Sometimes it makes sense to pay more for something than its market value. Maybe there was a limited supply of that new electric vehicle that you wanted, you were in a bidding war, or you purchased a home during a seller’s market.
There are several reasons you can use to justify paying a premium for getting what you want (or need), and the same is true in business acquisitions. Sometimes, one company is willing to pay a premium to acquire another, and that premium is referred to as goodwill.
For businesses, it’s important to track goodwill in accounting so there’s transparency around the fact that you paid more than market value.
What is goodwill in accounting?
Goodwill is an accounting term that refers to purchase premiums that occur when one company pays more than market value to acquire another. In short, goodwill is the value of a company beyond its physical assets.
Typically, the acquirer is willing to pay more for a company because they see value in assets that aren’t easy to quantify.
Examples of goodwill assets include:
- Customer relationships: when a company has a loyal and engaged customer base, typically measured using metrics like retention, lifetime value of the customer, and customer acquisition cost
- Reputation capital: the value that a company has acquired by consistently creating high-quality products and earning trust in the consumer base
- Human capital: the knowledge, skills, and capabilities that the workforce brings to the company
- Brand equity: the added value of the brand name, logo, and trademarks
These intangible assets are hard to quantify and may not be used in calculating the fair market value of the target company, but they can still give the purchasing company a competitive advantage.
What is negative goodwill?
Negative goodwill is the term used to describe the price discount that happens when one company acquires another below fair market value. This often happens when the company for sale is trying to liquidate assets to pay off debts or has gone bankrupt.
How is goodwill calculated?
When calculating goodwill, start with the purchase price of the company and subtract the fair market value of its net assets, which refers to its assets minus liabilities. What you’re left with is the excess value.
You can refer to the formula below for calculating goodwill.
Goodwill = P - (A - L)
P = Purchase price
A = Fair value of assets
L = Fair value of liabilities
When calculating the value of a company’s assets, you can include:
- Tangible assets: such as cash, cash equivalents, accounts receivable, marketable securities, real estate, inventory, furniture, and equipment
- Quantifiable intangible assets: such as intellectual property rights, proprietary software, and product design
Liabilities, on the other hand, refer to all debts and money owed by the company, including:
- Income tax payable
- Accrued expenses
- Accounts payable
- Interest payable
- Business loans
- Bills payable
Goodwill calculation example
Say you acquired Company X for $16B, and it has the following asset and liability values.
- Fair value of assets: $17B
- Fair value of liabilities: $4B
If you plug those figures into the goodwill formula, you get the following:
Goodwill = P - (A - L)
Goodwill = $16B - ($17B - $4B)
Goodwill = $16B - $13B
Goodwill = $3B
The amount of goodwill comes out to $3B, which means that you paid $3B more than the fair market value. If that’s the case, you recognize this amount by recording it as goodwill on your balance sheet.
What is goodwill on a balance sheet?
Goodwill is listed as an intangible asset on the acquirer’s balance sheet when one company pays a premium to acquire another. It represents the difference between the final purchase price and the actual net value of the acquired company’s assets. This accounting record is referred to as recognizing the value of goodwill.
Negative goodwill, on the other hand, is not recorded as a balance sheet item. Instead, it gets marked down as an immediate increase in net income and is recorded on the income statement as an extraordinary gain. Extraordinary gain is the accounting term used to describe income from infrequent and less common events, such as acquiring another business at a bargain price.
Is goodwill a current asset?
No, goodwill is a long-term asset, also known as a noncurrent asset. Current assets are those that your company will consume or sell within one year. Goodwill cannot be sold, and its value lasts beyond one year, which makes it long term.
Specifically, goodwill is considered a long-term intangible asset because it represents nonphysical value, which can refer to things like brand recognition, strong supplier relationships, and a loyal customer base.
Goodwill vs. other intangible assets
The main difference between goodwill and other intangible assets is that goodwill cannot be separated from the business and sold, while other intangible assets can. To get a better understanding, consider the difference between brand recognition and patents.
Brand recognition cannot be separated from a company and sold individually. If you want to benefit from a company’s reputation, you need to acquire the company. So, brand recognition is included in goodwill.
Customer base loyalty, market share, and supplier relationships are other examples of goodwill assets.
In contrast, if you want a patent, you can buy it from a company without acquiring the entire business. This makes patents an intangible asset.
Other examples of intangible assets include trademarks, copyrights, customer lists, and proprietary software.
If the value of goodwill assets declines over time, this is known as goodwill impairment. Basically, it means that the value of the asset has dropped below the amount that you paid for it. This usually happens because of an external economic event or a change in the competitive landscape.
Say you acquire a company and pay a goodwill premium because it has a strong workforce. However, a few years later, that company had to lay off a significant number of employees due to a recession.
That’s an example of goodwill impairment because you’re no longer able to reap the full value of the workforce. Common goodwill impairment triggers include significant changes in the economy, changes in the competitive landscape, and new regulations.
Both the US Generally Accepted Accounting Principles (US GAAP) and International Financial Reporting Standards (IFRS) require that companies test their goodwill at least once a year and after a possible triggering event. However, each set of standards provides different instructions for impairment testing.
If the impairment test results say that your goodwill has decreased, that loss needs to be recorded. Accounting for goodwill impairment involves two steps: Record the loss in value as a noncash expense on the income statement, and reduce the value of goodwill on your company’s balance sheet.
Limitations of goodwill in accounting
Including goodwill in a company’s valuation is a helpful way to illustrate the value of assets such as brand reputation and customer loyalty. While these may be difficult concepts to put a price tag on, they can have a positive impact on the company’s future cash flow.
That being said, there are some limitations to goodwill, including:
- Lack of objectivity: Goodwill is ultimately a subjective calculation that’s based on assumptions about future cash flow. As a result, you may get different estimates of goodwill from different investors, analysts, or accountants.
- Lack of uniformity: There’s no universal way to determine the value of goodwill. For instance, one company may be willing to pay a higher premium for brand reputation than another.
- No guarantee of return: Marco Andolfatto, chief underwriting officer at insurance company Apollo Cover, explains, “Goodwill doesn’t bring in cash on its own, even though it represents the extra amount paid for a company's intangible value.” Unlike tangible fixed assets, you can’t convert goodwill assets into cash by selling them.
- Risk of impairment: Goodwill depends on factors like economic and market conditions. If those change in the future, you can lose some of the value. For instance, you may pay a premium for customer loyalty, but if a recession happens and customers cut their spending, that benefit can decrease.
- Only used for acquisitions: Goodwill can only be used if a company is bought at a higher price than its fair market value. Even then, it will only appear on the acquirer’s balance sheet. A business cannot put goodwill on its own balance sheet and increase its valuation by putting numbers on items like customer loyalty or brand reputation.
When it comes to understanding how goodwill affects a company’s valuation, entrepreneurs should keep in mind that goodwill is a subjective calculation and isn’t a direct measure of potential revenue. Just because one company is willing to pay a premium for something doesn’t mean it has the same value to you.