What is Goodwill?

Goodwill is like buying a house for more than the listed price…

Imagine you see a house listed for sale for $300,000. Based on your research, you’re confident the house is actually worth much more and won’t stay on the market for long. You make an offer of $350,000 to buy the house. The extra $50,000 you’re willing to pay is like the goodwill in a business acquisition –- You’re confident the value is there, and you see it as an asset even though it’s not reflected in the listing price.

According to Generally Accepted Accounting Principles (GAAP), goodwill is the difference between the purchase price of a company and the fair market value of its net assets (assets minus liabilities). The premium the acquiring company pays above the fair market value takes into account certain intangible elements of the company, such as a loyal client base or brand recognition.

These things don’t have a price tag in the market, but they almost certainly provide financial benefits to a company. For that reason, most of the time one company buys another for more than just the value of its quantifiable assets. The difference — or goodwill — goes on the acquiring company’s balance sheet as an intangible asset.

It’s rare but possible to have negative goodwill, which is what happens when one company purchases another for less than the value of its net assets. The company doing the purchasing gets a bargain. Negative goodwill can happen when the sellers aren’t able to do a thorough valuation or need to sell quickly because they’re facing financial difficulties or are being forced to sell by a court judgment. The company doing the purchasing can claim the negative goodwill as income on its income statement.

It might seem counterintuitive that goodwill goes onto the balance sheet as an asset. After all, didn’t the acquiring company pay more for the other company than it was worth? While it’s true that the company paid more than fair market value, it generally paid that premium for a reason.

International Financial Reporting Standards define an asset as an economic resource a company controls as a result of past events that have the potential to produce economic benefits.

There are some parts of a company that you can easily put a price tag on. For example, the buildings, machinery, and cash the company owns have clear market values.

Other assets are harder to price because they are intangible. These can include patents, trademarks, a skilled workforce, and brand loyalty. Even though they don’t have a clear market value, they still provide economic benefits to the company. These intangible assets are typically the reason a company buys another company for more than its fair market value, and they are what allow the acquiring company to claim goodwill as an asset on its balance sheet.

It used to be that goodwill would have to be amortized gradually. That meant companies had to claim a portion of goodwill as an expense every year, reducing their net income, until it reduced to zero.

Goodwill no longer has to be amortized on a particular schedule, but that doesn’t mean a company can continue to claim it on its balance sheet forever. Instead, goodwill is evaluated for impairment.

Impairment is an adjustment in accounting to reflect the actual benefit a company is getting from the asset they acquired. Generally Accepted Accounting Principles (GAAP) require that companies look for goodwill impairment once a year.

If the goodwill is impaired, meaning it doesn’t bring in an economic benefit that at least matches the amount of goodwill, the company writes down the goodwill as an expense, which appears on its income statement. This expense reduces the company’s net income.

Goodwill emerges when one company buys another company for more than its fair market value. To determine goodwill, first find the fair market value of the assets and liabilities of the company being acquired. This is the value that someone would reasonably place on those assets and liabilities in an open market.

Next, subtract the value of the liabilities from the assets to get net assets. Then subtract net assets from the company’s purchase price to get goodwill.

The formula looks like this:

Goodwill = Purchase Price - (Assets - Liabilities)

Let’s say Joan’s Flower Shop decides to purchase Ann’s Candy Shop to create Joan’s Flower and Candy Shop. Based on its balance sheet, Ann’s Candy Shop has $150,000 in assets and $50,000 in liabilities, resulting in $100,000 in net assets. Joan offers to buy Ann’s shop for $125,000.

In this case, the goodwill comes to $25,000 ($125k – $100k). When Joan’s Candy and Flower Shop files its balance sheets from now on, it will include that $25,000 as an asset.

Everything a company owns is known as an asset. An intangible asset is one that brings economic value to the company but doesn’t necessarily have a fair market value. It’s an asset you can’t see or put up for sale, but it has value nonetheless. The opposite of an intangible asset is a tangible asset. These include cash, buildings, and equipment. Tangible assets have a physical form and a clear market value.

Goodwill is one example of an intangible asset, but it’s not the only one. Other examples include copyrights, trademarks, and proprietary software.

Companies can continue to claim goodwill as an asset for as long as it brings corresponding profits to the company. The Internal Revenue Service (IRS) generally requires that companies amortize other intangible assets (though not goodwill) over 15 years. Amortization involves spreading the cost of the asset out over a set period of time in accounting.

It can be beneficial for a company to claim goodwill as an asset on its balance sheet. The company paid a premium for intangible assets, and they’re likely to bring increased revenue. But there are some concerns and controversies surrounding goodwill.

Because goodwill is an intangible asset, its value can be subjective. While a company may pay a premium of $50,000 for another company’s intangible assets, that doesn’t mean the assets are worth that much. Companies tend to buy firms when they’re doing well and may overvalue those assets in the sale.

There’s also some concern that companies are putting too high a premium on goodwill. This excess premium can be problematic for future financial statements. When goodwill is no longer worth what the balance sheet says it is, companies have to impair it, which means they write it down as an expense on their income statements. These write-downs can lead to a decrease in pre-tax earnings and profit.

Additionally, even though the intangible assets that a company paid a premium for might bring profit, they aren’t something that a company can easily buy and sell. That means some investors may prefer to evaluate companies based on their book value, which is the net value of a firm’s assets without taking into account intangible assets like goodwill.