Goodwill
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What Is Goodwill?
Goodwill is an intangible asset that is associated with the purchase of one company by
another. Specifically, goodwill is the portion of the purchase price that is higher than the
sum of the net fair value of all of the assets purchased in the acquisition and the liabilities
assumed in the process. The value of a company’s brand name, solid customer base, good
customer relations, good employee relations, and proprietary technology represent some
reasons why goodwill exists.
Key Takeaways
Goodwill is an intangible asset that accounts for the excess purchase price of
another company.
Items included in goodwill are proprietary or intellectual property and brand
recognition, which are not easily quantifiable.
Goodwill is calculated by taking the purchase price of a company and subtracting
the difference between the fair market value of the assets and liabilities.
Companies are required to reviewthe value of goodwill on their financial statements
at least once a year and record any impairments. Goodwill is different from
mostother intangible assets, having an indefinite life, while mostother intangible
assets have a finiteuseful life.
Understanding Goodwill
The process for calculating goodwill is fairly straightforward in principle but can be quite
complex in practice. To determine goodwill in a simplistic formula, take the purchase
price of a company and subtract the net fair market value of identifiable assets and
liabilities.
Goodwill = P-(A-L), where: P = Purchase price of the target company, A = Fair market
value of assets, L = Fair market value of liabilities.
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Goodwill
What Goodwill Tells You
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The value of goodwill typically arises in an acquisition—when an acquirer purchases a
target company. The amount the acquiring company pays for the target company over the
target’s net assets at fair value usually accounts for the value of the target’s goodwill If the
acquiring company pays less than the target’s book value, it gains negative goodwill,
meaning that it purchased the company at a bargain in a distress sale.
Goodwill is recorded as an intangible asset on the acquiring company's balance sheet
under the long-term assets account. Under generally accepted accounting principles
(GAAP) and International Financial Reporting Standards (IFRS), companies are required
to evaluate the value of goodwill on their financial statements at least once a year and
record any impairments.1 Goodwill is considered an intangible (or non-current) asset
because it is not a physical asset like buildings or equipment.
Goodwill Calculation Controversies
There are competing approaches among accountants as to how to calculate goodwill. One
reason for this is that goodwill represents a sort of workaround for accountants. This
tends to be necessary because acquisitions typically factor in estimates of future cash
flows and other considerations that are not known at the time of the acquisition. While
this is perhaps not a significant issue, it becomes one when accountants look for ways of
comparing reported assets or net income between different companies; some that have
previously acquired other firms and some that have not.
Goodwill Impairments
Impairment of an asset occurs when the market value of the asset drops below historical
cost. This can occur as the result of an adverse event such as declining cash flows,
increased competitive environment, or economic depression, among many others.
Companies assess whether an impairment is needed by performing an impairment test on
the intangible asset.
The two commonly used methods for testing impairments are the income approach and
the market approach. Using the income approach, estimated future cash flows are
discounted to the present value. With the market approach, the assets and liabilities of
similar companies operating in the same industry are analyzed.
If a company's acquired net assets fall below the book value or if the company overstated
the amount of goodwill, then it must impair or do a write-down on the value of the asset
on the balance sheet after it has assessed that the goodwill is impaired. The impairment
expense is calculated as the difference between the current market value and the purchase
price of the intangible asset.
The impairment results in a decrease in the goodwill account on the balance sheet. The
expense is also recognized as a loss on the income statement, which directly reduces net
income for the year. In turn, earnings per share (EPS) and the company's stock price are
also negatively affected.
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The Financial Accounting Standards Board (FASB), which sets standards for GAAP rules,
is considering a change to how goodwill impairment is calculated.2 Because of the
subjectivity of goodwill impairment and the cost of testing impairment, FASB is
considering reverting to an older method called "goodwill amortization" in which the
value of goodwill is slowly reduced annually over a number of years.
Goodwill vs. Other Intangibles
Goodwill is not the same as other intangible assets. Goodwill is a premium paid over fair
value during a transaction and cannot be bought or sold independently. Meanwhile, other
intangible assets include the likes of licenses and can be bought or sold independently.
Goodwill has an indefinite life, while other intangibles have a definite useful life.
Limitations of Using Goodwill
Goodwill is difficult to price, and negative goodwill can occur when an acquirer purchases
a company for less than its fair market value. This usually occurs when the target
company cannot or will not negotiate a fair price for its acquisition. Negative goodwill is
usually seen in distressed sales and is recorded as income on the acquirer's income
statement.
There is also the risk that a previously successful company could face insolvency. When
this happens, investors deduct goodwill from their determinations of residual equity. The
reason for this is that, at the point of insolvency, the goodwill the company previously
enjoyed has no resale value.
Example of Goodwill
If the fair value of Company ABC's assets minus liabilities is $12 billion, and a company
purchases Company ABC for $15 billion, the premium value following the acquisition is
$3 billion. This $3 billion will be included on the acquirer's balance sheet as goodwill.
As a real-life example, consider the T-Mobile and Sprint merger announced in early 2018.
The deal was valued at $35.85 billion as of March 31, 2018, per an S-4 filing. The fair
value of the assets was $78.34 billion and the fair value of the liabilities was $45.56
billion. The difference between the assets and liabilities is $32.78 billion. Thus, goodwill
for the deal would be recognized as $3.07 billion ($35.85 - $32.78), the amount over the
difference between the fair value of the assets and liabilities.3
What Is Goodwill?
Goodwill is an important accounting concept in investing. Shown on the balance sheet,
goodwill is an intangible asset that is created when one company acquires another
company for a price greater than its net asset value. Unlike other assets that have a
discernible useful life, goodwill is not amortized or depreciated but is instead periodically
tested for goodwill impairment. If the goodwill is thought to be impaired, the value of
goodwill must be written off, reducing the company’s earnings.
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How Is Goodwill Used in Investing?
Evaluating goodwill is a challenging but critical skill for many investors. After all, when
reading a company’s balance sheet, it can be very difficult to tell whether the goodwill it
claims to hold is in fact justified. For example, a company might claim that its goodwill is
based on the brand recognition and customer loyalty of the company it acquired. When
analyzing a company’s balance sheet, investors will therefore scrutinize what is behind its
stated goodwill in order to determine whether that goodwill may need to be written off in
the future. In some cases, the opposite can also occur, with investors believing that the
true value of a company’s goodwill is greater than that stated on its balance sheet.
What Is an Example of Goodwill on the Balance Sheet?
Consider the case of a hypothetical investor who purchases a small consumer goods
company that is very popular in her local town. Although the company only had net assets
of $1 million, the investor agreed to pay $1.2 million for the company, resulting in
$200,000 of goodwill being reflected in the balance sheet. In explaining this decision, the
investor could point to the strong brand following of the company as a key justification for
the goodwill that she paid. If, however, the value of that brand were to decline, then she
may need to write off some or all of that goodwill in the future.
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