Goodwill Explained With Example — Accounting — What It Is, How It Works and How To Calculate
What Is Goodwill?
Goodwill is an intangible asset that is created on the balance sheet with the purchase of one company by another.
It represents the competitive advantage a company can get by buying another company. And its amount is the portion of the purchase price that is higher than the book value of the company being bought.
The reasons that one company may pay a premium for another can be things like company’s name, brand reputation, loyal customer base and solid customer service which all of them are not easily quantifiable.
And on this article we are gonna explain what it is, how it works and how to calculate it.
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Understanding Goodwill
To understand Goodwill let’s start with an example. We have two companies here with their simplified Balance Sheet.
Company A has 10 million of cash, 5 million of fixed assets like property, plants and equipment, and 2 million of debt, which gives them 13 million of equity.
Company A
Cash: 10,000,000
Fixed assets: 5,000,000
Debt: 2,000,000
— — — — — — — —
Equity: 13,000,000
Company B has 100 thousand of cash, 200 thousand of fixed assets and 200 thousand of debt, giving them 100 thousand of equity.
Company B
Cash: 100,000
Fixed assets: 200,000
Debt: 200,000
— — — — — — — —
Equity: 100,000
Company A wants to buy company B for 500,000 while its book value is 100,000. So they are paying a 400,000 premium. Let’s see how the transaction will work.
Step 1 — 500,000 cash from company A will be moved to owners of company B and now company A owns company B with all its assets and liabilities.
Step 2 — Company A moves the 100,000 equity company B had to its Balance Sheet
Step 3 — But company A need to have the same equity as before the transaction, so they will record the 400,000 premium paid in cash on Goodwill account and now their new Balance Sheet looks like this
Company A
Cash: 9,600,000
Fixed assets: 5,200,000
Goodwill: 400,000
Debt: 2,200,000
— — — — — — — —
Equity: 13,000,000
If for some reason company A pays less than the book value for company B, it gains negative goodwill, which can happen in a distress sale and is recorded as income on the buyer’s income statement.
Goodwill is recorded as an intangible asset on the buyer company’s balance sheet under the long-term assets account because it is not a physical asset like buildings or equipment.
Companies are required to evaluate the value of goodwill on their financial statements at least once a year and change them if needed, for example when the market value of the asset drops below historical cost or estimated future cash flows discounted to the present value declines.
And this will be expensed as a loss on the income statement, which directly reduces net income for the year.
The formula for calculating goodwill is fairly simple in principle, just deduct the book value from purchase price, but it can be quite complex and costly in practice.
So many companies will just amortise Goodwill like other intangible assets annually over a number of years.
Goodwill vs. Other Intangibles
Goodwill is a premium paid over fair value during a transaction and cannot be bought or sold independently. Meanwhile, other intangible assets like licenses or patents can be bought or sold independently. Therefore, at the point of insolvency, the goodwill will be ignored since it has no resale value.
Also Goodwill can have an indefinite life, while other intangibles have a definite useful life.
Goodwill and Investing
Evaluating goodwill is a critical skill for investors. When reading a company’s balance sheet, it’s important to tell whether the goodwill it claims to hold is in fact justified.
For example, a company might claim that its goodwill is based on the brand recognition and customer loyalty of the company it bought.
Investors need to understand what is behind the stated goodwill in order to determine whether that goodwill may need to be written off in the future.
Or the opposite if you believe that the true value of a company’s goodwill is greater than that stated on its balance sheet.
Sum-up
So to sum everything up, goodwill represents a value like a potential competitive advantage, that may be obtained by one company when it purchases another. It is 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 is an intangible asset that can relate to the value of the purchased company’s brand reputation and loyal customer base.
While goodwill officially has an indefinite life, it should be looked over annually to see if the value needs adjusting, due to an adverse financial event. If there is a change in value, the goodwill account will be decreased on the balance sheet and a loss is recognised on the income statement.
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