What is goodwill?
Goodwill is an intangible asset resulting from the purchase of an entity for more than its fair market value. The concept of goodwill is used when an entity is acquiring another entity. It is recorded when the buying price is more than the sum of the fair value of all the assets bought and liabilities assumed during the acquisition.
How to calculate goodwill
To calculate goodwill, subtract the difference between the fair market value of the assets and liabilities from the consideration paid. While assigning numeric values to goodwill is a little complicated in practice, there is a formula you can use to determine if an acquisition will generate goodwill:
Goodwill = P-(A-L)
P = Purchase price of the company,
A = Fair market value of assets,
L = Fair market value of liabilities.
For example, if Company X acquired Company Y, but paid more than the net market value of company Y, goodwill is the result. To calculate the amount of goodwill, Company X needs a list of the assets and liabilities of Company Y at their fair market value.
How to account for goodwill
Goodwill is an intangible asset associated with the purchase of one company by another. Specifically, goodwill is the difference between the purchase price and the fair value of the purchased entity’s equity, or net assets. Goodwill is only recognized for the purchase of an entity.
Therefore, goodwill is not recorded in an asset acquisition. Even if the purchase price is larger than the net fair value of the acquired assets, sometimes referred to as economic goodwill, this amount is allocated to the assets acquired based on their relative fair values at the time of the transaction. The new asset values are then amortized or depreciated.
Goodwill is an intangible asset, but the accounting treatment is different from other intangible assets in that it does not have a finite life over which to be amortized. Once goodwill has been established from an acquisition, it stays on the acquiring company’s books indefinitely, or until it is impaired.
What is goodwill impairment?
Goodwill impairment is an accounting charge which occurs when the value of goodwill is determined to be below the amount previously recorded at the time of the original purchase. Typically, goodwill impairment is caused when an asset or group of assets doesn’t generate their expected cash flows. Companies record the reduction of goodwill as a charge on their income statements with a debit to loss on impairment and credit directly to goodwill.
US GAAP requires an annual analysis of goodwill balances. However more frequent analysis may be required if certain indicators of a possible decline in the value of goodwill are present. Goodwill impairment testing procedures are decided by the FASB.
Example of goodwill
Goodwill doesn’t include any identifiable assets you can separate from the company to sell, rent, or exchange. The intangible assets must be acquired through purchase, not created individually.
Some examples of the intangible value that can generate goodwill include:
- The company’s recognition
- Brand name
- Licenses and permit
- Copyrights and patents
- Staff talent
- Domain names
In summary, goodwill is the excess amount a buyer pays in addition to the market value of an acquired company’s assets and liabilities and is a result of the intangible value that exists in a business such as brand name or managerial talent. However, these assets can fail to generate the expected financial results, so there is a goodwill impairment test required by US GAAP each year.
Understanding goodwill is essential to business combination accounting. To learn more about accounting and receive the latest news and updates, join the MaterialAccounting mailing list.