“Goodwill” is a term used in accounting that represents the excess amount between the purchase price and fair market value of a business. Goodwill, also referred to as business goodwill, directly impacts a business’s perceived value, often making it synonymous with a good reputation. It is important when considering business acquisitions and is considered an intangible asset.
It’s important to learn how goodwill works if you’re considering acquiring a new business. Learning how it is valued on the balance sheet will help you to keep track of assets, as well as other legal requirements regarding goodwill.
Definition and Examples of Goodwill in Accounting
When an excess amount is calculated from the difference between a business’s purchase price and its fair market value, you find the amount known as “goodwill.”
Goodwill, in a sense, represents a business’s reputation within a market, which is something to consider when acquisitions are involved. Businesses that are well-known have gained popularity, or have other assets, such as branding and customer loyalty. They can sell their business for more than it’s worth since these assets can increase its price. Because these assets that generate goodwill are not physical in form, goodwill is considered an intangible asset because it still adds value to the company. Some of these assets that can be considered goodwill include:
- Brand recognition
- Trade secrets
- Domain names
- Reputation and connections with professionals
- Copyrights, trademarks, and other intellectual property
For example, let’s say Business A purchases Business B for $500,000. If Business B is worth $450,000 as determined by the marketplace buyers and sellers, otherwise known as fair market value, then Business A would place an excess amount of $50,000 as goodwill on its balance sheet.
How Goodwill in Accounting Works
To calculate goodwill, you’ll need to understand the formula. Goodwill is equal to the excess amount after the fair market value is deducted from the purchase price:
Goodwill = Cost of acquisition – Value of net assets
You’ll need to determine the business’s value of net assets, which is equal to the business’s identifiable assets minus its liabilities. Subtract this total from the amount paid to acquire the business.
Once a business completes the purchase and acquires another business, the purchase is placed on the balance sheet. Goodwill is listed as a noncurrent asset on the balance sheet and is considered an intangible asset since it is not a physical object.
Businesses must record goodwill as a requirement of the Generally Accepted Accounting Principles, or GAAP, which is set by the Financial Accounting Standards Board (FASB).
Understanding Goodwill Impairment
“Impairment” refers to the fluctuations in a business’s fair market value. Since the value of goodwill can change due to circumstances, such as a change in customer base or reputation, it must be reflected correctly and reported accurately. Businesses are required to review this annually, as well as when a business is first acquired, per the FASB.
Impairment tests are also required if certain events have an impact on the business’s fair market value, such as layoffs, changes in competition, or changes in the overall business climate.
Types of Goodwill
Goodwill can be divided into different types, based on what was acquired and how it was acquired. Generally, goodwill is either purchased or inherent. It can also be broken down based on industry and can be referred to as business goodwill, practitioner goodwill, or practice goodwill.
Business goodwill represents the excess amount between the price paid to acquire a business and its actual fair market value. Business goodwill is generally used in accounting when acquisitions take place, unless the type of business is more specific, such as a practice.
Goodwill, in general, is typically referred to as business goodwill as the two terms are often used interchangeably.
Practice goodwill refers to the amount of goodwill specifically for practices, such as a law firm. Practice goodwill is similar to business goodwill as it considers the practice’s overall value.
Practitioner goodwill refers to goodwill in regard to a specific line of business that is practiced, similar to practice goodwill. But this type of goodwill is focused specifically on the skills, knowledge, and talent of the practitioners.
Purchased goodwill means the business simply purchased the other company, which is generally the concept in business goodwill.
Inherent goodwill is not purchased and results from within the same company. For example, this can result from changes in a company’s reputation, which then increases its value.
- Goodwill is equal to the amount between a business’s purchase price and its fair market value, and is usually considered during a business acquisition.
- A business’s reputation, branding, customer base, and intellectual property can be represented by goodwill as an intangible asset on the balance sheet.
- Businesses are required to calculate goodwill annually to test for impairment, which is caused by the change in a business’s fair market value.