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What is Goodwill?
Goodwill is a concept that is often prevalent in accounting. It is an intangible asset that companies acquire when they purchase another company. Usually, goodwill represents the difference between the purchase price and the net fair value of a company’s net assets. When the sum that companies pay is higher than the net fair value of the net assets they get, the difference is considered goodwill.
Usually, goodwill comprises various underlying assets. These include a company’s brand name, customer relations, proprietary technology, customer base, etc. During a company acquisition, the parent company may be willing to acquire the company more than it is worth. In accounting, this premium that companies pay for acquisitions is considered goodwill.
Is Goodwill an Asset?
As mentioned, goodwill is the premium that companies pay for acquisitions. Therefore, goodwill is an asset that companies recognize in their Balance Sheets. Since it is an intangible asset that companies use for a long time, goodwill is a part of a company’s non-current assets.
However, companies can only recognize it in specific conditions. Accounting standards require companies to recognize goodwill when they acquire another company. Since it is an intangible asset, all the provisions applicable to other intangible assets also apply to goodwill. Therefore, companies must have a valid basis to calculate its value.
Like other intangible assets, companies cannot recognize internally-generated goodwill. It may be due to various reasons. Most importantly, it is because they cannot measure the value reliably. When companies purchase other companies, it provides a basis for goodwill calculation. Therefore, the recognition of goodwill is only possible when there is an acquisition.
How to calculate Goodwill?
Goodwill calculation is only relevant when one company acquires another company. As mentioned, they cannot calculate their internal goodwill for various reasons. Companies can use the following formula to calculate the value.
Goodwill = Purchase price of the acquired company – Net fair value of the acquired company’s net assets
The net fair value of the acquired company’s net assets is the residual amount after deducting its liabilities from its assets. As long as the above formula returns a positive result, the residual amount will be the goodwill. If it provides nil or a positive amount, it is not considered goodwill. In that case, companies cannot recognize it as an asset.
Once companies calculate the goodwill for an acquisition, they can use the accounting treatment give below.
| Dr | Net assets |
| Dr | Goodwill |
| Cr | Bank / Cash |
Example
A company, Red Co., acquires another company, Blue Co., for $100 million. The net fair value of Blue Co.’s total assets on its Balance Sheet was $90 million and its total liabilities were $20 million. With this transaction, Red Co. paid for the acquisition more than Blue Co.’s worth. Therefore, the premium paid will be its goodwill.
The calculation for goodwill for Red Co. will be as follows.
Goodwill = Purchase price of the acquired company – Net fair value of the acquired company’s net assets
Goodwill = $100 million – ($90 million – $20 million)
Goodwill = $30 million
Red Co. can recognize the amount in its accounts using the following double entry.
| Dr | Net fair value of assets | $90 million |
| Dr | Goodwill | $30 million |
| Cr | Net fair value of liabilities | $20 million |
| Cr | Bank / Cash | $100 million |
Conclusion
Goodwill represents the premium that companies pay when purchasing another company. It represents the difference between the acquisition price and the net fair value of the acquired company’s net assets. Goodwill is an intangible asset that companies must present on their Balance Sheet.
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