What Is Goodwill?
Goodwill is an intangible asset associated with the purchase of one company by another. Specifically, goodwill is recorded in a situation in which the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets purchased in the acquisition and the liabilities assumed in the process. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology represent some examples of goodwill.
The Formula for Goodwill Is
- P = Purchase price of the target company
- A = Fair market value of assets
- L = Fair market value of liabilities
How to Calculate Goodwill
The process for calculating goodwill is fairly straightforward in principle but can be quite complex in practice. To determine goodwill, take the purchase price of a company and subtract the fair market value of identifiable assets and liabilities.
What Does Goodwill Tell You?
The value of goodwill typically arises in an acquisition—when an acquirer purchases a target company. The amount the acquiring company pays for the target company over the target’s book value usually accounts for the value of the target’s goodwill. If the acquiring company pays less than the target’s book value, it gains negative goodwill, meaning that it purchased the company at a bargain in a distress sale.
Goodwill is recorded as an intangible asset on the acquiring company's balance sheet under the long-term assets account. Under generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS), companies are required to evaluate the value of goodwill on their financial statements at least once a year and record any impairments. Goodwill is considered an intangible (or non-current) asset because it is not a physical asset like buildings or equipment.
- Calculated by taking the purchase price of a company and subtracting the fair market value of identifiable assets and liabilities.
- Companies are required to evaluate the value of goodwill on their financial statements at least once a year and record any impairments.
- Goodwill is very different from other intangible assets, having an indefinite life, while other intangible assets have a definite useful life.
Example of How to Use Goodwill
If the fair value of Company ABC's assets minus liabilities is $12 billion, and a company purchases Company ABC for $15 billion, the premium value following the acquisition is $3 billion. This $3 billion will be included on the acquirer's balance sheet as goodwill. Goodwill is also recorded when the purchase price of the target company is higher than the debt that is assumed.
As a real-life example, consider the T-Mobile and Sprint merger announced in early 2018. The deal was valued at $35.85 billion as of March 31, 2018, per an S-4 filing. The fair value of the assets is $78.34 billion, and the fair value of the liabilities is $45.56 billion. Thus, goodwill for the deal would be recognized as $3.07 billion, or $35.85 billion - ($78.34 billion - $45.56 billion).
Impairment of an asset occurs when the market value of the asset drops below historical cost. This can occur as the result of an adverse event such as declining cash flows, increased competitive environment or economic depression, among many others. Companies assess whether an impairment is needed by performing an impairment test on the intangible asset.
The two commonly used methods for testing impairments are the income approach and the market approach. Using the income approach, estimated future cash flows are discounted to the present value. With the market approach, the assets and liabilities of similar companies operating in the same industry are analyzed.
If a company's acquired net assets fall below the book value or if the company overstated the amount of goodwill, then it must impair or do a write-down on the value of the asset on the balance sheet after it has assessed that the goodwill is impaired. 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, which directly reduces net income for the year. In turn, earnings per share (EPS) and the company's stock price is also negatively affected.
Goodwill Calculation Controversies
There are competing approaches among accountants as to how to calculate goodwill. One reason for this is that goodwill represents a sort of workaround for accountants. This tends to be necessary because acquisitions typically factor in estimates of future cash flows and other considerations that are not known at the time of the acquisition. While this in and of itself is perhaps not a significant issue, it becomes one when accountants look for ways of comparing reported assets or net income between different companies when some of those businesses have not purchased other companies and others have.
The Difference Between Goodwill and Other Intangibles
Goodwill is not the same as other intangible assets. While goodwill is a premium paid over fair value during a transaction and cannot be bought or sold independently. Meanwhile, other intangible assets include the likes of patents and licenses and can be bought or sold independently. Goodwill has an indefinite life, while other intangible has a definite useful life.
Limitations of Using 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 occurs when the target company cannot or will not negotiate a fair price for its acquisition. Negative goodwill is usually seen in distressed sales and is recorded as income on the acquirer's balance sheet.
Because the components that goodwill is composed of have subjective values, there is a substantial risk that a company could overvalue goodwill in an acquisition. This overvaluation would be bad news for shareholders of the acquiring company since they would likely see their share values drop when the company has to write down or impair goodwill later.
There is also the risk that a previously successful company could face insolvency. When this happens, investors deduct goodwill from their determinations of residual equity. The reason for this is that, at the point of insolvency, the goodwill the company previously enjoyed has no resale value.
Learn More About Goodwill
For related insight, read more about how goodwill impacts financial statements.