What Is Goodwill in Accounting?
When a business is purchased, it is often for a price greater than the market value of its identifiable assets and liabilities. The surplus paid over this market value is termed goodwill. Unlike tangible assets such as buildings and equipment, goodwill is an intangible asset recorded under the long-term assets section of the acquiring company’s balance sheet. It cannot be sold or separated from the business itself. Despite its significant contribution to a company’s success, valuing goodwill can be challenging because it does not directly generate cash flows. Examples of assets that fall under goodwill include:
- Business Reputation
- Brand name
- Licenses and permits
- Domain names
- Trade secrets
- Copyrights and patents
- Managerial and executive talent
Types of Goodwill
Goodwill can be categorized based on various factors such as the nature of the business and the client base. Business goodwill is linked to the company’s market standing and the quality of its customer service. On the other hand, professional practice goodwill pertains to fields like medicine, engineering, law, and accounting. This goodwill can be further divided into practitioner goodwill, which is tied to the individual professional’s reputation and expertise, and practice goodwill, which stems from the institution’s established reputation, location, and business operations.
Calculating Goodwill
To assess goodwill, financial analysts often employ residual analysis. Here, goodwill is the remaining value of the business after accounting for all tangible and identifiable intangible assets. The steps to calculate goodwill are as follows:
- Determine the book value of all assets listed on the balance sheet.
- Ascertain the fair value of these assets.
- Identify the fair value adjustment, which is the difference between the fair value and the book value of the assets.
- Compute the excess purchase price by subtracting the net book value of the assets from the price paid for the acquisition.
- Goodwill is calculated by taking the excess purchase price and deducting the fair value adjustments.
Example
Suppose you acquire a business for $3 million. The business has $2 million in identifiable assets and $600,000 in liabilities. The net identifiable assets amount to $1.4 million ($2 million minus $600,000). In this scenario, goodwill would be $1.6 million, calculated as follows:
Goodwill = Purchase Price – Net Identifiable Assets
Goodwill = $3 million – $1.4 million
Goodwill = $1.6 million
This goodwill should then be recorded as a noncurrent asset on your balance sheet.
The Accounting Treatment of Goodwill
Goodwill is recognized and listed as a long-term asset on a company’s balance sheet. Unlike some other assets, goodwill is not subject to amortization for accounting and tax purposes. However, according to accounting standards, goodwill must undergo periodic impairment testing to ensure it has not lost its value.
In 2014, the Financial Accounting Standards Board (FASB) made updates to how goodwill should be accounted for. The FASB Accounting Standards Update No. 2014-02, titled “Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill,” permits private companies to amortize goodwill using a straight-line method over a period of 10 years.
Is Goodwill a Current Asset?
Goodwill is classified as a noncurrent asset rather than a current asset. Noncurrent assets typically include long-term investments in business resources such as property, plant, and equipment, as well as other intangible assets.
Is Goodwill a Nominal Account?
Goodwill is not categorized as a nominal account. Instead, it is considered an intangible real account, representing assets that, while not physical, can be valued in monetary terms.
The Valuation of Goodwill
Goodwill needs to be valued when a triggering event results in the fair value of goodwill falling below its current book value. Such events can include:
- Damages caused by a breach of contract, copyright infringement, or interference with a business opportunity
- Mergers or separations of businesses or professional practices
- Bankruptcy and reorganization
- Conversion from a C corporation to an S corporation
While businesses can cultivate internal goodwill by training employees, maintaining good client relationships, and expanding their customer base, only the goodwill acquired through the purchase of another business can be recorded as an asset. Internal goodwill does not meet the criteria to be classified as an asset.
Goodwill significantly influences the purchase price of a business because it mitigates the risk of profitability decline post-acquisition. Thus, evaluating and maintaining the fair value of goodwill is essential in mergers and acquisitions, ensuring that the intangible elements that contribute to the business’s success are accurately reflected in financial statements.
