It’s no secret that how people perceive a company and the company’s standing in the marketplace have a profound effect on its overall financial success. Just look at the positive reputation enjoyed by companies like Apple and Starbucks, and how it affects the prices of goods sold. These companies can increase the purchase price of their products because of the public’s perception of their brand.
As a small business owner, wouldn’t it be great to assign a dollar value to the positive reputation that your firm carries? One that you could use as part of your business valuation? What if there was a way to “quantify” the strong brand and positive image that you’ve worked to achieve for your business?
You can, and it’s called “goodwill” or “business goodwill.” A crucial asset when determining a company’s overall valuation, goodwill reflects the portion of a company’s value that owners can’t ascribe to cash or physical assets. In this sense, a business’s true worth is often far more than the value of its individual —tangible — parts.
Recognizing goodwill accounting practices could be worthwhile for your business because it could allow you to more accurately determine the fair value of your company. This, in turn, would make you more attractive to potential investors.
In this article, we’ll answer important questions like, “What is goodwill in accounting?” and “What is goodwill on the balance sheet?” By the end of this article, you should have a much clearer understanding of what goodwill is and how it can impact your company’s financial statements.
What is goodwill in accounting?
Goodwill is an intangible asset used to explain the positive difference between the purchase price of a company and the company’s perceived fair value. Goodwill typically only comes into play when one company purchases another. If the purchase price is higher than the company’s fair value, the acquiring company can explain so on its financial statements through goodwill. Only the acquiring company recognizes goodwill.
Determining the fair value of the company being purchased is simple. All you have to do is total the assets offered by the purchased company and subtract any liabilities that the purchaser is taking on. If the acquiring company pays more than this sum, there would need to be a “goodwill” accounting transaction.
Although goodwill is generally regarded as an intangible asset, businesses purchase a company with “goodwill” are required to value it annually and record any impairments. Goodwill impairments are instances in which the value of assets decline after being purchased by an acquiring company.
So, for instance, imagine that the book value of a company being sold is $10,000,000. But the market value is $15,000,000. The acquiring company adds goodwill to the balance sheet for $5,000,000. But after acquiring the company, the market value decreases to $14,000,000. The acquiring company would need a goodwill impairment of $1,000,000 to explain this loss in value.
One of the other terms that seems to come up during the sale of a company is “going concern value.” Business goodwill is distinct from “going concern value,” which refers to those assets that contribute to the production of income and may include equipment, facilities, and other tangible assets owned by the company.
Going concern value is more of a financial projection into the future, and an estimate of how much a company’s acquired assets will continue to earn. When business goodwill value and going concern value are combined, you have a rough estimate of the business’s overall valuation.
What affects business goodwill?
Various factors affect a company’s business goodwill. When calculating goodwill for your company, it’s essential to take all the applicable assets into account. Some of the assets that can be categorized as goodwill include:
- A strong customer base
- Reputation among professional groups
- Brand-name recognition
- Company website and domain name
- Managerial and executive talent
- Trade secrets
- Client and supplier lists
- Licenses and permits
- Copyrights, trademarks, and patents
- Processes and training systems
The above is only a partial list of the factors that affect a business’s goodwill value. Combined with going concern value, companies should be sure to include all possible value propositions to arrive at the fairest and most accurate number.
Accounting for business goodwill
Accounting for business goodwill in your books requires that you subtract the fair market value of tangible assets from the total worth of the business. Goodwill is, therefore, equal to the cost of acquisition minus the value of net assets.
While it’s possible to estimate goodwill, there’s no need to until the completion of the sale. Goodwill is an adjusting entry on the balance sheet to help explain why the cash spent to acquire a company is greater than the assets received in return.
To start, determine the value of net identifiable assets by subtracting liabilities from identifiable assets like inventory and real estate. When valuing assets, such as patents or client lists, that don’t have a precise market rate you may need to base data on estimates of future cash flow generated from the items in question.
Additionally, professional companies like doctors’ offices and law firms will need to account for both practitioner goodwill (i.e., the value of the practitioner’s talents and abilities) and practice goodwill (i.e., the value of the business as a whole).
For instance, if a highly-esteemed partner leaves a law firm, the value of the firm could decline significantly. Goodwill should account for individuals whose talents and reputations bring value to the firm.
If a doctor’s office has two practicing healthcare professionals, one of whom is very new and in training, there’s a strong chance that a lot of the office’s value is tied up in the older doctor who has been practicing for years.
Some businesses use a cost approach to valuing business goodwill. Under this system, companies estimate the financial cost of recreating the current level of goodwill from scratch.
