Topics Covered Hide
- Becoming familiar with the goodwill concept
- Understanding the meaning of goodwill
- Different types of goodwill and what they mean
- Goodwill calculation controversies and potential issues
- Potential limitations associated with goodwill
- Considering goodwill versus other intangible assets
- How to calculate goodwill by the book
Things change to 180 degrees when it comes to business. Some companies target goodwill when they are in trouble, yet there are also situations when goodwill is offered without the receiver actually struggle financially.
The concept of goodwill goes even further and may also have different explanations in terms of accounting. In this field, goodwill is considered an intangible asset. All in all, here is everything you need to know about this aspect.
Becoming familiar with the goodwill conceptAgain, goodwill is not a tangible asset. The concept is most commonly used when one company purchases another company. It does not make too much sense – after all, goodwill is often seen as a donation, but not in the business industry.
To make it clear, the goodwill represents an extra amount of money. When a company purchases another one, there is a price for all the assets, potential profits, and so on. However, when goodwill is there, the price will be much higher than the fair price of all these things.
The goodwill is not used for one thing in particular – for example, it is not used for liabilities of a company that is struggling. Instead, it occurs after all these aspects have been taken care of. Without goodwill, the trade would be relatively fair.
However, there is a bit of meaning behind goodwill. It targets things that cannot really be counted. For example, the goodwill covers the brand name and reputation, as well as the customer database. The goodwill also accounts for good customer relations or employee happiness.
Such things cannot be measured financially. This is what makes it an intangible asset. It is quite easy to calculate. Practically, you take the overall purchase price of the company and subtract the difference between a fair value for all of its assets.
Just because the asset is not tangible, it does not mean that it can be avoided from financial reports. In fact, companies must review the goodwill on financial statements every now and then – in most countries, they have to do it at least yearly.
The difference between goodwill and tangible assets is the fact that goodwill has an indefinite lifespan.
The process of calculating the target goodwill is fairly simple in theory. However, once you start writing things down, you realize that it can become very complex, and you may actually need an accountant or another expert for it.
Understanding the meaning of goodwillNormally, the target goodwill becomes a reliable aspect in an acquisition. A company buys another company, so the goodwill kicks into play. It is not a general rule – for example, a small business may not necessarily benefit from it.
The buyer will have a certain price in mind. Normally, this price covers every asset of the target company. Everything must be valued by a professional upfront. The goodwill is often directly proportional with this valuation.
Goodwill can be both positive and negative. When positive, it is referred to as goodwill – nothing else. When negative, it is mentioned. If the company being acquired struggles, chances are the acquiring company will try to get a cheaper price.
If the overall price is smaller than the valuation, the goodwill is negative. There is a lot of pressure involved in the process if the goodwill is negative because the acquiring company makes the purchase at a bargain.
Apart from the above-mentioned reason, goodwill is considered intangible because it is not a physical asset. It is not like a building or a piece of equipment. Therefore, its value is not perfectly established, regardless of the transaction.
Different types of goodwill and what they meanGoodwill can go in more categories. Sometimes, it is referred to as business goodwill. But then, you also have economic goodwill, which is different. Then, there is goodwill in accounting as well. Operating principles are the same, but there are also some particularities.
Sometimes, accounting goodwill is basically the recognition of economic goodwill in accounting, so they are interconnected. Accounting goodwill is intangible and represents the most common concept – one company buys another one for a higher price.
Just because the asset is intangible, it does not mean that it has been created. Sure, there will be an accounting journal entry for it, but the asset is already there. Adding the goodwill to the financial statement is not creating it but recognizing its presence.
Business or economic goodwill goes in the same category – intangible. For instance, a top-notch brand recognition and a solid identity will count in the overall price. The same rule applies to brand loyalty and excellent customer relations. This means the respective company has a serious advantage.
The presence of goodwill is analyzed by checking the return on assets ratios of the respective company.
Warren Buffer gave a fairly good example a while ago. Take See’s Candies – a popular business from California. The company had consistent profits and made annual profits of around $2 million for a while. The actual tangible assets were worth $8 million only.
The return on assets, in this case, is about 25%, which is incredibly high. Substantial goodwill assets contributed to it. It has a good reputation, offers good value for money and customers are loyal. Companies interested in buying it would have to spend more than $8 million.
These intangible assets made See’s Candies a top choice. If someone bought it based on the asset value, they would make their money back within four years only. The company stands out with its reputation and successful customer relations.
