Goodwill – What is goodwill?
Goodwill is an intangible asset that represents non-physical items that add to a company’s value but cannot be easily identified or valued.
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Goodwill is usually associated with mergers and acquisitions (M&A). When one company is purchased by another, it is common for the buyer to pay more than the market value of the target business’s identifiable assets and liabilities. The amount paid in excess of the market value is known as goodwill.
Why is goodwill important?
Although they cannot easily be calculated, intangible assets significantly contribute to a company’s success and value.
During a business acquisition, it is therefore important to consider factors such as brand identity, customer relations, customer loyalty, and staff satisfaction to ensure purchases are made at a fair price.
Goodwill does not consider identifiable assets such as contracts; legal rights; or assets that can be separated, divided, transferred, or sold.
To calculate goodwill, subtract the market value of the acquired company’s assets and liabilities from the price the company was purchased for.
For example, business A is purchased for £100,000 by business B. Business A had assets worth £90,000 and liabilities worth £15,000. Using the following formula, we can value goodwill at £25,000:
£100,000 – (£90,000 – £15,000) = £25,000
Because goodwill is made up of components with subjective values, there is always a risk that the purchasing company will overvalue goodwill. If this happens, goodwill should later be written down to reflect a more accurate value.
Goodwill should always be recorded in a separate line under the assets section of the buyer’s balance sheet; however, the treatment of goodwill varies between different accounting standards.
According to the IFRS Standards, businesses should not amortise goodwill. Instead, it is the business’s responsibility to monitor the value of goodwill and apply impairment when necessary.
Under the UK GAAP, goodwill has a finite useful life and should therefore be amortised. If a company cannot accurately estimate the goodwill’s useful life, it cannot exceed five years. In the UK, the UK GAAP is much more commonly used than the IFRS Standards.
Negative goodwill occurs when one company acquires another for a price less than the fair market value. Negative goodwill should be recorded as income on the purchasing company’s balance sheet.
Negative goodwill usually occurs when the company being accquired cannot or will not negotiate a fair price for their assets – for example, if a company is in financial distress.