Additionally, companies can utilize comparative data from sales of similar businesses in the industry. Doing this allows businesses to calculate goodwill as a percentage of the sale price.
Recording goodwill on the books
Goodwill is an accounting practice that is required under the Generally Accepted Accounting Principles (GAAP). Under these accounting methods, you’re required to recognize goodwill on your books after acquiring another company.
While U.S. law does not require businesses to amortize the value of goodwill anymore, they do have a responsibility to subject their goodwill to yearly impairment tests. If future cash flow resulting from the sale of an asset falls below its book value, the business must report the impairment loss in its financial documents.
Companies must compare their goodwill balances to their estimated market values every year and adjust their books to reflect instances in which the carrying values are too high.
A company should list goodwill on a balance sheet in cases when it purchases another business for a price higher than the recorded value of assets. It’s important to note that companies cannot have negative goodwill on the books, though this value can be equal to zero if the acquired business suffers enough goodwill impairments.
Recognizing a goodwill impairment will result in a decrease in the goodwill account on the balance sheet. This will also reduce net income for the year, which will then cause a loss on the income statement.
Business goodwill may be intangible, but that doesn’t mean its calculation is unimportant. By assessing goodwill accurately, you can ensure you don’t overpay on a business purchase or sell your meticulously built company for less than it’s really worth.
A goodwill example
Imagine you have two companies, Company A and Company B. In this case, Company A is the acquirer, and Company B is the target company. Company A seeks to acquire all of Company B’s assets and liabilities. On the day of acquisition, Company B’s Balance Sheet shows:
- Current assets = $1,000,000
- Property, plant, and equipment (Non-current assets) = $2,500,000
- Goodwill = $500,000
- Liabilities = $2,000,000
- Stockholder’s Equity = $2,000,000
“Goodwill” is already on the company’s balance sheet not necessarily because of this transaction, but because of a previous transaction. We won’t count this amount of goodwill when evaluating the market value of the assets because it’s not a real, fixed asset.
During the acquisition period, an auditor concludes that the fair market value (FMV) of the property, plant, and equipment (PP&E) is $3,500,000. So, Company A can determine the business value of Company B is equal to:
Current Assets + PP&E – Liabilities = Value
If the acquirer were interested in the present value of Company B, then they would use the $2,500,000 figure for PP&E. But because the acquirer is more concerned about fair market value, it uses the $3,500,000 figure. So, the company uses the following FMV equation:
$1,000,000 + $3,500,000 – $2,000,000 = $2,500,000.
The acquirer values Company B very highly and pays a premium for the remaining stock for a total acquisition price of $5,000,000. There’s a net difference of $2,500,000 between the sale price and the FMV. This net difference is known as goodwill. Company A will need to enter a $2,500,000 transaction for goodwill on its balance sheet as soon as the purchase is complete, and Company B is recognized as an acquired company.
How does goodwill work for private companies?
Determining goodwill for publicly-traded companies is rather straightforward. The acquirer will purchase outstanding shares of the company. If the total purchase price is higher than the FMV of the company, then the balance net difference is considered goodwill. It’s also easier to test for goodwill impairments since the current market value of the company is more readily available.
But what about with a private company? Fortunately, the Financial Accounting Standards Board (FASB) clarifies that nonprofits and private companies can test for goodwill impairments based on a triggering event instead of having to do so annually. Examples of triggering events include:
- Regulatory action
- Increased competition that reduces a company’s market value
- Loss of critical personnel
- Deterioration in economic conditions
Private companies can also choose to amortize goodwill on a straight-line basis over ten years. These companies can make changes to the remaining useful lives of the goodwill, but the period itself cannot exceed ten years. Amortization allows smaller, private companies to not have to run impairment tests, which can be quite expensive because they require extensive market research.
Additionally, FASB has simplified how private companies can recognize goodwill. In the past, companies needed to make efforts to identify and differentiate between different types of intangible assets. Now, however, private companies can realize all intangible assets as goodwill, simplifying the acquisition process.
Using goodwill as a tool for financial reporting
If you’ve built a strong brand, goodwill will likely come into play one day. Remember, goodwill only appears on the balance sheet to represent the difference between the acquisition price and the fair market value of a company. As your business grows, you may find yourself in the position of acquiring another company, at which point goodwill may be a necessary addition to your balance sheet.
But when you do find yourself acquiring another business, you’ll want to make sure you follow U.S. GAAP and include goodwill on your balance sheet. If you do carry goodwill on your balance sheet, you’ll also want to make sure you conduct impairment tests each year and enter adjusting journal entries when need be. Doing so will help keep you compliant and maximize the value of your company.