Goodwill calculation controversies and potential issuesCalculating goodwill can raise quite a few controversies. Sure, there is a formula for it, but how do you estimate the reputation of a brand? How do you estimate the relationships with customers? Many things are just difficult to deal with, and this is what leads to all the controversies.
Now, there are a few different approaches when it comes to accounting, and different experts take it differently. The main reason? Most accountants hate doing this calculation. It is a workaround for them – extra work and things that cannot be perfectly accurate. It is just not what they are trained to do.
However, this is mandatory. After all, acquisitions determine potential cash flows later on. Then, there are many other aspects that are not even known or considered when the acquisition is made, hence the necessity of extra work.
To some accountants, it may not look like a major issue. But then, some accountants must find solutions to compare all the assets in the process, as well as the income between various companies. Some others may have acquired other firms before, making the job even more sophisticated.
It is also worth considering the impairment of an asset, which is pretty common. This issue arises when the market value of a specific asset goes under the historical cost. It may arise out of nowhere, as there are more reasons behind it.
One of them is the declining cash flow. Another reason is the environment – if there is more competition than ever, it becomes more difficult to thrive. Economic depression is another major issue that could arise out of nowhere… And these are only a few examples.
Companies will need to determine if the specific asset needs an impairment. There are a few different ways to do it. Most commonly, companies will have to take a few impairment tests on these intangible assets.
Two specific impairment tests stand out in the crowd. One of them is the income approach. It is fairly simple to perform because you need to evaluate potential cash flows. Then, they are discounted to what they are worth at the moment.
The other test is the market approach. Liabilities and assets of different companies in the same industry are analyzed before making a comparison. These companies should be similar in size and must have similar operations.
If the acquired net assets go under the book value, impairment kicks in. The same rule applies if the company overestimates the amount of target goodwill. Apart from the impairment, the balance sheet also needs to be updated.
The impairment is practically an expense. It is the difference between the purchase price and the market value of the respective asset. All these things lead to a chain reaction. Eventually, the goodwill amount will be decreased.
The expense is also considered to be a loss when it comes to statements. Obviously, the net income for the respective fiscal year is reduced. The stock price of the company will be affected too, not to mention the EPS – Earnings Per Share.
Potential limitations associated with goodwillGoodwill represents a challenge for most experts out there because the price for it is difficult to set. Two different accountants could give two completely different prices, and they would both be considered correct.
Then, negative goodwill can also occur if the company is acquired for less than what it is worth. The negative goodwill is normally observed in distressed sales or acquisitions under pressure. It becomes an income on the acquiring company's statement, though.
Finally, what happens when an apparently successful company ends up in insolvency? Such situations are also common. All investors will need to deduct the goodwill from the equity. This is because when insolvency kicks in, the goodwill becomes worthless – no resale value.
While goodwill is considered an intangible asset, the truth is there are other intangible assets in this category, and they are completely different from all points of view. In fact, goodwill should probably have its own unique category.
Considering goodwill versus other intangible assetsMaking the difference between goodwill and other intangible assets is an idea that will give most accountants headaches. It is perfectly normal. After all, goodwill is valued based on all sorts of resources that have no actual value – non physical stuff. This is what intangible assets are too.
There are some similarities between goodwill and other intangible assets, but also some crystal clear differences. Intangible assets are not physical, but they can be identified. Goodwill is mostly an estimate rather than having a clear value.
For example, proprietary technologies – such as software – are considered intangible assets. The same rule applies to patents or copyrights. Website domain names are not to be overlooked either, not to mention licenses or agreements.
With these thoughts in mind, goodwill is not part of intangible assets in balance sheets.
Goodwill should be a miscellaneous category – a category that cannot be measured in an accurate manner. Brand reputation, customer loyalty, and so on will count, but no one can put a price on these things.
Goodwill does not exist if the business does not exist – they go hand in hand. It cannot be purchased, and it cannot be sold. It cannot be used separately either. Company records and managers are counted too, so the life of this asset is indefinite.
Goodwill does not show up on balance sheets. However, it becomes important only when two companies face an acquisition or perhaps a merger. If one company buys another, anything that goes over the net value is considered goodwill.
How about other intangible assets then? Similar to goodwill, intangible assets are not physical. Unlike goodwill, they can be identified. None of the above-mentioned things (such as software or patents) can be touched. But then, these things do hold some value.
Then, unlike goodwill, these intangible assets can actually be sold independently, without affecting the company. You can sell a patent for an invention. You can also sell software you have developed. But you cannot sell goodwill.
