How does it work?
You record goodwill when the purchase price of a business is higher than the tangible and intangible assets purchased minus the liabilities assumed. When one company purchases another company at a price that is higher than the fair market value of its net assets (assets minus liabilities), the difference is goodwill. It can include things like a company’s reputation, sound customer base, customer relationships and good employee relations.
Not all intangible assets are goodwill. For example, patents, trademarks and licences that can be sold separately do not fall into this category.
How do you calculate it?
To calculate this figure, you start with the purchase price of a company then subtract the fair market value of the assets and liabilities. In an equation, this would be:
Goodwill = P – (A – L)
P = price of the company purchased
A = fair market value of assets
L = fair market value of liabilities
The standard definition of goodwill
According to the Australian Accounting Standards Board (AASB), goodwill includes:
‘Future economic benefits arising from assets that are not capable of being individually identified and separately recognised.’
They also describe how goodwill is measured:
‘…the excess of the cost of the business combination over the acquirer’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities…’
Where does goodwill fit on the balance sheet
Since it is an asset, it fits on the asset section of the balance sheet. Let’s say Company A purchases Company B for $1 million. Company B has assets valued at $750,000 and liabilities of $50,000. In this case, Company A, the acquiring company, paid a premium of $300,000 above the value of identifiable assets:
Goodwill = $1,000,000 – ($750,000 – $50,000) = $300,000
This amount is goodwill and includes intangible things that add value to the business even though they can’t be sold separately.
The value of goodwill can change over time. For example, if a large number of customers of the company being purchased decide to purchase from competitors, instead of the new owners, this will impact goodwill. Also, if the company culture changes and experience staff decide to leave the acquired business, this can also lead to a decrease in goodwill, known as impairment.
When considering goodwill, it’s best to consult with a professional accountant. The Australian Tax Office offers a summary of how to value goodwill:
Its valuation is generally based on the calculation of a residual value. In basic terms, this approach requires the valuation of the net identifiable assets of the business (market-adjusted) and the valuation (market value) of the equity of the business.
A residual value may be derived by subtracting the value of the net identifiable assets of the business from the value of equity of the business. As a general rule, the calculation of a residual value will be the most appropriate method for deriving goodwill. However, other methods may be accepted if they are appropriate to the circumstances.