Goodwill (Accounting)
Goodwill in accounting is an intangible asset that represents the value of a company’s reputation, customer relationships, and other non-physical assets.
It is commonly referred to as an “accounting plug” as it fills a gap between identifiable asset value and aggregate measured value.
It is often recorded on a company’s balance sheet as a result of an acquisition, when the purchase price paid for a company exceeds the fair value of its tangible assets and liabilities.
Goodwill is considered an intangible asset because it does not have a physical form and it’s difficult to quantify. Goodwill is also considered as an asset because it generates future economic benefits for the company.
Goodwill is also an indicator of brand value and customer loyalty.
Calculating Goodwill
Goodwill is calculated as the difference between the purchase price of a company and the fair value of its tangible assets and liabilities.
The formula for calculating goodwill is as follows:
Goodwill = Purchase Price – (Fair Value of Tangible Assets + Fair Value of Liabilities)
For example, if a company is purchased for $1 billion and the fair value of its tangible assets and liabilities is $800 million, the goodwill would be $200 million.
It’s important to note that the fair value of the assets and liabilities must be determined by an independent appraiser or valuation expert and this calculation should be done regularly to ensure the accuracy of the goodwill value.
Additionally, the accounting standard IFRS3, defines a two-step approach for accounting for business combinations, in which first the identifiable assets and liabilities are measured at fair value and second, the residual amount is allocated to goodwill.
What Is a Goodwill Impairment?
A goodwill impairment occurs when the carrying value of goodwill on a company’s balance sheet exceeds its fair value.
This means that the value of the company’s intangible assets such as reputation, brand, and customer relationships has decreased.
This can happen due to a variety of reasons such as:
- a decline in the company’s financial performance
- changes in the industry, or
- negative developments in the company’s reputation
When a goodwill impairment is identified, the company is required to record an impairment charge on its financial statements, reducing the value of goodwill on the balance sheet.
This charge is recognized as an expense in the current period and is reflected in the company’s income statement.
The impairment charge can have a significant impact on the company’s earnings and can also affect the company’s stock price.
How Does Goodwill Compare to Other Forms of Intangible Assets?
Goodwill is one type of intangible asset, which refers to non-physical assets that provide economic benefits to a company.
Other types of intangible assets include:
Patents, trademarks, and copyrights
These are legal rights granted by the government that give the owner exclusive rights to use, sell, or license certain products or services.
Licenses and franchises
These are agreements that allow a company to operate under the name or brand of another company, or to use certain technology or intellectual property.
Customer lists and relationships
These are the value of a company’s customer base and the relationships that it has built with them.
Software and technology
This includes computer programs, databases, and other forms of technology that are used to operate and manage a business.
Trade secrets and confidential information
This refers to non-public information that gives a company a competitive advantage.
Each type of intangible asset has a different value, lifespan and different regulations to be accounted for and therefore the impact of their impairment can vary.
Goodwill is unique among intangible assets in that it is typically associated with the acquisition of one company by another, and it’s usually the excess of purchase price over the fair value of the identifiable assets and liabilities of the acquired company.
Goodwill Explained
Conclusion
Goodwill in accounting refers to the intangible asset that arises when a company acquires another company for a price that is higher than the fair market value of the net assets that are being acquired.
Goodwill represents the value of the acquired company’s reputation, customer relationships, and other intangible assets that are not separately identifiable and measurable.
When a company acquires another company, it must allocate the purchase price among the various assets and liabilities that are being acquired.
Any excess of the purchase price over the fair market value of the net assets is recorded as goodwill on the acquirer’s balance sheet.
Goodwill is considered an intangible asset because it is not a physical asset and it is not separately identifiable and measurable.
Unlike other intangible assets, goodwill is not amortized (i.e., written off) over time.
Instead, it is tested for impairment at least annually. If the fair value of a reporting unit (a business or operating segment) is less than its carrying amount, an impairment loss is recognized for the amount by which the carrying amount exceeds the fair value.
To sum up, Goodwill is a measure of the premium paid for a company over and above the value of its net assets. It’s an intangible asset which should be tested for impairment at least annually.