Goodwill (Accounting): What It Is, How It Works, and How To Calculate

What Is Goodwill?

Goodwill in business is an intangible asset that's recorded when one company is purchased by another. It's the portion of the purchase price that's higher than the sum of the net fair value of all of the assets purchased in the acquisition and the liabilities assumed in the process.

This difference is due to issues such as the value of a company’s name, brand reputation, loyal customer base, solid customer service, good employee relations, and proprietary technology. Goodwill represents a value that can give the acquiring company a competitive advantage. It's one of the reasons that one company may pay a premium for another.

Understanding Goodwill

The value of goodwill typically comes into play when one company acquires another. A company's tangible value is the fair value of its net assets but the purchasing company may pay more than this price for the target company. This difference is usually due to the value of the target’s goodwill.

Goodwill is recorded as an intangible asset on the acquiring company's balance sheet under the long-term assets account. It's considered to be an intangible or non-current asset because it's not a physical asset such as buildings or equipment.

Companies are required under generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS) to evaluate the value of goodwill on their financial statements at least once a year and record any impairments.

Goodwill Impairments

Accounting goodwill involves the impairment of assets that occurs when the market value of an asset drops below historical cost. This can occur as the result of an adverse event such as:

• Declining cash flows
• Increased competitive environment
• Economic depression

The company must impair or do a write-down on the value of the asset on the balance sheet if a company assesses that acquired net assets fall below the book value or if the amount of goodwill was overstated. The impairment expense is calculated as the difference between the current market value and the purchase price of the intangible asset.

The impairment results in a decrease in the goodwill account on the balance sheet. The expense is also recognized as a loss on the income statement. This directly reduces net income for the year. Earnings per share (EPS) and the company's stock price are also negatively affected.

Impairment Tests

Companies assess whether an impairment exists by performing an impairment test on an intangible asset. The two commonly used methods for testing impairments are the income approach and the market approach.

• Income approach: Estimated future cash flows are discounted to the present value.
• Market approach: Assets and liabilities of similar companies operating in the same industry are analyzed.
  

Calculating Goodwill

The process for calculating goodwill is fairly straightforward in principle but it can be complex in practice. You can determine goodwill with a simple formula by taking the purchase price of a company and subtracting the net fair market value of identifiable assets and liabilities.

$\begin{aligned}&\text{Goodwill} = \text{P} - ( \text{ A } - \text { L } ) \\&\textbf{where:} \\&\text{P} = \text{Purchase price of the target company} \\&\text{A} = \text{Fair market value of assets} \\&\text{L} = \text{Fair market value of liabilities} \\\end{aligned}$​Goodwill=P−( A − L )where:P=Purchase price of the target companyA=Fair market value of assetsL=Fair market value of liabilities​

Accountants use competing approaches in calculating goodwill.

Goodwill involves factoring in estimates of future cash flows and other considerations that aren't known at the time of the acquisition. This may not normally be a major issue but it can become significant when accountants look for ways to compare reported assets or net income between companies. Some of them may have acquired other firms and some may not have.

The Financial Accounting Standards Board (FASB), which sets standards for GAAP rules, was considering a change to how goodwill impairment is calculated. FASB was considering reverting to an older method called "goodwill amortization" due to the subjectivity of goodwill impairment and the cost of testing it. This method would have reduced the value of goodwill annually over several years but the project was set aside in 2022 and the older method was retained.

Limitations of Goodwill

Goodwill is difficult to price and negative goodwill can occur when an acquirer purchases a company for less than its fair market value. This usually happens when the target company can't or won't negotiate a fair price for its acquisition.

Negative goodwill is usually seen in distressed sales and is recorded as income on the acquirer's income statement.

There's also the risk that a previously successful company could face insolvency. The goodwill the company previously enjoyed has no resale value at the point of insolvency. Investors deduct goodwill from their determinations of residual equity when this happens.

Example of Goodwill

The premium paid for the acquisition is $3 billion ($15 billion - $12 billion) if the fair value of Company ABC's assets minus liabilities is $12 billion and a company purchases Company ABC for $15 billion. This $3 billion will be included on the acquirer's balance sheet as goodwill.

Consider the T-Mobile and Sprint merger announced in early 2018 for a real-life example. The deal was valued at $35.85 billion as of March 31, 2018, per an S-4 filing. The fair value of the assets was $78.34 billion and the fair value of the liabilities was $45.56 billion.

The difference between the assets and liabilities is $32.78 billion so goodwill for the deal would be recognized as $3.07 billion ($35.85 billion - $32.78 billion), the amount over the difference between the fair value of the assets and liabilities.

The Bottom Line

Goodwill is an intangible asset that can relate to the value of a purchased company's brand reputation, customer service, employee relationships, and intellectual property. It represents a value and potential competitive advantage that may be obtained by one company when it purchases another. It's the amount of the purchase price over and above the amount of the fair market value of the target company's assets minus its liabilities.

Goodwill officially has an indefinite life but impairment tests can be run to determine if its value has changed due to an adverse financial or publicity event. These events can include a negative PR situation, financial dishonesty, or fraud. The amount decreases the goodwill account on the balance sheet if there's a change in value and it's recognized as a loss on the income statement.