Goodwill – Definition

Cite this article as:"Goodwill – Definition," in The Business Professor, updated October 6, 2019, last accessed August 10, 2020, https://thebusinessprofessor.com/lesson/goodwill-definition/.

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Goodwill Definition

Goodwill refers to an intangible assets associated with the purchase of one firm by another firm. More specifically, goodwill comes into play when the bidding price of a firm is greater than the total value (which is considered fair) of all the identifiable and located tangible assets and intangible assets purchased in the merger and the liabilities incurred in the purchase process. Goodwill can come in the form of a brand name, customer base, customer retention skills and relationship, good employees relationship and patents rights held by the acquired firm. It can also include intellectual property and proprietary technology specific to the firm alone.

A Little More on What is Goodwill

  • Goodwill is calculated by taking the purchase value of a firm and finding the difference between it and the fair market value of the locatable assets and incurred liabilities.
  • All firms are mandated to estimate and analyze the value of goodwill reflected on their financial statements per annual at the minimum, and also record any error or modifications.
  • Goodwill is generally not to be confused with intangible assets as intangible assets have a finite lifetime, while goodwill doesn’t.

To calculate Goodwill, one can make use of this formula:

Goodwill = P – (A + L)

Where, P is the purchase price of the acquired firm

A is the fair market value of the assets, both tangible and intangible

L is the liabilities incurred in the merger process.

Calculating Goodwill

It is quite easy to calculate goodwill in theory, but the practical aspect is quite complicated. This is due to the different assets and liabilities that go into the calculation. To determine goodwill, one must assess the purchase price of the target firm, and find the difference between this value and the fair market value of the target firm, its assets and all liabilities incurred. The fair market value of a market firm can be gotten from an appraisal or a valuation.

What Can You Learn From Goodwill?

The value of goodwill usually rises with the acquisition or merger. This simply refers to the process where a company wishes to purchase another company and turn it into of its own. The amount which the acquirer will pay for the target firm over the fair value of the target value is what usually makes up the target’s goodwill. Goodwill can go either ways. If the acquirer more than it is supposed ton pay for the target company, then it will be registered as positive goodwill. On the other hand, negative goodwill arises when the acquirer pays less than the book value (fair market value) of the target firm. Negative goodwill actually occurs when the target firm is purchased in distress, that is when the target firm is sold due to a number of unfavorable events.

Goodwill is usually denoted as intangible assets on an acquirer’s balance sheet, and it is filed under the long-term assets account. Under the generally accepted accounting principles (GAAP), and the International Financing Reporting Standards (IFRS), every firm is expected to evaluate the value of goodwill available on their financial statements, and also report any errors or deformity. Goodwill is generally called an intangible asset since it isn’t a physical assets unlike machineries and buildings.

How to Use Goodwill: Detailed Examples

Let us assume that Company CX assets separate from their liabilities is $20 billion, and a firm, say PB Enterprise acquires Company CX for $30. Here the premium value following the acquisition is $10 billion, and it will be recorded in PB Enterprise’s balance sheet under the long-term assets account as goodwill. Goodwill can also be recorded when the amount used in purchasing a target company is higher than the debt incurred.

Using a real life example, let us consider T-Mobile and Sprint’s merger in 2018. As at March 31, 2018, using S-4 filing, the deal was valued at $35.85 billion. The fair assets value was $78.34 billion, and the fair value of the firm’s liabilities was $45.56 billion. In this case, goodwill for this deal was $3.07 billion or basically the different between the assets value and the liabilities value which is $35.85 billion.

Impairment of Goodwill

Impairment of an asset happened when the book value of such an asset declines below its historical cost. This happens due to an adverse event such as reduction in cash flows, economic depression, increased competition and many other factors. Companies evaluate and decide if impairment is required by testing for impairments in intangible assets.

There are two main methods of analyzing impairments: the income approach and the market approach. In the income approach, estimated cash flows are reduced or modified to their present value. The market approach takes the step of analyzing the assets and liabilities of competitors in the industry. If a firm’s goodwill is largely in the positive, or if the assets purchase price is way higher than the fair market value, an impairment or a write down must be conducted and reflected on the assets after the goodwill test shows that the impairment exists. In this case, the impairment expenses would be computed as the difference between the present market value of the asset, and the price at which the intangible asset was purchased. Impairment brings about a reduction in the goodwill balance on the acquirer’s balance sheet. The expense is also denoted as a loss on the financial income statement, and this subsequently leads to a decrease in the net income for the year. This further leads to a decrease in the earnings per share (EPS) and the firm’s shares price for the business year.

Issues Surrounding Goodwill Calculation

Different accountants have different debates on how to compute goodwill. This is because goodwill is typically a workaround for accountants. This is really needed as mergers take different factors into account, even those that are not visible at the time of the acquisition. This doesn’t seem to be an issue during the acquisition process, since the acquirer has already done his homework on what to pay. However, when goodwill is calculated, this becomes a significant issue as accountants are basically running around trying to calculate the value of both firms that have acquired other firms, and those that haven’t.

Difference Between Intangible Assets and Goodwill

Goodwill is not the same thing as intangible assets. Although both are not physical assets, goodwill is the amount paid over the book value during a transaction, and it cannot be sold or purchased as a standalone asset. Intangible assets are however like patents and they can be transferred from the original firm to another as they deem fit. It also include licenses that can be sold as standalone assets. Also, intangible assets have a finite life, while goodwill has an infinite life.

Shortcomings Involved in Using Goodwill

Goodwill is not easy to tag a price on, and negative goodwill mostly occurs when the acquirer spends less money in acquiring a firm than the book value of the assets and liabilities of the target company. Negative goodwill usually occurs in distress sales, and it is most visible in situations where the target firm decides not to, or cannot possibly negotiate their price in the merger. Negative goodwill is basically recorded as profit in the acquirer’s balance sheet. There is a chance that firms can overvalue goodwill in an acquisition due to its subjective values. Overvaluation can be a bad news for the shareholders of the acquiring form, as they prefer to see their share values increase rather than drop as will be the case in an overvalued goodwill. Another associated risk with goodwill is the chance that a firm that was previously successful would face insolvency. If this is the case, the goodwill becomes invalid as investors would remove it from their residual equity. When insolvency occurs, goodwill will have no resale value.

References for “Goodwill”

https://www.investopedia.com › Investing › Financial Analysis

https://www.accountingcoach.com/terms/G/goodwill

https://debitoor.com/dictionary/goodwill

https://en.wikipedia.org/wiki/Goodwill_(accounting)

https://www.reviso.com/accountingsoftware/accounting-words/goodwill

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