangible asset that represents the value of a company’s reputation, brand recognition, customer loyalty, and other non-physical attributes that contribute to its overall success and competitive advantage.

What is goodwill?

Goodwill is considered an intangible asset because it doesn’t have a physical presence like buildings or equipment. It’s the intangible value that arises from factors such as a company’s strong customer base, established brand name, skilled workforce, favourable location, and positive relationships with suppliers and distributors.

Furthermore, goodwill often comes into play during mergers and acquisitions (M&A) when one company acquires another. The purchase price of the acquired company might exceed the value of its tangible assets and liabilities. The excess amount is recorded as goodwill on the acquiring company’s balance sheet.

Prior to changes in accounting rules, companies used to amortise goodwill over a specific period. However, modern accounting standards do not allow amortisation of goodwill but require periodic assessments for impairment.

Companies are required to disclose information about goodwill in their financial statements. This includes details about acquisitions, any impairment charges, and changes in the carrying amount of goodwill.

Calculation of goodwill

Calculating goodwill is simple but can become complex in action. It involves subtracting the net fair market value of identifiable assets and liabilities from the purchase price of a company to derive the goodwill amount. This is done using the formula:

Goodwill = P − ( A − L )

Where:

P = Purchase price of the target company
A = Fair market value of assets
L = Fair market value of liabilities

What is goodwill impairment?

Goodwill impairment occurs when the value of goodwill on a company’s balance sheet exceeds its fair market value. Goodwill represents the premium paid for an acquired company above its tangible assets’ book value.

Periodically, companies assess whether the goodwill’s value has decreased due to factors like changes in market conditions, poor performance, or strategic misalignment. If the fair value of goodwill is determined to be less than its carrying value, the excess is written off as a goodwill impairment charge on the income statement. This charge reduces net income and shareholders’ equity, reflecting a more accurate representation of the goodwill’s current value.

Example of goodwill

XYZ Corporation decides to buy ABC Retail, a successful retail chain with a strong brand and a loyal customer base. The purchase price for ABC Retail is $10 million, and the identifiable net assets of ABC Retail are valued at $8 million.

Purchase price: $10 million
Identifiable net assets: $8 million
Goodwill: $2 million

In this example, the $2 million difference between the purchase price and the identifiable net assets is recorded as goodwill on XYZ Corporation’s balance sheet. This $2 million represents the intangible value that XYZ believes it is gaining from acquiring ABC Retail beyond the measurable value of its tangible assets.