Then, assets are counted differently on the books. With time, assets tend to lose a bit of value. Therefore, there are times when companies may need to make write-downs – quite common. Intangible assets can also be amortized.
Despite all these significant differences between goodwill and intangible assets, they are still used interchangeably quite often. However, when it comes to acquisitions and mergers, the difference will become obvious.
How to calculate goodwill by the bookThe first step in calculating goodwill implies getting the value of every single asset. If you do this for your own company or you work in accounting, you need to get the balance sheet and count everything that is on it.
Double check all the current assets, not to mention assets that are not current. Include the fixed assets too, as well as other intangible assets – like the ones mentioned above. The most recent financial statement should give you all these details.
Second, each of these assets requires a fair evaluation. The process is not always objective – ask a few different accountants to do it, and they may give you different final answers. An accounting firm will have to perform a deeper analysis to identify the market value of every single asset.
Next, there are a bunch of adjustments you need to make, but also calculate them. Each asset needs to be taken through a sophisticated process. Identify the fair value, as well as the book value of every asset. The difference is an adjustment – do it for all assets.
You may notice that some assets do not provide any differences.
The next step covers the excess purchase price. You have to figure the purchase price to get the target company, as well as the net value of the assets. At this point, you need to remove the liabilities – the final number will give you the excess purchase price.
Finally, the last step implies calculating the actual goodwill. With all the numbers above calculated, you need to get the final excess purchase price and remove the fair value adjustments from it. The resulting number is goodwill.
The goodwill will go when the deal is closed – it can be positive, but negative goodwill is also possible.
FAQsStill unsure about the target goodwill? Here are some of the most common questions.
Can intangible assets be written off?
The answer depends on a few different factors. In theory, you can actually write off intangible assets with no issues at all. However, there is a condition to be met. You need to do it over a 15-year write-off period of time.
At the same time, you can only write off intangible assets that have been bought using rates set by the IRS. If you fail to meet these conditions, assets cannot be written off – it is wiser to have this discussion with an accountant, though.
What happens to goodwill during an acquisition?
While not always a general rule, the goodwill value tends to go up a little throughout the acquisition. Basically, when a company purchases another company, the goodwill is likely to increase. The value depends on the difference between the asset price and the total amount paid in the transaction.
What is an intangible asset?
An intangible asset is an asset that you cannot touch physically, yet its value is defined. For example, patents and trademarks are considered intangible assets, not to mention copyrights and different types of licenses. Proprietary software goes in the same category, just to name a few examples.
Is goodwill amortized on acquisition?
At this point, purchased goodwill goes in the same category with other intangible assets, if any. It should be amortized over the economic lifespan. About 20 years will be enough, but in many situations, the useful economic lifespan can easily exceed this time frame.
How is goodwill treated in a merger?
A merger is different from acquisition, but they also have some similarities. When it comes to goodwill, it will only be present on the balance sheet when the merger or acquisition is over. Other than that, it is irrelevant.
Do you have to pay capital gains tax on goodwill?
Goodwill is considered a form of income in many countries – there are, of course, a few exceptions. In the USA, for example, you will need to pay capital gains tax. The seller is responsible for paying it – basically, the company getting acquired.
How do you figure out goodwill impairment?
The impairment becomes an important consideration because it is seen as a loss. It is mentioned on the income statement and will obviously affect the goodwill too – negatively, of course. The recorded loss is practically the difference between the market value of an asset and its carrying value.
What can cause goodwill to go negative?
Negative goodwill becomes a reality when the purchase price of the asset is under the market value. Basically, if the net value of a company is $100,000 and it is acquired for $90,000, there is negative goodwill in this situation.
What are the most important factors causing goodwill changes?
There are more factors that may influence goodwill. Some of them are considered consequences of other factors. Overall, no matter what the goodwill value is, most of the appreciation or depreciation changes are given by three major elements.
First of all, you have an obvious deterioration in economic conditions. The company is less profitable, and the goodwill drops. Second, extra competition means less customers and less profits, so the goodwill is likely to be affected too.
Finally, regulatory action may also have consequences on goodwill values.
ConclusionAs a short final conclusion, no one really pays attention to goodwill until a merger or acquisition is likely to become a reality. With all these, factors that determine goodwill are often taken into consideration – such as customer relations or brand reputation. Everyone is focused on increasing these aspects.
Target goodwill is based on a few concepts that can determine how successful the business is. But at the same time, its actual value is irrelevant and will never make the difference in other circumstances. Finally, goodwill is calculated by subtracting the net value from the selling value.