Goodwill in Accounting – Definition, What is Goodwill, and How Goodwill Works?

Goodwill in Accounting - Definition, What is Goodwill, and How Goodwill Works?
|Updated on: March 15, 2022

Goodwill is an intangible asset in a company. Businesses that are successful build excellent relationships with other companies and individuals and generate goodwill among them. This is an asset that bolsters the image and value of the company. So while the value of a company and its assets is enhanced by the goodwill that the company has generated. When another company buys this company they may pay more than the fair value of the company. The goodwill of the company is intangible but can encompass different factors such as the brand value, brand recognitions, employee satisfaction, a loyal customer base and other technical knowhow or intellectual property that is unique to the company. While these may be intangible they are very important factors that make a company more successful, attractive and valuable.

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What is goodwill in accounting?

It is essential to understand what is goodwill in accounting. Generally the value of a company is calculated based on the value of its assets minus the amount of its liabilities. However, the actual value of a company is so much more than that. There are assets that a company builds or acquires that make it very valuable over and above the calculated value. Some of these assets are the customer base, brand recognition, talent of the human resources and intellectual property. When the purchase price of a company is more than the calculated value due to its intangible assets, this is called goodwill. This is evaluated annually and since it does not have a definite lifespan it may or may not be amortized based on the accounting standards that are being followed.

Understand what a goodwill is in detail

So, you can estimate the reputation and the attractiveness of a company by goodwill. One would find significant sums paid as goodwill for companies that are well recognized or that have built a very impressive reputation in the market. The brand value of a company is a huge goodwill asset that will attract buyers who pay a large sum of money as goodwill for the purchase of the company. The goodwill amount can also go towards the connections and tie ups that the company has, domain names, intellectual property rights, trade secrets, licenses, trademarks, copyrights or exceptionally talented human resources.

There are two types of goodwill; purchased and inherent. Purchased goodwill is the goodwill that is acquired when a company pays a sum larger than the fair value to buy another business. It is not goodwill that is generated by the purchasing company itself but is a value that the buyer acquires through the purchase. For example, by buying a company, the purchaser may acquire access to the research or intellectual property of the company. This purchased goodwill is recorded as an asset under the label of goodwill on the balance sheet. Inherent goodwill does not need a purchase to be recognized and is not recorded in accounting. It is the value that a company acquires over time and that reflects on its reputation. For example, a snack manufacturer may become the leader in the market and be the most recognizable brand. Its brand value is a very valuable inherent goodwill.

Sometimes, there is negative goodwill which happens when circumstances cause a company to be less desirable and attractive. If there is a news report that negatively impacts the reputation of the brand, the goodwill value also goes down. Shocking scandals or malpractices that adversely impact the company’s reputation may cause the sale price to be lower than the company’s fair value. So, in short goodwill is an asset that is built over time. It cannot be directly measured and it can greatly vary over time. In rare cases, it can even be a negative number.  There may be a risk when the buyer pays too much as goodwill and finds that it was not as valuable as they perceived it to be.

Importance of goodwill

Goodwill may not be tangible but it is a very important factor that a company should work on. It has many advantages that will benefit the company.

  • Customer loyalty

Customers have a tendency to return to companies that they like. To build this brand loyalty a company should work on generating goodwill with customers. So, the next time a customer needs a product or a service they will unhesitatingly come back to you. Customer loyalty also works when customers recommend you to their near and dear. This word of mouth recommendation is more valuable than any advertising. Customer goodwill and loyalty can help a company organically grow its customer base.

  • Differentiation

When there are many competitors in the market, a company’s goodwill helps it stand out. Despite similarity in other aspects, goodwill makes a company stand out and be preferred. This goodwill can be generated by a better product, better service or any other benefit that enhances customer satisfaction.

  • Tolerance

Sometimes, the unexpected happens and the best of companies may slip up and upset a customer. When there is no goodwill, the customer will be hard to calm down and may publicly post their negative feedback. However, if there is a background of goodwill, the customer would be more likely to overlook and forgive any shortcomings. This may require that the company do something extra or make an exceptional effort to exceed expectations.

  • Perceived value increase

Just as goodwill attracts more customers, it also makes the company more attractive to investors. People are more likely to bet on a winning horse. So, a company that has proved itself by generating goodwill, is a very attractive prospect for investors, partners and prospective buyers. Other companies would want to be allied with you as suppliers or service providers as your goodwill will also have a positive effect on theirs. If you want to sell the company, the goodwill will boost the company’s value greatly. It will also make financial institutions and suppliers more eager to extend credit to the company.

  • Human resources

An often overlooked but important benefit of goodwill is that it attracts human resources. People are more eager to work with and for a company that has goodwill. Companies with a good reputation in the market attract better human resources.

Essential features of goodwill

  • Goodwill is by definition an asset that is intangible. It cannot be measured or estimated unless it is the excess amount that a company pays to purchase another company
  • Goodwill is the excess amount that a purchasing company pays but it cannot be bought or sold as a separate asset
  • It is built over time but cannot be specifically invested in
  • Goodwill cannot be precisely defined. It can refer to the intangible value of a company’s brand name, brand value, intellectual property, talent pool, customer loyalty and other factors
  • Goodwill varies greatly over time. It is not constant with a specific lifespan
  • Positive goodwill makes a company attractive to investors, financial institutions and customers

Some of the factors that can affect goodwill are

  • Quality: When the products and services that a company offers are excellent, they generate goodwill
  • Value: A company whose products and services offer excellent value for money gain more goodwill
  • Stability: A company that is table and perceived to be low risk has higher goodwill
  • Customer base: A company with a loyal customer base has more value
  • Efficiency: A company that is efficient is more likely to be ahead of the market competition
  • Type of business: some businesses have more competition and more opportunity to generate goodwill.
  • Financials: A company that has its finances in order and that has given high returns on lower investments will be more attractive to buyers and investors and have higher goodwill.
  • Valuable patents and trademarks: A company that possesses patents and trademarks that will be of great value to the buyer, will generate more goodwill.
  • Connections: Goodwill is higher for a company that already has lucrative or big name contracts or tie-ups.

How to calculate goodwill?

The value of a company is generally calculated as the value of its assets minus the value of its liabilities. When a company is cold for higher than its fair price, the difference amount is called goodwill.

Goodwill = Purchase Price of target Company- (Assets-Liabilities)

The steps to calculate goodwill on the sale/purchase of a company are:

  • Determine the book value of assets including the fixed, current and noncurrent assets
  • Determine the fair value of the assets
  • Make adjustments in the books of accounts between the book value and fair value of the assets. The net book value of the assets is the assets minus the liabilities
  • Deduct this from the actual purchase price to determine the excess purchase price paid
  • Record as goodwill on the balance sheet after the company acquisition

Example of goodwill

We often read about acquisitions of companies for huge sums of money. If a company A is worth $350,000 but is purchased for $400,000, the difference amount of $50,000 would be recorded on the balance sheet as goodwill.

Recording the goodwill amount

According to the Generally Accepted Accounting Principles (GAAP), goodwill is an intangible asset and is only recorded when there is a sale of the entire business or a whole segment of the business. It can only be recorded when there is an actual amount that has been paid over the fair price of the company. However, when there are negotiations for the sale or purchase of a company, the calculation of the goodwill is very important to estimate the business valuation amount. An accounting software that is able to understand what is goodwill in accounting is essential to post the goodwill amount correctly. Tally accounting software allows accountants to record goodwill on the balance sheet when there has been a sale/purchase of a company.

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