How To Calculate Goodwill
Assigning a numeric value on goodwill can be challenging. However, the need for determining goodwill often arises when one company buys another firm, a subsidiary of another firm, or some intangible aspect of that firm's business. Two different ways to calculate goodwill exist.
- Goodwill is an intangible asset, and it comes in a variety of forms, including reputation, brand, domain names, and intellectual property.
- The need for determining goodwill often arises when one company buys another firm.
- Goodwill is calculated as the difference between the amount of consideration transferred from acquirer to acquiree and net identifiable assets acquired.
The concept of goodwill in business affairs goes back at least a century. One of the first definitions of it appeared in Halsbury's Laws of England, a comprehensive encyclopedia that dates from 1907. The current Halsbury's (4th edition, Vol. 35), states that:
“The goodwill of a business is the whole advantage of the reputation and connection with customers together with the circumstances, whether of habit or otherwise, which tend to make that connection permanent. It represents in connection with any business or business product the value of the attraction to the customers which the name and reputation possess.”
In listing goodwill on financial statements today, accountants rely on the more prosaic and limited terms of the International Financial Reporting Standards (IFRS). IAS 38, "Intangible Assets," does not allow the recognizing of internally created goodwill (in-house-generated brands, mastheads, publishing titles, customer lists, and items similar in substance). The only accepted form of goodwill is the one that acquired externally, though business combinations, purchases or acquisitions.
For example, in 2010, Reuters reported that Facebook (FB) bought the domain name fb.com for $8.5 million from the American Farm Bureau Federation. A domain name's sole value is the name, or (in this case) the initials. So, the entire amount paid for it can be considered as goodwill and Facebook would have recognized it as such on its balance sheet. However, before the acquisition, the American Farm Bureau Federation could not recognize fb.com as goodwill on its balance sheet—goodwill has to spring from an external source, not an internal one, remember.
How To Calculate Goodwill
According to IFRS 3, "Business Combinations," goodwill is calculated as the difference between the amount of consideration transferred from acquirer to acquiree and net identifiable assets acquired. The general formula to calculate goodwill under IFRS is:
Goodwill=(C+NCI+FV)−NAwhere:C=Consideration transferredNCI=Amount of non-controlling interestFV=Fair value of previous equity interests
Non-Controlling Interests in the Goodwill Calculation
The method to calculate goodwill is straightforward. Where the wrinkles occur comes in measuring one of the variables. As you see, the amount of non-controlling interest (NCI) plays a significant role in the goodwill-calculation formula. A non-controlling interest is a minority ownership position in a company whereby the position is not substantial enough to exercise control over the company.
Under IFRS 3, there are two methods for measuring non-controlling interest:
- Fair value or full goodwill method
- Non-controlling interest’s proportionate share of the acquiree’s net identifiable assets
As it happens, these two methods can yield different results.
Example: “A Inc.” acquires “B Inc.”, agreeing to pay $150 million (the consideration transferred) to obtain a 90% interest in B. The fair value of the non-controlling interest is $16 million. Let's also stipulate that the fair value of net identifiable assets to be acquired is $140 million and that no previous equity interests exist.
Using method 1 of measuring NCI, the amount of the goodwill is $26 million ($150m + $16m - $140m).
Under the second method of measuring the NCI, we take into account the 10% of B that A didn't acquire. As a result, the goodwill value is $24 million ($150m + [140m x 0.1] - $140m). Thus, there is a difference of $2 million between the amount of the goodwill calculated under the two methods.
Although goodwill is the premium paid over the fair value of an entity during a transaction, goodwill's value cannot be sold or bought as an intangible asset in of itself.
Goodwill can be challenging to determine its price because it is composed of subjective values. Transactions involving goodwill may have a substantial amount of risk that the acquiring company could overvalue the goodwill in the acquisition and ultimately pay too much for the entity being acquired.
However, despite being intangible, goodwill is quantifiable and is a very important part of a company's valuation.
Disclosure: At the time of writing, the author did not have holdings in any of the companies mentioned in this article.