What is goodwill in accounting?

Goodwill in accounting is the value of your business above your tangible or physical assets. It includes things like customer loyalty, your brand’s reputation and factors that make your business successful but are difficult to value.

The value of goodwill is most important when one business purchases another. The amount a business pays for the one they’re buying increases based on the value of the goodwill.

Here’s an example of goodwill in a business. Let’s say you want to buy a bakery and that bakery has a famous recipe that is well-loved. Even if the value of the assets – the oven, building and ingredients – is $300,000, you might pay $400,000 to own the bakery. You pay more for its recipe, solid reputation, and loyal customers. That additional $100,000 is the goodwill value of the business.

Goodwill versus other assets

Goodwill is a broad category of asset that covers any extra value in a business that can’t be tied to a specific asset. It excludes tangible assets, also known as fixed assets, which can be sold independently and reduce in value (are amortized) over their lifespan.

Goodwill also excludes some other intangible assets:

• Goodwill cannot be bought or sold on its own, unlike other intangible assets. Registrations, patents, copyrights and other intangible and net identifiable assets can be sold separately from the business, but goodwill cannot.
• Goodwill can exist indefinitely, while other intangible assets usually have a legal lifespan or a useful life.
• Goodwill can’t be bought or developed internally, while other assets, such as intangible assets can.
• Good tends to be harder to identify and value than other intangible assets.

Example: Patents have a specific legal lifespan, can be separated from the business that registered them, and often have a more precise value.

Types of goodwill

The two main types of goodwill in accounting are inherent goodwill and purchased goodwill. Inherent goodwill is developed internally and its value only becomes quantifiable when the business is acquired by another. Purchased goodwill originates externally.

Inherent goodwill is also referred to as internally generated goodwill. It refers to the value of a company that’s above the fair market value of its net assets. This type of goodwill is self-generated and takes time to establish. It comes, for example, from having outstanding customer service and solid brand recognition.

Under most accounting standards, businesses cannot recognize inherent goodwill as an asset on their balance sheet. While it doesn’t appear on a balance sheet, it’s still an important part of the business’s value because it indicates a competitive advantage.

Purchased goodwill refers to the amount a business pays when purchasing another business that is above the fair market value of net assets. It is the extra amount the purchaser pays for the business’s reputation, brand recognition, large market share, its strong customer base, and other intangible assets.

Because it arises from a transaction, it is recognized as an intangible asset on the acquirer’s balance sheet. It isn’t amortized (reduced in value over time) after the purchase but is tested annually for goodwill impairment.

Why goodwill is important in accounting

The value of goodwill can be either positive or negative on an income statement. Positive goodwill means the value of the business is higher than its assets and liabilities. Negative goodwill means the value of the business is lower than its assets and liabilities.

This is important for valuing a business that is about to be sold. If you’re thinking about selling your business, you want to understand the amount of goodwill your business has and how that affects its value.

High goodwill typically means a business has a competitive advantage. This can increase value to investors and the goodwill valuation can be a factor in strategic business decisions. A sudden drop in goodwill might indicate issues with underperformance or poor decision-making.

Goodwill is also important for financial records. Both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), require goodwill to be shown annually on financial statements. Goodwill is shown on a business’s balance sheet as an intangible asset.

Aspects of goodwill to keep in mind

Goodwill can fluctuate, depending on how a business is performing. While negative goodwill can hurt a business, it can also be improved by making changes.

Goodwill signifies a competitive advantage but its value mainly arises when a business is being valued for a sale. It cannot be sold on its own and has no value separate from the business. Businesses can benefit from goodwill by using it to build market share and earn additional revenue. In some cases, negative goodwill can lower revenue and decrease a business’s tax burden.

Calculating goodwill exactly can be difficult. There are ways to determine it, but the value of goodwill can fluctuate depending on timing and how the business performs. Because it isn’t subject to wear or tear and has an unlimited useful life, there is no depreciation or amortization. It must be recorded on business financial statements annually, including impairments.

How to calculate goodwill in accounting for small businesses

Calculating goodwill itself is straightforward. Determining the value of each factor is difficult. The formula is:

Goodwill = Consideration paid + fair value of non-controlling interests + fair value of equity interests – fair value of net assets recognized

Here’s how that breaks down:

• Consideration payment (also known as consideration transfer) refers to the total amount the purchasing business pays to buy the target business.
• Fair value of non-controlling interests refers to any portion of the purchased business not owned by the buyer. This is valued at fair market share at the time of purchase.
• Fair value of equity interests refers to situations where the purchasing business held a stake in the acquired business before buying it. This represents the fair value at the time the business is purchased.
• Net assets recognized are the fair value of all tangible and identifiable intangible assets minus liabilities held by the acquired business.

Example: Say you decide to buy a bakery:

• You pay $1.2 million to own 90% of the bakery.
• You previously owned 5% of the bakery, valued at $50,000.
• You don’t own the remaining 5%, valued at $60,000.
• On the date you purchase the bakery, the fair value of all tangible and identifiable intangible assets is $550,000.

Goodwill = $760,000 using the formula:

Goodwill = $1.2 million (what you paid) + $60,000 (the value of the 5% you don’t own) + $50,000 (the value of the 5% you already owned) – $550,000 (the value of net assets recognized)

Methods for calculating goodwill valuations

Each of the three main methods for estimating the value of intangible assets is used differently depending on the business, historical financial data, and future outlook.

• The average profits method involves calculating the average of the past profits multiplied by a certain number of purchased years. The number of years is typically the period it would take to recover the goodwill through profits. It’s used in businesses that are expected to have stable future cash flows. It’s easy and straightforward for small businesses to use.

Goodwill = Average profit x years of acquisition

• The capitalization method is used when the emphasis is on the business’s net profit-generating ability and its tangible assets. The capitalized average net profit is calculated by dividing the average net profit by the capitalization rate.

Goodwill = Capitalized average net profit – tangible net assets

• The weighted average profit method is used when you don’t want to treat all years of profits equally. This is important when there are fluctuations in profits making some years a better indicator of future profitability.

Goodwill = Weighted average x years of acquisition

Conducting goodwill impairment tests

If the value of the business goodwill falls below historical cost, an impairment is likely. For example, this could be a patent for a suddenly obsolete item, since it has lost its value. There are two main approaches to impairment tests – the income approach and the market approach.

• Income approach: In the income approach, you estimate how much money an asset will bring to you in the future. You predict future earnings for the next several years and then adjust those amounts to reflect their value in today’s dollars. If the book value is higher than the present value of future earnings, it might be overvalued.
• Market approach: In the market approach, you analyze what similar assets sell for in your market, similar to how you might compare prices of similar houses. If the book value of your asset is higher than similar assets, you might have overvalued the asset.

How to calculate goodwill for acquisition

Before an acquisition or merger, goodwill must be established. For a prospective buyer, it’s important to understand the value of the goodwill to ensure they aren’t overpaying for the business. The seller wants to make sure they are being paid adequately for their business.

A goodwill evaluation should include analyzing the business’s:

• brand strength and reputation
• customer relationships and employee satisfaction
• intellectual property
• competitive position

If in doubt, a business appraiser or valuation expert can help determine the goodwill in a business.