Definition of Goodwill
Goodwill is an intangible asset that arises when one company purchases another company. Specifically, it 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 reasons that result in goodwill include customer loyalty, brand name, extensive customer list, innovative technologies etc…
Simply put, it is the extra cost or premium that one company pays to acquire another company. For example, if company A purchases company B for $2 million and the fair value of net identifiable assets of company B is $1.5 million, the extra $0.5 million that company A pays to acquire company B is referred to as goodwill.
How To Calculate Goodwill?
Goodwill is simply calculated by subtracting the fair value of net identifiable assets from the purchase price of the company. Basically, we calculate the premium that the company pays over the net assets. Here is an example that explains how the goodwill is calculated.
Question: X company acquired Z for $7000. Below is the calculation of the total fair value of net assets of company Z. Calculate Goodwill?
| Item | Fair Value ($) |
|---|---|
| Current Assets | 2000 |
| Non-current Assets | 8000 |
| Current Liabilities | 1500 |
| Non-current Liabilities | 5000 |
| Net Assets | 3500 |
Solution:
Formula to calculate goodwill = Purchase Price (Also known as Acquisition Price) – Fair value of net assets.
Putting values in the equation,
= 7000-3500
Goodwill= $3500
The above goodwill calculation is for companies that are fully (100% subsidiary) acquired. In some circumstances, the acquirer company acquires a percentage of the total shares of the company in which case the goodwill is calculated differently. Here is how we can calculate goodwill if the company purchases less than 100% of shares.
Having less than 100% shares means that there are other shareholders of the company too, known as non-controlling interests or NCI. To calculate the goodwill, you should add the value of non-controlling interests with the purchase consideration to accurately reflect the value of goodwill. That being said, we can calculate it as follows.
Question: C company acquired 70% of D company for $5m. The fair value of the net assets of D company is $5.5m. Calculate the goodwill?
Solution
Consideration paid= $5m
We know that $5m is 70% of the company so the remaining 30% is owned by non-controlling interests.
To calculate the value of NCI, we need to perform some quick math.
$5m = 70%
To find the value of the 100% shares, divide 5 by 70 and multiply it by 100. Here is how:
5/70*100
= 7.14
>> 7.14 – 5 (purchase consideration) = 2.14m
*Alternative method that directly calculates the value of NCI*
5/70*30 = 2.14m NCI value
Formula to calculate goodwill of partially acquired company = purchase consideration + NCI – fair value of the acquiree’s net assets
putting values in the formula we get >> 5m+2.14m-5.5m
Goodwill = $1.64m
Why Goodwill Arises?
Goodwill in an acquisition arises because the company is worth more than just its net assets mainly due to reasons like the strong and loyal customer base of the company, expertise of the company’s employees, the social impact of the company, stability, and experience etc…
Creating a stable business from scratch is a tough cookie and therefore, if a company wants to acquire another established company, it has to pay some kind of premium to compensate for the effort that has been done in the start. This premium is referred to as goodwill.
7 Factors That Affect The Value Of A Goodwill
There are a lot of factors that decide the value of goodwill of a company. Following is the list of 9 factors that affect the value of goodwill. Note that these factors indirectly reflect how much the goodwill should be and there are no hard and soft rules or formulas to exactly find out the value. Ultimately, it depends on how much one company is willing to pay to acquire another.
#1 Synergy Of The Acquisition
Sometimes, one company acquires another company simply to become the bigger player in the industry and control most of what the market offers. This creates synergy and could ultimately lead to forming a monopoly that companies desire to attain. Therefore, in such acquisitions, the acquirer is willing to pay a premium, in other words, goodwill.
#2 Highly Valued And Respected Brand Name
A valued brand name stands out in the saturated market and gives credibility to the company thus an acquirer would be willing to pay a premium over the net assets of the company.
#3 Excellence And Experience In The Industry
Companies that have experience and expertise in an industry are considered more stable and legit, hence attracting investors who are willing to pay more than the net assets of the company.
#4 Extensive Customer And Supplier Data
The phrase “data is the new oil” fits perfectly here. Companies with extensive and relevant data generated throughout the years better understand and predict the market and efficiently plan things. An example would be a clothing brand that knows what type of t-shirt designs and fabric people of particular localities like and what price are they willing to pay for it.
#5 Innovative Technology
Having an advanced or unique technology is yet another factor that has an impact on the company’s goodwill. The better and unique the technology is, the more premium (goodwill) investors would be willing to pay to acquire the company.
#6 Robust And Organized Management
Organizations are strengthened by various practices and one such practice is employing dedicated and organized staff which then leads to an organized work environment and ultimately helps achieve the company’s objectives and goals. Therefore, companies are far more likely to pay a premium to acquire companies with an organized structure.
