Discover everything you need to know about goodwill in accounting, including how it’s calculated in the UK and what to look out for.
Goodwill Definition
Goodwill is an intangible asset that comes about when a company acquires another business. Intangible means that the asset has no physical value, but still offers value long term.
In accounting, goodwill is the purchase cost, minus the fair market value of the liabilities, tangible assets, and intangible assets that a company can identify.
Simply put, goodwill is a part of the purchase price that is over the net fair value of all net assets and liabilities at the time of sale.
There are a few things that increase goodwill in a business:
- Good customer relations
- Strong employee relations
- A brand name
- Owned technology
- Good location with a settled lease
Goodwill Accounting Example
Let’s take a look at an example, to improve your understanding.
The fair market value of company A’s net assets minus its liabilities is £100,000. Now, company B purchases company A for £150,000. The premium for the acquisition is £50,000 because it is above the fair market value once the liabilities have been taken off. That means that company B can put the £50,000 on their financial statements as goodwill.
Goodwill Accounting—GAAP and IFRS
Based on the International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Practice (GAAP), goodwill is an intangible asset with an unlimited lifespan. This is different to other intangibles because it means goodwill doesn’t need to be depreciated or amortized.
However, the companies that buy these businesses do need to evaluate the business for impairment every year. Impairment would be if the market value drops lower than the cost of the business has ever before.
If the goodwill of a company is impaired the goodwill value needs to be written off. This, in turn, reduces the acquiring company’s earnings as a whole.
How to Calculate Goodwill
Calculating goodwill can be hard because there is no way to know for sure that the amount determined is 100% accurate.
While learning how to calculate goodwill is tough, there is a formula to help get you going:
Goodwill = the purchase price – (Fair market value of identifiable assets – fair market value of liabilities)
In other words, goodwill = P − ( A − L )
It’s all good and well to have the formula, but here are some steps to help guide calculating goodwill:
- Get the book value of assets: You need access to the non-current assets, fixed assets, current assets, and intangible assets of the business.
- Obtain a fair value of assets: With the help of an accountant, you can determine the fair value of assets. This is quite subjective, but an experienced professional will know how to analyse the current market value for each asset.
- Calculate the difference: Once you have the fair value of assets and the book value of assets, you find the difference between the two.
- Work out the excess purchase price: Take the difference between the purchase price and the net book value of the purchased company’s assets. Simply put, it’s assets minus liabilities; this will give you the excess purchase price.
- Calculate goodwill: Take the excess purchase price and minus the fair value adjustments. This will give you the goodwill value to put on the balance sheet.
How is Goodwill Different From Other Intangible Assets?
Put simply, goodwill can only happen during an acquisition. This means it can’t be sold or bought independently, unlike other intangibles like copyrights.
Are There Limitations of Goodwill?
Yes, negative goodwill can happen when a company acquires a business for less than the fair market value. Since goodwill is already difficult to calculate, it may raise questions surrounding the company’s balance sheet and the value of goodwill.
Our Final Thoughts
Understanding the basics of goodwill in accounting is difficult if you don’t know about accounting principles and how to calculate the values (assets) of a company. Plus, being an intangible asset, goodwill is difficult to estimate because it will never be 100% accurate.
If you’re thinking of acquiring another business, consider hiring an accountant to provide you with the fair value of assets to get you started.
Sources:
https://www.investopedia.com/terms/g/goodwill.asp
https://gocardless.com/guides/posts/what-does-goodwill-mean/
https://corporatefinanceinstitute.com/resources/accounting/goodwill/
https://www.gov.uk/hmrc-internal-manuals/capital-gains-manual/cg68010