What is Goodwill in Accounting?

Goodwill Accounting Definition

In the accounting world, goodwill arises when one company acquires another company for a higher purchase price than the fair market value of the company’s net assets.

 

The difference between the purchase price and the fair value of the net assets is recorded as goodwill.

 

Goodwill is an intangible asset, which means that it cannot be physically touched.

 

Goodwill is a reflection of the reputation, customer loyalty, and other intangible benefits that a company possesses, making it an essential consideration during mergers and acquisitions.

 

For example, imagine Company A buys Company B for £100m. The net assets on the balance sheet of Company B only total £80m. Therefore, there is £20m of goodwill associated with this purchase.

 

Goodwill is recorded on the balance sheet as a long-term asset.

What is Goodwill in Accounting?

Types of Goodwill

The two types of goodwill are purchased goodwill and inherent goodwill.

 

  • Purchased Goodwill arises when one company acquires another company at a price that is higher than the fair value of company’s net assets.
  • Inherent Goodwill, also known as self-generated goodwill, does not arise from acquisition, but is instead built internally over time by the company’s own efforts and operations.

Goodwill Accounting Examples

Examples of goodwill in accounting would typically include:

 

  • Brand Reputation: A strong brand with a positive reputation can create a loyal customer base and a competitive advantage.

For example, Coca-Cola’s brand is familiar and trusted around the world, which contributes significantly to its goodwill.

 

  • Customer Loyalty: A company with a loyal customer base is likely to generate stable and recurring revenue, adding value to the business.

For example, Apple’s customer loyalty and dedicated fan base add to its substantial goodwill.

 

  • Intellectual Property: Ownership of patents, trademarks, copyrights, and trade secrets can enhance a company’s competitive edge.

For example: The patents held by pharmaceutical companies on their exclusive drugs and treatments will contribute greatly towards their goodwill.

 

  • Long-Term Contracts: Having long-term contracts with customers can secure a predictable revenue stream, making the business more valuable.

For example, a mobile phone service provider with long-term contracts for customers would have higher goodwill.

 

  • Skilled Workforce: A company with a talented and skilled workforce may possess a competitive advantage over its peers.

For example, a technology company with exceptional software engineers and developers will have higher goodwill.

examples of goodwill in accounting

Goodwill Accounting Formula

The accounting formula to calculate goodwill is as follows:

Goodwill = Purchase Price – Net Assets

Where Net Assets = Fair Market Value of Assets – Fair Market Value of Liabilities

How To Calculate Goodwill

Here is a step-by-step guide on how to calculate goodwill:

 

Step 1: Recognise Identifiable Net Assets

 

Identifiable net assets are the assets and liabilities of the acquired business that can be individually identified and measured at fair value. These typically include items like cash, accounts receivable, inventory, property, plant, equipment, and any liabilities.

 

Step 2: Determine the Fair Value of Identifiable Net Assets

 

For each identifiable net asset, determine its fair value. Fair value represents the price at which an asset could be sold, or the price that a liability could be settled.

 

Step 3: Establish Purchase Price

 

Collect all relevant financial information related to the purchase price of the acquired business.

 

Step 4: Calculate Goodwill

 

Calculate the goodwill by using the goodwill formula and the values for net assets and purchase price.

 

Goodwill = Purchase Price – Net Assets

 

For example:

 

Company A acquires Company B for £5m.

 

The fair value of Company B’s net assets is £3.8m.

 

Using the formula, the goodwill calculation would be as follows:

 

Goodwill = £5m (Purchase Price) – £3.8m (Net Assets) = £1.2m

What is Goodwill Impairment?

Goodwill is not amortised, but the value needs to be assessed each year to check that it hasn’t fallen in value.

 

This is called an impairment test.

 

If it is deemed that the goodwill value has fallen, then the value must be reduced on the balance sheet.

 

Impairment is a non-cash accounting adjustment that reduces the value of goodwill on the balance sheet, and also negatively impacts the company’s net income.

Limitations of Goodwill

Goodwill in accounting has certain limitations that can affect the accuracy and usefulness of financial statements.

 

Understanding these limitations is crucial for investors, analysts, and decision-makers.

 

Here are some key limitations of goodwill in accounting:

 

  • Subjective: The calculation of goodwill involves estimating the fair value of identifiable net assets and the purchase price, both of which can be subjective. Different valuation methods and assumptions can lead to varying values of goodwill, potentially impacting financial reporting.
  • Non-amortisation: Unlike tangible assets, goodwill is not amortised over time. Instead, it is regularly tested for impairment. Not amortising goodwill may lead to the value remaining unchanged on the balance sheet even if its actual value has diminished.
  • Intangible Nature: Goodwill represents intangible assets, such as brand reputation and customer loyalty, which are challenging to quantify accurately. This can make it difficult for stakeholders to assess the true value and contribution of goodwill to a company’s success.