Goodwill (Accounting): What It Is, How It Works, and How To Calculate

What Is Goodwill?

In business, goodwill is an intangible asset that is recorded when one company is purchased by another. It is the portion of the purchase price that is higher than the sum of the net fair value of all of the assets purchased in the acquisition and the liabilities assumed in the process.

This difference is due to things like the value of a company’s name, brand reputation, loyal customer base, solid customer service, good employee relations, and proprietary technology. Goodwill represents a value that can give the acquiring company a competitive advantage. It is one of the reasons that one company may pay a premium for another.

Understanding Goodwill

The value of goodwill typically matters when one company acquires another. A company's tangible value is the fair value of its net assets. However, the purchasing company may pay above this price for the target company. This difference is usually due to the value of the target’s goodwill.

Goodwill is recorded as an intangible asset on the acquiring company's balance sheet under the long-term assets account. Goodwill is considered an intangible (or non-current) asset because it is not a physical asset like buildings or equipment.

Under generally accepted accounting principles (GAAP) and the 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 Impairments

Accounting goodwill involves impairments. 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
• Economic depression

If a company assesses that acquired net assets fall below the book value or if the amount of goodwill was overstated, then the company must impair or do a write-down on the value of the asset on the balance sheet. 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 are also negatively affected.

Impairment Tests

Companies assess whether an impairment exists by performing an impairment test on an intangible asset.

The two commonly used methods for testing impairments are the income approach and the market approach.

• Income approach: Estimated future cash flows are discounted to the present value.
• Market approach: Assets and liabilities of similar companies operating in the same industry are analyzed.
  

Calculating Goodwill

The process for calculating goodwill is fairly straightforward in principle but can be complex in practice. To determine goodwill with a simple formula, take the purchase price of a company and subtract the net fair market value of identifiable assets and liabilities.

$\begin{aligned}&\text{Goodwill} = \text{P} - ( \text{ A } - \text { L } ) \\&\textbf{where:} \\&\text{P} = \text{Purchase price of the target company} \\&\text{A} = \text{Fair market value of assets} \\&\text{L} = \text{Fair market value of liabilities} \\\end{aligned}$​Goodwill=P−( A − L )where:P=Purchase price of the target companyA=Fair market value of assetsL=Fair market value of liabilities​

There are competing approaches among accountants to calculating goodwill. One reason for this is that goodwill involves factoring in estimates of future cash flows and other considerations that are not known at the time of the acquisition.

While normally this may not be a major issue, it can become significant when accountants look for ways to compare reported assets or net income between different companies. Some of these may have acquired other firms and some may not have.

The Financial Accounting Standards Board (FASB), which sets standards for GAAP rules, at one time was considering a change to how goodwill impairment is calculated. Because of the subjectivity of goodwill impairment and the cost of testing it, FASB was considering reverting to an older method called "goodwill amortization." This method would have reduced the value of goodwill annually over a number of years. However, in 2022, this project was set aside and the older method was retained.

Limitations of 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 income statement.

There is also the risk that a previously successful company could face insolvency. At the point of insolvency, the goodwill the company previously enjoyed has no resale value. When this happens, investors deduct goodwill from their determinations of residual equity.

Example of 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 paid for the acquisition is $3 billion ($15 billion - $12 billion). This $3 billion will be included on the acquirer's balance sheet as goodwill.

For an actual 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 was $78.34 billion and the fair value of the liabilities was $45.56 billion. The difference between the assets and liabilities is $32.78 billion. Thus, goodwill for the deal would be recognized as $3.07 billion ($35.85 billion - $32.78 billion), the amount over the difference between the fair value of the assets and liabilities.

The Bottom Line

Goodwill is an intangible asset that can relate to the value of the purchased company's brand reputation, customer service, employee relationships, and intellectual property. It represents a value and potential competitive advantage that may be obtained by one company when it purchases another. It is the amount of the purchase price over and above the amount of the fair market value of the target company's assets minus its liabilities.

While goodwill officially has an indefinite life, impairment tests can be run to determine if its value has changed due to an adverse financial event. If there is a change in value, that amount decreases the goodwill account on the balance sheet and is recognized as a loss on the income statement.