#7 Stable And Progressive Financial Performance
If a company does well financially and generates stable and progressive returns then an extra monetary value is added to its acquisition price.
The above factors increase or decrease a company’s goodwill and if the company lacks some or all of these, it could lead to negative goodwill.
What Is A Negative Goodwill?
Unlike normal goodwill, negative goodwill arises in acquisition when the purchase price of the company is less than the fair value of its net assets. Basically, when the company is valued at less than the sum of its total net assets, that is when total liabilities are deducted from the total assets of the company.
Negative goodwill arises due to factors like bargain purchases, poor management of a company, bad reputation, incompetence of the workforce, etc…
Accounting Treatment Of Goodwill
Like every other accounting transaction, goodwill is accounted for as per the procedures laid out by its respective accounting standard. IFRS 38 has made it clear that goodwill should be accounted for only when it arises on the acquisition. That means internally generated goodwill is not recorded or accounted for in the books. Goodwill in an acquisition is accounted for in the following manner.
Suppose that Company D acquires Company Z for $100m. The fair value of the net assets of company D is 65m and consists of the following items.
| ITEM | FAIR VALUE (IN MILLIONS) |
|---|---|
| Receivables | 20 |
| Securities | 10 |
| Inventories | 30 |
| Equipment (NCA) | 100 |
| Licenses | 50 |
| Account Payables | (15) |
| Loans | (80) |
| Bonds Payable | (50) |
| Net Assets | 65m |
Goodwill = consideration paid – fair value of net assets
= 35m (100-65)
Accounting entries for the acquisition will be;
| Item | Debit | Credit |
|---|---|---|
| Receivables | 20 | |
| Securities | 10 | |
| Inventories | 30 | |
| Equipment | 100 | |
| Licenses | 50 | |
| Goodwill | 35 | |
| Accounts Payable | 15 | |
| Loans | 80 | |
| Bonds Payable | 50 | |
| Consideration Paid | 100 | |
| Total | 245m | 245m |
Hence, goodwill on acquisition is considered as an intangible asset and is debited by the acquirer against the purchase price (consideration paid) whereas, negative goodwill is recognized as an income and credited.
What Is Internally Generated Goodwill?
Internally generated goodwill does not involve the acquisition and is referred to as goodwill created by a business over a period of time. Creating a stable business, a customer list and a positive image takes time and energy and adds credibility to the business which in turn leads to goodwill. Though considered as goodwill, IFRS 38 has strictly prohibited companies to record internally generated goodwill in the books.
Internally generated goodwill is only realized upon the acquisition of the company and that is when it is given a monetary value. However, for the acquirer company, the internally generated goodwill of the acquiree (the company that is subject to acquisition or merger) becomes goodwill on the acquisition and it will record it in its books.
Impairment Of Goodwill
Once a company records goodwill, it becomes an intangible asset of the company and is subject to impairment. Goodwill impairment means when the carrying amount of the goodwill exceeds its fair value. In other words, when the goodwill is no longer as valuable as it was on the date of acquisition.
Impairment in goodwill occurs due to reasons like the poor financial performance of the company, changing dynamics in the industry, or simply if the company realizes from the cash flows that the goodwill had been overstated in the acquisition.
In such circumstances, the carrying value of the goodwill should be lowered to its fair value and an impairment loss recognized; that is the difference between its carrying value and fair value. In addition, goodwill should be tested for impairment at least annually.
Related Questions
A: Goodwill is not a current asset because it has an indefinite useful life whereas current assets are used or sold in less than 12 months. In addition, goodwill is not liquid and does not directly participate in generating revenue for the business.
A: Tangible non-current assets are physical long-term assets such as property or machinery whereas goodwill does not have a physical form hence it is not a tangible non-current asset.
A: Negative goodwill is not an asset but a gain (income) for the acquirer and is recorded in the income statement.
A: A company should only value and record goodwill that arises as a result of purchasing another entity. IFRS has prohibited companies from recording internally generated goodwill.
A: Goodwill is an intangible asset because it cannot be seen or touched whereas tangible assets are long-term assets that have physical existence.
A: Both IFRS and GAAP have prohibited companies to amortize goodwill because goodwill has an indefinite useful life. Companies are required to test goodwill at least annually for impairment.
A: Goodwill is an intangible asset of the company and not a fictitious asset because it can be realized in acquisition. The fact that it does not have a physical existence does not make it fictitious because it can actually be converted to cash.
References
- https://www.investopedia.com/terms/g/goodwill.asp – Definition of goodwill
- https://link.springer.com/article/10.1007/s11142-017-9401-7
