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Goodwill in accounting refers to the excess amount between the purchase price and fair market value of a business. This “extra” accounts for the purchased business's intangible assets, such as a loyal customer base, brand recognition, and excellent management. Goodwill is important in business acquisitions, whether you’re on the buying or selling end of the deal.Here’s a closer look at what goodwill in accounting is, how it’s calculated, how it is valued on the balance sheet, and why companies are often willing to pay a premium for another company during an acquisition.
What Is Goodwill in Accounting?
Goodwill is defined as the portion of a business’s purchase price that is higher than the market value of its identifiable assets and liabilities.Unlike physical assets, such as a building, inventory, or equipment, goodwill is an intangible asset that is listed under the long-term assets of the acquirer’s balance sheet. While goodwill has value, it doesn’t generate cash flows, nor can it be sold or transferred separately from the business as a whole. This makes it different from other intangible assets like licenses or trademarks, which can be purchased individually.Some examples of goodwill include:
Customer loyalty
Proprietary technology
Employee relations
Brand name recognition
Future sales or economic benefits
Company reputation
Managerial and executive talent
How Does Goodwill Work?
Goodwill in accounting is often used in mergers and acquisitions. Once a business completes the purchase and acquires another business, the purchase is placed on the purchasing company’s balance sheet. Goodwill is listed as a non-current asset on the balance sheet and is considered an intangible asset, since it is not a physical object. By recording goodwill, you ensure that the books are balanced during and after an acquisition. Businesses must record goodwill as a requirement of the Generally Accepted Accounting Principles (GAAP).Goodwill isn’t always a positive number, however. It can be negative if the purchased company agrees to a purchase price that is less than its book value. These types of sales are called “distress sales” and can occur for a variety of reasons. For example, the seller’s company may sell to avoid insolvency or filing for bankruptcy. Recommended: How to Get a Business Acquisition Loan
Calculating Goodwill
Calculating goodwill is simple in theory. You first determine the business’s value of net assets (the business’s identifiable assets minus its liabilities), then subtract that number from the total amount paid to acquire the business. This difference is goodwill.In practice, however, the process for calculating goodwill can be complex and require an in-depth knowledge of small business accounting, or the help of an accountant. There are five steps involved in calculating goodwill.
Determine the book value of the purchased company’s assets. An asset’s book value is an asset’s cost minus depreciation. These are the types of assets you will need to add up.
Current assets Cash, inventory, or any asset that can be converted to cash within a year or less.
Fixed assets Assets that cannot be easily converted to cash within a year. Examples may include:
Land
Real estate
Equipment/ Machinery
Intangible assets Any asset that is not physical in nature but has a book value. Examples may include:
Copyrights
Patents
Trademarks
Licenses
2. Determine the fair value amount of a company’s assets. Fair value is the estimated amount at which an asset can be sold. It’s the amount that both the seller and buyer agree upon. This amount may be the same as an asset’s book value, but there may be a difference between the two.3. Calculate the difference between the book value of a company’s assets and the fair value. The difference between the two is called the fair value adjustment. 4. Calculate the excess purchase price. Subtract liabilities from the net book value of a company’s total assets. Next, subtract the difference between those numbers from the actual purchase price. 5. Run the goodwill accounting formula. Subtract the fair value adjustments figure from the excess purchase price. The resulting figure is the goodwill amount that will go on the acquirer’s balance sheet when the deal closes.
Goodwill in Accounting Formula
While the steps that go into calculating goodwill can be time-intensive, the formula itself is simple. Purchase Price - (Market Value of Assets - Liabilities) = Goodwill
Pros and Cons of Goodwill Accounting
Using goodwill in accounting has benefits, as well as limitations. Here’s a look at how they compare.
Pros of Goodwill Accounting
Cons of Goodwill Accounting
Provides a way to account for a premium purchase price in company financial statements
Goodwill is difficult to price
Ensures that the books are balanced during and after an acquisition
Negative goodwill can occur when a business is purchased for less than its fair market value
There’s always a risk that a previously successful company could face insolvency
Other Intangible Assets
While Goodwill is a type of intangible asset, it isn’t like other intangible assets. For example, goodwill cannot be bought or sold in the way that other intangible assets, such as patents and copyrights, can. And, while other intangible assets have a set amount of time they can be used before they expire, goodwill does not have a predetermined shelf life. As long as there is no impairment (drop in market value), the acquiring company will continue to list it on its balance sheet.
Examples of Goodwill
Here is a goodwill accounting example: A major software company has a fair value of $100 million after its assets are tallied up and its liabilities are accounted for. Another software company decides to purchase it for $120 million. This extra $20 million paid beyond fair market value is listed as goodwill on the purchasing company’s balance sheet. Here’s a look at a real-life example: In 2021, Microsoft finalized its purchase of Zenimax Media, which is the parent company of Bethesda — the gaming studio behind the games Skyrim and Fallout. Microsoft purchased Zenimax for $8.1 billion, but at the time of the acquisition, Zenimax only had a net worth of $2.652 billion. This means Microsoft paid $5.448 billion for goodwill.
What Is the Use of Goodwill for Investors?
An investor can look at the goodwill listed on a company’s balance sheet, scrutinize what is behind it, and then determine if the goodwill a company claims to hold is justified. This can help an investor determine whether that goodwill may need to be written off in the future. In some cases, an investor might determine that the goodwill listed actually has a higher value than stated on the balance sheet.
Where Does Goodwill Fit Onto a Balance Sheet?
For the acquiring company, goodwill is recorded under the long-term (or non-current) assets on the balance sheet. The number recorded is the amount that exceeds the fair market value of a company minus its liabilities. While goodwill is an intangible asset, it is listed as a separate line item to intangible assets.Under GAAP, public companies are required to evaluate the value of goodwill once a year to determine whether it is impaired or not.
How Is Goodwill Amortized?
Unlike other intangible assets that have a discernible useful life, goodwill is not amortized under GAAP. Instead, it is periodically tested for goodwill impairment. If the goodwill is thought to be impaired, the value of goodwill must be written off, reducing the company’s earnings.Private companies, however, may opt to amortize goodwill generally over a 10-year period. This allows them to minimize the cost and complexity involved with testing goodwill for impairment. Some private companies, however, don’t take this election, since it means they would have to restate all of their financials if they ever went public.
Economic Goodwill vs Goodwill Accounting
Goodwill is sometimes separately categorized as economic goodwill vs. goodwill in accounting. However, these two terms generally refer to the same thing. Accounting goodwill is the formal accounting of a company’s economic goodwill, which is the value of intangible assets like the existing customer base, brand name, reputation, and positive employee relations.
The Takeaway
Goodwill in accounting refers to a certain value above and beyond the fair market value of a business that can give it a competitive advantage. There are many reasons why one company would pay a premium to purchase another one, including the target company’s brand reputation, customer service, employee relationships, and intellectual property.Goodwill is reported as a line item on the acquiring company's balance sheet under non-current assets. Because goodwill is generally a positive number, having it on your balance sheet can be advantageous if you’re looking to woo investors or apply for a small business loan.
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Frequently Asked Questions
Is goodwill an expense in accounting?
Why would goodwill be considered an asset?
Does goodwill need to be amortized?
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About the Author
Lauren Ward
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
