Goodwill in Accounting Explained for Dummies

  What is goodwill in accounting? In accounting, goodwill, typically associated with mergers and acquisitions (M&A) of companies, refers to the amount that a company’s fair market value is exceeded by the purchase price for the company. Factors that contribute to a company’s goodwill are things such as:

• management of high quality and excellence,
• loyal and satisfied customers,
• quality of employees,
• intellectual property,
• respected and well-recognised brand, and
• excellent reputation.

Simply put, anything that contributes to the value of a company beyond the amount with which its assets exceed its liabilities is regarded as goodwill.  

Is goodwill an asset?

  Goodwill is reported as an intangible asset under the long-term assets accounts on the balance sheet of the acquiring company. Goodwill is viewed as an intangible asset because it is not a physical long-term asset such as property or equipment. Although not all companies report goodwill on their balance sheets because items included in goodwill are not always easily or accurately quantifiable, valued, or identified. Furthermore, goodwill differs from other types of intangible assets. Intangible assets such as licences, trademarks, and patents can be bought or sold independently. Contrarily, goodwill cannot be purchased or sold independently because it presents a price premium over the fair market value of the net assets (assets less liabilities) of a company. Also, goodwill has an unspecified lifetime, while other intangible assets have specified useful lifespans.  

🏆10 Best Forex Brokers in South Africa

Calculation of goodwill

  Calculating goodwill is reasonably straightforward in theory but can be quite intricate in practice. The basic formula for the calculation of goodwill is: Goodwill = P-(A-L) Where:

• P is the purchase price of the acquiree or target company
• A is the fair market value of assets
• L is the fair market value of liabilities

 

What is fair value?

  International Financial Reporting Standards (IFRS) 13 defines fair value as: ‘The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’ (Accentuation by the article writer.) Conversely, the book value, also referred to as carrying value, refers to the value of an asset or liability as it appears on the balance sheet of a company. The book value of an asset is calculated by deducting the accumulated depreciation of the asset, as well as the impairment expenses (if applicable) from the original purchase price of the asset.  

Example of goodwill

  During the negotiations between company Never Give Up (the acquiring company) and company Hopeful (the target company), company Hopeful provides the following figures from its most recent financial statements:

• Current assets: R4 000 000
• Fixed assets: R3 500 000
• Intangible assets: R750 000
• Total liabilities: R5 500 000

  However, the accountant and auditor of the company Never Give Up made the following recommendations about the fair value of company Hopeful’s assets and liabilities:

• Current assets: R3 500 000
• Fixed assets: R4 000 000
• Intangible assets: R600 000
• Total liabilities: R5 500 000

  Based on the figures above, the company Never Give Up offers a purchase price of R4 700 000 and it is accepted by the company Hopeful. The amount of goodwill included in the offer is calculated as follows: Goodwill = Purchase price - (Fair market value of assets - Fair market value of liabilities) = R4 700 000 - ((R3 500 000 + R4 000 000 + R600 000) - R5 500 000) = R4 700 000 - (R8 100 000 - R5 500 000) = R4 700 000 - R2 6000 000 =R2 100 000   Company Never Give Up will record the transaction as follows:

• Debit current assets for R3 500 000
• Debit fixed assets for R4 000 000
• Credit total liabilities for R5 500 000
• Credit cash for R4 700 000
• Debit intangible assets for R2 700 000 (R600 000 + R2 100 000)

 

Impairment of goodwill

  In accounting, impairment refers to the value by which the book value of an asset exceeds its recoverable amount. The recoverable amount of an asset is described by International Accounting Standards (IAS) 36 as ‘the higher of an asset’s fair value less costs of disposal (sometimes called net selling price) and its value in use.’ Furthermore, IAS 36 requires that the recoverable amount of ‘goodwill acquired in a business combination’ are measured annually ‘whether or not there is any indication that it may be impaired.’   Generally, IAS 36 provides the following guidelines in order to determine the recoverable amount of an asset:

• The asset is not impaired if the fair value less costs of disposal or value in use is more than the carrying value (book value).
• Recoverable amount = value in use if the fair value less costs of disposal cannot be determined.
• Recoverable amount = fair value less costs of disposal for assets to be disposed of.

  Specifically, IAS 36 states that the carrying value (book value) of an asset should not be reduced below the highest of:

• its fair value less costs of disposal (if measurable),
• its value in use (if measurable), or
• zero.

  Impairment can occur as a result of a detrimental event such as economic depression, disasters (such as the Covid-19 pandemic), or an increasingly competitive environment, to name a few. According to Investopedia, the two common methods used to test for impairments are:

• The income approach - estimated future cash flows are discounted to the present value (PV).
• The market approach - assets and liabilities of similar companies operating in the same industry are analysed.

 

What is negative goodwill?

  Negative goodwill occurs when a company’s purchase price to acquire another company is less than the fair market value of the target company.

Recommended brokers