Goodwill is an intangible asset that represents the non-physical items of a company has that cannot be easily valued. It is the excess value of a business after subtracting the assets from the liabilities. This value can be generated from customer loyalty, the quality of the management, the brand image or even the location of the company. Anything that adds value to a company beyond its assets and liabilities is considered goodwill.
Why is goodwill important to a company?
The importance of goodwill comes into play during a merger or acquisition. A buyer who is looking to acquire the company can pay more than the market value due to the business’ intangible assets. When acquiring another business, companies often look beyond the physical assets that the company owns and consider the brand identity, customer satisfaction and efficiency of the staff to arrive at a fair price for the company. The total amount of money that the buyer pays for these intangible assets in excess of the company’s market value is considered goodwill.
Goodwill is subjective and can be a different value for each company. When Facebook acquired Instagram, many people believed that Instagram (a free app that allows you to share images at no cost) was not worth more than $500 million. But after valuing Instagram’s total assets, liabilities and goodwill, Facebook believed that Instagram was worth over $1 billion which is what they paid for it. It is often hard to put a specific value on a company.
What creates goodwill in a business?
There are three factors that makeup goodwill in a business. They include:
This includes the existing assets in the business such as the employees and equipment that can be used in the day to day operations of the business. When these assets are functional, they create intangible value for the business known as going-concern. The going concern of a company can be used in one of two ways.
It can either be shown as an individual intangible asset for specific valuation or tax reasons or as a component of the total goodwill in the company. This second method is in accordance with the Financial Accounting Standards Board (FASB) for deriving the fair value of a company.
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Going-concern can increase the value of specific assets in the business. For example, the value of a machine will be greater when it is seen as being fully functional and adding value to the business every day versus being valued as a single entity in the company. Going concern can also add value to an intangible asset such as a trademark or copyright. These assets are usually worth more when there are seen as providing continuous value to the company.
2. Excess business income
When a company earns a rate of return that is greater than the fair value of the tangible and intangible assets combined, the excess income is considered goodwill for the company. This excess income cannot be assigned to any specific tangible or intangible asset and is hence included in the goodwill of the company. For example, any income earned by an actor or singer that is in excess of their direct return from their acting or singing abilities is considered goodwill.
3. The expectation of future events
Goodwill can also be created through any future events that are not directly related to the current operations of the business. This can include a merger or acquisition, expansion of the business or new clients. When valuing a company, financial advisors will use the current operations of the business (NPV) in relation to the future events assuming that it will have a positive impact on the company.
The different types of goodwill
There are three different types of goodwill:
— Institutional goodwill
This is the company’s reputation of the company in the market and their ability to serve customers. That is the goodwill created from the collective operations of the business through its assets.
— Professional goodwill
This is the goodwill in professions such as a doctor, lawyer or athlete. It consists of two types:
- Practitioner goodwill- this is the goodwill created by the skills, talent, and reputation of the professional.
- Practice goodwill- this is the goodwill created by the business the professional works and includes the location of the business, its reputation in the market and the efficiency of the operations.
— Goodwill as a result of fame
Famous people can also create goodwill through various factors. For an actor, their goodwill is attributable to their skill level while athletes create goodwill through their professional accomplishments and accolades. Top business executives and politicians create goodwill through their skill level and any professional accomplishments.
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Company X purchased Company Y for $115,000. Business Y has assets worth $100,000 and liabilities worth $20,000. The value of goodwill is:
Goodwill = 115,000 – (100,000 – 20,000) = $35,000
The journal entry for Company X is:
Goodwill is shown separately in the assets of the buying company’s balance sheet but the treatment of goodwill can vary by the accounting standard followed by the company. Under the IFRS and US GAAP standards, goodwill should not be amortized on the balance sheet every year rather the goodwill should be monitored and only reported on the balance sheet when necessary i.e. during a merger or acquisition.
Under the UK GAAP, goodwill is seen as providing continuous value to the business and should be amortized every year. The intangible assets are included in the financial statements of the buyer at their fair value (the price at which the intangible assets could have been disposed of individually).
Sometimes, the goodwill of a company can be negative (the company is sold at a price lower than its market value). In this case, goodwill is shown as an income on the buyer’s balance sheet.
Quick Note: If you are new to the financial world and want to learn how to effectively read the financial statements of companies, feel free to check out this awesome online course- Introduction to Financial Statements & Ratio Analysis.
Goodwill refers to the reputation of a business and is vital to any company in acquiring new customers and retaining existing ones. It also attracts new investors and keeps shareholders happy. Moreover, Goodwill represents the true value of a company, that is, its total worth over and above its market value. The goodwill of a company is often valued by financial advisors for the purpose of taxation, litigation or maintaining financial statements.