“Goodwill” is an “intangible asset” associated with the acquisition or possession of a business by another. Specifically, goodwill is the portion of the purchase price that exceeds the sum of the net fair value of all the acquired assets and the liabilities assumed during the acquisition. Goodwill exists due to the value of a company's brand name, solid customer base, positive customer relations, positive employee relations, and proprietary technology.
What Is Goodwill

• Goodwill is an intangible asset that represents the excess purchase price of another business.

• Items included in goodwill are called as “proprietary or intellectual property” and brand recognition, which are difficult to quantify.

• Goodwill is calculated by subtracting the difference between the fair market value of the assets and liabilities from the purchase price of a company. 

• Companies are required to evaluate the value of goodwill on their own financial statements at least once a year and record any impairments. Goodwill differs from the majority of intangible assets. In that case it has an infinite useful life, whereas the majority of intangible assets have a finite useful life.

Understanding Goodwill

In theory, the calculation of goodwill is straightforward, but in practice it can be quite complex. To calculate goodwill using a simple formula, subtract the net fair market value of a company's identifiable assets and liabilities from the purchase price.

Goodwill equals the difference between the purchase price and the fair market value of the target company's assets and liabilities.

What Goodwill Reveals

Typically, the value of goodwill arises during an acquisition, when the acquirer acquires the target company. Typically, the amount the acquiring company pays for the target company in excess of the target's net assets at fair value represents goodwill. If the acquiring company pays less than the book value of the target, it acquires negative goodwill, indicating that it purchased the target at a discount in a distress sale.

What Is Goodwill?

Goodwill is recorded as an intangible asset under the long-term assets account on the balance sheet of the acquiring company. Companies are required by generally accepted accounting principles (GAAP) as well as the International Financial Reporting Standards (IFRS) to assess the value of goodwill on their financial statements and record any impairments at least once per year. Goodwill is categorised as an intangible (or noncurrent) asset because it is not a physical asset like equipment or buildings.

Goodwill Calculation Controversies

There are competing approaches to calculating goodwill among accountants. One reason for this is that goodwill provides accountants with a sort of workaround. This is typically required because acquisitions typically incorporate estimates of future cash flows and other unknown factors. This may not be a significant issue, but it becomes one when accountants attempt to compare the reported assets or net income of different companies, some of which have previously acquired other businesses and others of which have not.

Goodwill Deterioration

An asset is considered impaired when its market value falls below its historical cost. This can occur as a result of a variety of negative events, including declining cash flows, an increased competitive environment, or economic depression. By performing an impairment test on the intangible asset, businesses determine if an impairment is required.

The market approach and the income approach are the two most common methods for assessing impairments. Estimated future cash flows are discounted to their present value using the income approach. The market approach analyses the assets and liabilities of comparable companies operating within the same industry.

If a company's acquired net assets fall below the book value or if it overstated the amount of goodwill, it must impair or write down the asset's balance sheet value after determining that the goodwill is impaired. The impairment expense is calculated as the difference between the intangible asset's current market value and its acquisition cost.

The impairment causes a reduction in the balance sheet's goodwill account. The expense is also recorded as a loss on the income statement, which reduces the company's annual net income. In turn, earnings per share (EPS) and the stock price of the company are negatively impacted.

The Financial Accounting Standards Board (FASB), which establishes GAAP rules, is contemplating a change to the calculation of goodwill impairment. Due to the subjectivity of goodwill impairment and the expense of testing impairment, the FASB is considering reverting to an older method known as "goodwill amortization," in which the value of goodwill is gradually reduced over a number of years.

Goodwill vs. Other Intangibles

Goodwill differs from other intangible assets. Goodwill is the premium paid over fair value during a transaction, and it cannot be purchased or sold separately. In contrast, other intangible assets, such as licenses, can be purchased or sold independently. Goodwill has an infinite useful life, whereas other intangibles have a finite one.

Constraints of Employing Goodwill

Goodwill is difficult to value, and negative goodwill can result when a company is acquired at a price below its fair market value. This typically occurs when the target company cannot or will not negotiate a fair purchase price. Typically observed in distressed sales, negative goodwill is recorded as income on the acquirer's income statement.

There is also the possibility that a once-profitable company could become insolvent. When this occurs, investors deduct goodwill from their equity determinations. The reason for this is that the company's goodwill has no resale value at the point of insolvency.

Example of Goodwill

If the fair value of Company ABC's assets minus its liabilities is $15 billion and it is acquired for $20 billion, the premium value is $5 billion. This $5 billion will be recorded as goodwill on the acquirer's balance sheet.

Consider the T-Mobile and Sprint merger announced in early 2018 as a real-world example. As of March 31, 2018, the deal was valued at $35.85 billion, according to an S-4 filing. The fair market value of the assets was $78.34 billion, whereas the fair market value of the liabilities was $45.56 billion. $32.78 billion is the difference between assets and liabilities. Thus, goodwill for the transaction would be recorded at $3.07 billion ($35.85 - $32.78), the excess of the fair value of the assets over the fair value of the liabilities.

What Distinguishes Goodwill from Other Assets?

Goodwill is an intangible asset that appears on the balance sheet and is created when one company acquires another for more than its net asset value. Goodwill, unlike other assets with a discernible useful life, is neither amortized nor depreciated, but is instead subject to periodic impairment tests. If goodwill is believed to be impaired, its value must be written off, which reduces the company's earnings.

How Is Goodwill Used in Investing?

The evaluation of goodwill is a difficult but essential skill for many investors. In fact, it can be exceedingly difficult to determine whether a company's claimed goodwill is actually justified by its balance sheet. For instance, a company may assert that its goodwill is based on the brand recognition and customer loyalty of a company it has acquired. Therefore, when analyzing a company's balance sheet, investors will scrutinize the reasons for its stated goodwill to determine if it will need to be written off in the future. In some instances, investors may believe that the true value of a company's goodwill is greater than what is reflected on its balance sheet.

What Is an Example of the Goodwill on Balance Sheet?

Consider the situation of a hypothetical investor who purchases a small, locally popular consumer goods company. Despite the fact that the company had only $1 million in net assets, the investor agreed to pay $1.2 million for it, resulting in $200,000 of goodwill being reflected on the balance sheet. In explaining this decision, the investor could cite the company's strong brand loyalty as a primary justification for the amount of goodwill paid. Nonetheless, if the brand's value were to decline, they may need to write off some or all of their goodwill in the future.