What is Goodwill?

What is Goodwill? | Accounting Smarts
Charles Hall

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Charles Hall

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March 1, 2021

Many small business owners struggle with the concept of Goodwill due to the complexities of its concepts and application.

Many small business owners struggle with the concept of Goodwill due to the complexities of its concepts and application.

Many ask, “What does it really mean, and how does it affect my business?”

Goodwill is an asset that comes into play when one company purchases another one. It is the value of the purchase price minus the fair value of the assets of the company that is being purchased. 

Goodwill calculations can trip up some seasoned accountants, so we expect that more of an explanation will be needed if you’re new to small business accounting. In this article, we will explore every aspect of Goodwill, the importance of it, and more. If you’re interested in learning more, then keep on reading!

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What Does Goodwill Mean?

The concept of Goodwill can be particularly difficult to grasp, especially if the concept is novel to you, but we will take things slow and begin by telling you exactly what Goodwill means. 

Goodwill is a measure of how much a company paid for another company over the fair market value of the other company’s assets and any liabilities. Goodwill is not a tangible asset- it is intangible, and no one can buy or sell it. 

It’s not even relevant enough for many investors to consider it before lending money to a company. On top of that, it’s extremely hard to determine Goodwill with certainty, being that the fair value of the assets is determined by an educated guess. Yet, the Generally Accepted Accounting Principles dictate that this measure be included as necessary in a company’s financial records. 

You’ll never have to deal with Goodwill unless you’re involved in a transaction where one company purchases another one. But once you are, you’ll need to quickly get a handle on Goodwill. 

What Makes Up Goodwill

To understand the meaning of Goodwill, you need to become familiar with its components. For the purpose of explanation, we will act as if your company is purchasing another company. 

Goodwill is calculated from the following values: 

  • The purchase price (P) - The price that your company is paying to purchase another company. 
  • The fair market value of the other company’s assets (A) - Assets like the other company’s brand recognition, favorable reputation, workers, and technology are some examples. These calculations cannot be precise because they are very difficult to quantify. These values are more like estimates than anything else. 
  • The Fair market value of the other company’s liabilities  (L) - A company that is to be purchased may have liabilities like debts or loans. These liabilities are subtracted from assets in the goodwill calculation. 

The equation that you will plug in when calculating Goodwill is Goodwill= P-(A-L).  If you follow this calculation, you will come up with the right result every time. Keep in mind that your monetary calculations may not necessarily be representative of the other company’s assets, but you should take your absolute best guess and have some justification for the arrived value. 

Examples of Goodwill

Now that you know all of the components of Goodwill, it’s time to go over a couple of examples to deepen your understanding of the concept. 

Goodwill Example 1

Think of a situation where your company just purchased another one.

Here are the figures that you have to work with: 

  • Purchase price (P) = $3,000,000
  • Fair Value of other company’s assets (A)= $2,000,000
  • Fair value of other company’s liabilities (L) = $500,000

Using the equation, Goodwill= P-(A-L), this is how your calculations will look: 

Goodwill = $3,000,000 - ($2,000,000 - $500,000)

Goodwill = $3,000,000 -$1,500,000

Goodwill = $1,500,000

The Goodwill for this transaction comes out to be $1,500,000, and this is what you will enter for Goodwill on your balance sheet. 

Goodwill Example 2

Here is another example of a goodwill calculation using different figures. 

Here are the figures that you have to work with: 

  • Purchase price (P) = $2,000,000
  • Fair Value of other company’s assets (A)= $2,000,000
  • Fair value of other company’s liabilities (L) = $400,000

Using the equation, Goodwill= P-(A-L), this is how your calculations will look: 

Goodwill = $2,000,000 - ($2,000,000 - $400,000)

Goodwill = $2,000,000 -$1,600,000

Goodwill = $400,000

The Goodwill for this transaction comes out to be $400,000, and this is what you will enter for Goodwill on your balance sheet. 

How Long Goodwill Stays on the Balance Sheet

People who are not familiar with Goodwill often ask how long to include Goodwill on their balance sheet. To answer this plainly, Goodwill is kept on the balance sheet indefinitely. As a business continues to acquire more companies, the bookkeeper will continue to add additional Goodwill to the balance sheet. 

Though some feel that Goodwill can diminish as time progresses, reducing Goodwill is usually not done, as it is difficult to determine how much to decrease Goodwill at any given time.

The only time that you change Goodwill is if there has been an impairment.  Impairment is a more complicated issue and requires a more technical understanding.  For the purposes of this article just be aware Goodwill rarely if ever changes.

This inference is not made immediately- it’s made overtime after a pattern of high goodwill impairment is detected. 

Is Goodwill Good or Bad?

There is a good chance that your next question concerns whether Goodwill is good or bad. Goodwill is not necessarily a bad thing because it is not a figure that you can take any reliable action on. Goodwill is based on assumptions and estimates, which can be off by a large margin. So, it’s not possible to tell you with certainty whether a specific goodwill amount is good or bad. 

High Goodwill is not necessarily bad, just like low Goodwill is not necessarily good. The calculations could have been tainted with incorrect estimations of the assets of the company that’s being bought.  The bottom line is goodwill is essentially a plug number that explains the difference between the fair value of assets purchased and the purchase price.

The more intangible assets or benefits a company is perceived to have the higher the goodwill produced.

What Are the Types Of Goodwill?

Many don’t know that there are two types of Goodwill. The main type, which was explored above, is called purchased Goodwill. The other type of Goodwill is called “inherent goodwill,” and this type of Goodwill is the opposite of purchase goodwill. 

Inherent Goodwill is a measure of a business’s actual value, which is often used to refer to a company’s worth. Companies come up with their inherent Goodwill through internal calculations by internal staff. There is no generally accepted method that businesses use to come up with the inherent Goodwill. 

Unlike purchased Goodwill, this type of Goodwill is not shown on financial statements. It also does not have a real value, which is why this type of Goodwill is not the focus of this article. 

If you’re still struggling to understand Goodwill, we recommend that you read through the article again. It could take several read-throughs to begin to pick up these concepts. If you still find that you’re struggling with this concept, it may be worth reaching out to a bookkeeper or accounting professional to see if they can offer any additional assistance. 

Final Thoughts

Now you know a lot about Goodwill, how to calculate it for your business acquisitions, and what the calculation means for your business’s financials. We hope that this article is helpful to you in your pursuit of Goodwill information. Now you’re ready to put your new info into action.

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

Learn more about Charles Hall