How is goodwill treated in accounting? When you want to know the answer to this question, you need to suspend your normal thinking process around the definition of “goodwill.”
Outside of the world of accounting, you might refer to goodwill as a company’s value that results from:
- Excellent teamwork
- Top-notch management skills
- Outstanding customer service
However, we’re talking about mergers and acquisitions and the reporting of intangible assets on a company’s balance sheet when discussing goodwill accounting.
Below, we discuss what goodwill is in accounting, as well as how to calculate goodwill.
What Is Goodwill in Accounting?
Goodwill accounting relates to when one business buys another existing business. Goodwill in accounting is the intangible asset that results from the business purchase. Assets that cannot be identified separately are represented with goodwill accounting.
Goodwill gets reported as a noncurrent or long-term asset on the balance sheet. More specifically, a situation where goodwill gets recorded includes a purchase price that’s higher than the sum of the:
- Fair value of visible assets
- Intangible assets included in the purchase
- Liabilities that resulted from the acquisition
Examples of goodwill include a company’s employee relations, branding, proprietary technology or patents, or customer base.
The Types of Goodwill
The business type and its customers affect the different types of goodwill.
Business Goodwill relates to:
- The business
- The company’s marketplace position
- Customer service provided
Professional Practice, or Practitioner, Goodwill is associated with the professional services sector, such as accountants, attorneys, engineers, or doctors. The practitioner’s skill level and reputation are considered here, relating to operating procedures, track record, location, and institutional reputation.
What Goodwill Tells Us
Goodwill reveals the value represented after one company purchases another business. If the purchased company’s sale price was less than its book value, then that means it was bought in a distress sale. Conversely, the acquiring company gains negative goodwill because it bought at a bargain price.
The acquiring company’s balance sheet sees intangible assets recorded under the long-term assets account. The reason for the intangible asset classification is that the asset isn’t of the physical variety, such as equipment or a building.
Goodwill Controversies
Debate exists around the topic of goodwill accounting. Some people argue that companies required to partake in goodwill accounting are disadvantaged when compared to companies in countries where it isn’t necessary to amortize goodwill against income.
Furthermore, goodwill represents an accounting workaround. This means that accountants might approach goodwill calculation methods in different ways. The fact that acquisitions include factors that aren’t immediately known and future cash flow estimates means that it’s often necessary to get creative with the reporting.
Goodwill Impairments
Goodwill impairment becomes an issue when goodwill fair value dips under book value and acquired assets cannot generate cash flow. An accounting charge exists because the recorded value is less than what was estimated when the business was acquired.
The test for goodwill impairment should be undertaken annually to see if acquired assets no longer generate previously estimated financial results
Goodwill vs. Other Intangibles
Unlike other types of intangible assets, goodwill can’t be independently bought or sold because it’s a transactional premium paid on fair value. Other intangible assets provide a definite useful life. On the other hand, goodwill comes with an indefinite life. Licenses provide us with an example of other intangible assets.
Limitations of Using Goodwill
Goodwill limitations exist. For one thing, it’s challenging to come up with a set value when pricing goodwill. If a purchasing company acquires another company under fair market value, then the situation results in negative goodwill.
Often, negative goodwill happens because the acquired company can’t or refuses to provide a fair acquisition price during its negotiations. Distressed sales typically result in negative goodwill. The purchasing company sees its income statement record the sale as income.
Another limitation of goodwill arises in cases of insolvency. Investors deduct goodwill from residual equity determinations when previously successful companies reach insolvency. This is required because insolvency results in a situation where any previous goodwill now loses resale value.
Steps for Calculating Goodwill in an M&A Model
Let’s take a proper look at how to calculate goodwill throughout the merger and acquisition (M&A) process.
1. Book Value of Assets
The first order of business is calculating all asset book values on the purchased company’s balance sheet. Use the financial statements provided by the target company. Make sure you’re using the most recent statement and included the following:
- Intangible assets
- Fixed assets
- Non-current assets
- Current assets
2. Fair Value of Assets
An accountant must now calculate fair value for all the assets. It’s indeed a subjective process when making these determinations. However, a quality firm has the wherewithal to make the proper analysis that determines each asset’s current fair market value.
3. Adjustments
Use the difference between each asset’s fair value and book value to determine the adjustments.
4. Excess Purchase Price
Using the acquiring company’s actual purchase price paid to acquire the new company, subtract out the target company’s net book value of the company’s assets (using assets minus liabilities). This calculation provides you the excess purchase price.
5. Calculate Goodwill
How is goodwill calculated? Deduct the fair value adjustments from the excess purchase price. The goodwill figure should get entered on the acquiring company’s balance sheet upon closing the deal.
Conclusion
What is goodwill accounting? You asked this question, and we’ve answered it for you. You now know everything you need to know about goodwill, as it relates specifically to the accounting world. You also understand that goodwill isn’t easy to determine and that there’s some flexibility with how you fill it out on your balance sheet.
If you’d like to find an accountant with the required skills to help make sure your goodwill accounting needs are met with professionalism, then we encourage you to use our services.
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