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When one company purchases another, how is this transaction handled in the financial statements? Goodwill accounting is one way to reconcile a business’s purchase price when it’s higher than book or market value. We’ll delve into goodwill accounting and how it works below.
What is a goodwill asset?
When looking at the balance sheet, you’ll see goodwill listed as an intangible asset. So, what is a goodwill asset exactly? When one company purchases another at a higher rate than book value, the difference is called goodwill. This is treated as an intangible asset for accounting purposes.
There are many reasons why a purchase price might be higher than the company’s net fair value. When you buy a company, you’re not only buying its physical assets and assuming its liabilities. You’re also taking on all of its intangible items of value. This includes things like the existing customer base, brand name, reputation, and positive employee relations. All of these can be hard to quantify with a dollar value, but they add up to the concept of goodwill.
Although goodwill is treated as an asset for accounting purposes, it can’t be bought or sold on its own. It simply refers to the premium that the acquiring company has paid over fair value. This contrasts with other intangible assets like licenses or trademarks, which can be purchased individually.
Importance of goodwill in accounting
Goodwill can be positive or negative, depending on the variation between the purchasing price and the company’s fair value. The primary importance of goodwill in accounting is seen on the balance sheet, where it’s listed under long-term assets. This is because both the generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) require that goodwill be listed on financial statements at least once per year.
By recording goodwill, you ensure that the books are balanced during and after an acquisition. The concept of goodwill is also useful outside of accounting for valuation purposes. It’s used to refer to any value built up within the company due to intangible factors like customer service and teamwork.
How to calculate goodwill in accounting
There’s a very simple formula you can use when working out how to calculate goodwill in accounting:
Goodwill = Purchase Price – (Fair Market Value of Assets – Fair Market Value of Liabilities)
In other words, to calculate goodwill you first must determine the net fair market value by subtracting liabilities from assets. You can then subtract net fair market value from the purchase price to find the goodwill.
For example, imagine that Company A has just acquired Company B at a purchase price of $10 billion. Company B’s fair market value (assets minus liabilities) is $8 billion. The $2 billion discrepancy between purchase price and fair market value would be recorded on Company A’s balance sheet as goodwill.
Advantages of goodwill in accounting
There are many advantages of goodwill in accounting, chiefly that it provides a way to account for a premium purchase price in company financial statements. Beyond its advantages in accounting, however, goodwill is also useful for investors. When looking at a company’s balance sheet, investors can use goodwill as a jumping-off point for determining which factors provide that added value. A company might claim goodwill based on its loyal customer base, for example, which is useful for investors and analysts.
Limitations of goodwill in accounting
On the other hand, there are also some limitations to goodwill accounting methods. Goodwill can be vague to define beyond the balance sheet. Although you see a figure corresponding with a premium paid, it’s not always easy to quantify what justifies the goodwill price. Negative goodwill can also occur if the company’s purchased for less than its fair market value. For these reasons, you should look at goodwill along with other key performance indicators in any financial analysis.
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