When you acquire a new business, you’re not just purchasing their contracts, equipment, real estate, and inventory. You’re also purchasing those crucial assets that are more difficult to put a price tag on, such as the brand name, location, and customer base. That’s why having a good understanding of the concept of goodwill in business is so important, particularly for businesses that are being acquired or considering making an acquisition. Find out more about goodwill accounting with our simple guide.
Goodwill is an intangible asset (an asset that’s non-physical but offers long-term value) which arises when another company acquires a new business. Goodwill refers to the purchase cost, minus the fair market value of the tangible assets, the liabilities, and the intangible assets that you’re able to identify. In other words, goodwill is the proportion of the purchase price that is higher than the net fair value of all the assets and liabilities included in the sale. Some of the elements that produce goodwill in business include the value of your company’s brand name, good employee relations, strong relations with customers, excellent location with a secure lease, proprietary technology, and so on.
Goodwill accounting: GAAP and IFRS
According to both GAAP and IFRS, goodwill is an intangible asset which has an indefinite life. This means that – unlike other intangibles – it doesn’t need to be amortized. However, businesses are required to evaluate goodwill in business for impairment (when the market value drops below the historical cost) on a yearly basis.
How to calculate goodwill
Learning how to calculate goodwill can be difficult, as there’s no certainty that the amount you’ve arrived at is ever going to be 100% accurate. However, there is a relatively simple formula you can use to get started:
Goodwill = Purchase price – (Fair Market Value of Assets – Fair Market Value of Liabilities)
So, how does that work in practice? Here’s a step by step guide to the goodwill calculation process:
Obtain the book value of the assets, including the business’s fixed assets, intangible assets, current assets, and non-current assets.
Then, determine the fair value of these assets. Although fair value is usually determined by the marketplace, there are several different methods you can use to calculate fair value, including an assessment of the asset’s discounted cash flows.
Once you’ve found the book value of the assets and the fair value of the assets, you need to find the difference between the two amounts and note the difference in the book of accounts.
Now, you should calculate the difference between the actual purchase price and the net book value of the assets (assets minus liabilities) to find the excess purchase price.
Finally, you need to take the excess purchase price and deduct the fair value adjustments, and you’ll have a figure for goodwill.
Goodwill in business vs. other intangible assets
There’s a significant difference between goodwill and other intangible assets, such as a patent, intellectual property, or research and development. Essentially, goodwill only arises during an acquisition. As such, it can’t be bought or sold independently, unlike intangible assets such as copyright, for example. In addition, other intangibles are classified as “definite” as there’s a foreseeable end to their useful lives, whereas goodwill is “indefinite”.
The drawbacks of goodwill accounting
Because goodwill is so difficult to price, it can be very difficult to complete a goodwill calculation, particularly if you don’t have access to all the necessary data. It’s also important to note that negative goodwill is a possibility for any acquisition, occurring when the target company will not negotiate a fair price. Sometimes, when a company that was successful is facing insolvency, goodwill is removed from any determinations of residual equity. This is because at the point of bankruptcy/insolvency, the “goodwill” that the company once had is no longer of any value.
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