What is Goodwill in Accounting?
Goodwill in accounting is an intangible asset created when a company purchases a subsidiary at a price higher than the fair market value. Unlike other intangible assets, it has an indefinite life, but it can’t be sold or transferred individually.
A company’s “goodwill” is defined by its reputation, brand recognition, customer base, customer service, employee relations, and proprietary technology—all intangible assets whose value can’t be calculated precisely.
How Does Goodwill in Accounting Work?
Investment guru, Warren Buffett, had this to say about how goodwill in accounting works in his 1983 Berkshire Hathaway shareholder letter:
Quote: “….businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.”
Buffett is referring to intangible assets that can’t be mathematically calculated, but add great value to the business. For example, the company’s reputation, brand identity, and workforce talent.
They can be broadly categorized into two types of goodwill:
- Economic, or business, goodwill includes the intangible assets that offer the company a competitive advantage in the market like the company reputation, market share, customer base, etc.
- Professional goodwill accrued over time by the employee’s reputation, clients, location, brand reputation, and so on. It is most commonly seen in accounting firms, law firms, etc.
However, these aren’t categorized separately in the balance sheet. Goodwill accounting is the act of ‘recognizing’ both economic and professional goodwill in the balance sheet. This can be done in just one journal entry.
Factors Affecting Goodwill
Though considered intangible, there are certain factors defining a company’s goodwill:
- When a company offers great quality products and service
- Talented management whose efforts reap great profits through planning and execution
- Loyal customer base that only has good things to say about your product
- Business niche and location
- Proprietary technology and assets (patents, trademarks, etc.)
- Higher profit margins and investments
Take a hypothetical example where Ferrari buys out Lamborghini. Ferrari can calculate a price for the tangible assets, but there is still the question of Lamborghini’s strong brand value in the luxury sports car niche. Ferrari will account for this as goodwill when setting the purchase price.
Treatment of Goodwill in Accounting
Treatment defines how goodwill is recorded in the company’s financial statements. There are four types of goodwill accounting treatment:
- When the subsidiary’s profit-sharing ratio changes
- When a new partner joins the company
- When a partner retires or passes away
- When the business is sold or merged with another organization
How to Manage Goodwill Impairments in Accounting (With Example)
There is a chance the value of your intangible assets drops below the initial goodwill paid. This is called goodwill impairment. The drop may be sudden or gradual depending on external factors like changes in the economy, market, or government regulations.
Let’s take a goodwill example where you paid a premium for a company’s proprietary technology. The company owns a majority market share but over the years, customers adopted more advanced technology, making your technology obsolete. This is an example of goodwill impairment because you’re no longer able to profit from your technology.
Under US Generally Accepted Accounting Principles (US GAAP) and International Financial Reporting Standards (IFRS), goodwill needs to be evaluated for impairment every year or after a major trigger event. Any decrease in the company’s goodwill should be recorded in the balance sheet with two simple steps:
- Record the loss as a non-cash expense in the income statement
- Reduce the value of goodwill on your company balance sheet
Since evaluating accounting goodwill is a yearly ritual, I think it’s also worth understanding how to calculate goodwill.
How to Calculate Goodwill in Accounting
Goodwill is calculated by taking the difference between the purchase price and the fair value of the company’s assets and liabilities.
Goodwill = P − (A − L),
P = Purchase price of the target company
A = Fair market value of company assets
L = Fair market value of company liabilities
Example of goodwill in accounting
To understand how this formula works, let’s look at a hypothetical Company “A” that you just purchased for $600,000—a steal considering the great reputation and brand recall “A” brings with it (a.k.a the goodwill).
Company “A”s books reported the following amounts:
The goodwill created for company “A” can be calculated as:
Goodwill = $600,000 – ($700,000 – $175,000)
Goodwill = $75,000
The goodwill paid is $75,000.
The journal entry with goodwill will look as follows:
Drawbacks of Goodwill in Accounting
Goodwill has some limitations despite being a great tool for recognizing intangible assets in your balance sheets:
- It is a subjective calculation. At its core, goodwill is an estimate of future cash flows influenced by intangible assets. So, estimates can differ depending on the accountant’s outlook.
- It lacks consistency. Some companies may value goodwill more than others since there isn’t a universally accepted method for calculating goodwill.
- It is a buyer’s market. Goodwill is decided by the purchaser and only included in their balance sheet during purchase. Businesses can’t increase their valuation by including goodwill in the balance sheet.
- You always risk impairment. Market conditions have a major impact on goodwill. For example, you may pay a premium for brand reputation, but a faulty product or bad customer review can reduce a company’s goodwill.
Goodwill is the difference between the purchase price and the fair value of company assets minus liabilities. It offers an accurate representation of a company’s intrinsic value by accounting for intangible assets like company reputation, brand value, workforce skills, and so on.
However, it’s worth remembering that goodwill is subjective. How one company values intangible assets may not align with others’ outlook. Impairment tests need to be run yearly to evaluate if major financial events or market changes impacted the company’s goodwill. Any decrease in goodwill should be adjusted in the balance sheets.