In accounting terms, this extra value is known as ‘goodwill’ and it is considered an intangible asset. The concept of goodwill takes on particular importance when a company is looking to acquire another company. Often, they will need to be willing to pay a price premium over the market value of the company, particularly when that valuation is based simply on the net assets.
Successful businesses generate goodwill through the B2B and B2C relationships they build. This intangible asset enhances both the image and value of the company. Just think about the perceived value of companies like Apple, Microsoft and Tesla.
The goodwill of a company is made up of many elements, but important factors include:
These elements may be intangible and difficult to measure in financial terms, but they are critical success factors that can make a business more profitable, sustainable, attractive and valuable.
For example, the brand value of a successful company, such as Microsoft or Coca-Cola, is a huge goodwill asset. Buyers would expect to pay significant sums to purchase a well-known, respected brand. But it’s not just about the brand name or logo. Business partnerships, domain names, intellectual property rights, trade secrets, licenses, trademarks, copyrights and talented employees all contribute to the brand goodwill and value.
Purchased goodwill is the goodwill that is acquired when a company pays a sum larger than the fair value to buy another business. For example, when acquiring a company the buyer might gain access to expertise or intellectual property that conveys in competitive advantage. This purchased goodwill is recorded as an asset under the label of goodwill on the balance sheet.
Inherent goodwill doesn’t involve buying a company or brand. It is simply the value that a company acquires over time and that boosts its reputation. Coca-Cola, for example, is recognised as a market leader and highly recognisable brand. Inherent goodwill is not normally recorded in financial accounts, but nonetheless matters hugely to stock market valuations and in acquisition situations.
Negative goodwill is when something happens, such as bad publicity from a scandal or malpractice, that makes a company or brand less desirable and attractive. In this scenario, the goodwill value goes down and any sale price may be lower than the company’s fair value. It is often said that it takes years to build brand value but only moments to lose it, which is why successful companies pay so much attention to brand and reputation management.
Goodwill has many business advantages. These include:
In summary, goodwill is a valuable but intangible asset that cannot always be precisely defined and calculated. It is affected by multiple factors, including brand value, intellectual property, and proprietary technology, R&D pipeline, talent pool, and customer loyalty. It is built over time and can vary quite dramatically over time.
In simple terms, goodwill in accounting is the excess amount that a company pays to purchase another company.
If company X is worth €350,000 in net assets or open market value but is purchased for €400,000, the difference (€50,000) would be recorded on the balance sheet as goodwill.
According to the Generally Accepted Accounting Principles (GAAP), as goodwill is an intangible asset it is only recorded when there is a sale of the entire business or a subsidiary of the business; it cannot be generated internally. It can only be recorded in the accounts when there is an actual amount that has been paid over the fair price of the company. However, a calculation or estimate of the goodwill is often made during negotiations. This is often drawn from examining a company’s return on assets ratio.
As a company acquires subsidiaries or other entities, the group will need to take financial consolidation into account. Consolidated accounting is when the parent company combines the financial data from multiple entities to produce consolidated financial statements and/or management reports. These are essential to give business leaders a comprehensive overview of their group operations, its strengths and weaknesses.
One of the simplest methods of calculating goodwill is by subtracting the fair market value of a company’s net identifiable assets from the price paid for the acquired business.
Here is a simplified example of a goodwill formula and calculation:
Goodwill = (Consideration paid + Fair value of non-controlling interests + Fair value of equity interests) – Fair value of net identifiable assets
Company X acquires company Y for €2 million
Company Y has assets equalling €1.5 million and liabilities equalling €200,000
The net identifiable assets of the business are €1.5 million minus €200,000 which equals €1.3 million
Goodwill equals €700,000 (€2 million minus €1.3 million).
This means company X paid €700,000 premium above the company’s net identifiable assets
This amount is recorded in the assets section of a company’s balance sheet.
Financial modelling is used for a variety of scenario planning, budgeting and business analysis purposes. But it’s also used in mergers and acquisitions (M&A). Reliable financial modelling depends (in part) on an accurate reflection of the value of goodwill.
Analysts will take into account a number of factors when calculating the value of goodwill in an M&A Model. These include:
Once they’ve completed this analysis, they can estimate the goodwill by deducting the fair value adjustments from the excess purchase price. This is the goodwill figure that will normally go on the acquirer’s balance sheet when they close the deal.
The consideration paid when acquiring a new subsidiary or other entity can take many forms. For example:
In any M&A situation there will normally be professional fees, such as legal costs and advisory fees, to pay. These acquisition costs are reported as expenses in the statement of profit or loss and not included in the calculation of goodwill.
The parent company can choose to measure any non-controlling interest at either fair value or the proportionate share of net assets.
Including the non-controlling interest in the proportionate share of the net assets is really reflecting the lowest possible amount that can be attributed to the non-controlling interest. This method shows how much they would be due if the subsidiary company were to be closed down and all the assets sold off, incorporating no goodwill in relation to the non-controlling interest. Under the proportionate method, the goodwill figure is therefore smaller as it only includes the goodwill attributable to the parent.
At the date of acquisition, the parent company must recognise the assets and liabilities of the subsidiary at fair value. This can lead to a number of potential adjustments to the subsidiary’s assets and liabilities. Examples from the ACCA Financial Reporting syllabus include:
Tangible non-current assets
These will be held at the carrying amount in the subsidiary’s financial statements but will need to re-calculated to fair value in the consolidated statement of financial position. This will result in an increase to the value of property, plant and equipment. Instead of recording a revaluation surplus, it will actually result in a decrease to goodwill (that being the difference between the consideration paid and the net assets acquired in the subsidiary)
The subsidiary may have internally generated intangible assets, such as internally generated brand assets, which do not meet the recognition criteria of Intangible Assets. While these cannot be capitalised in the subsidiary’s individual financial statements, they must be recognised in the consolidated statement of financial position. This will result in an increase in the value of intangible assets with a corresponding decrease in goodwill.
The subsidiary must hold any inventory at the lower of cost and net realisable value, but this inventory must be reflected in the consolidated statement of financial position at fair value. This will result in an increase to inventory value and a decrease in goodwill.
These will simply be disclosure notes in the financial statements of the subsidiary, relating to potential future liabilities that do not have a probable outflow of resources embodying economic benefits. In the consolidated statement of financial position these must be recognised as liabilities at fair value, if there is a present obligation and it can be reliably measured. This will increase liabilities in the consolidated statement of financial position and actually increase goodwill (as the net assets of the subsidiary at acquisition will be reduced).
The final element to consider is the impairment of goodwill. Once goodwill has been recorded by the acquirer, there may be subsequent analyses that conclude that the value of this asset has been impaired. If so, the amount of the impairment is recognised as a loss. This reduces the carrying amount of the goodwill asset.
Impairment arises after the acquisition and reflects some form of decline in the expected benefit to be derived from the subsidiary. There is no amortisation of this figure, so the parent must assess each year whether there are indicators that the goodwill is impaired.
There are many indicators of impairment including loss of customers or key personnel or material changes in technology or market conditions. If an entity decides that the goodwill is impaired, it must be written down to its recoverable amount. Once goodwill is impaired, the impairment cannot be reversed.
The cumulative impairment is always deducted, in full, from the goodwill figure in the statement of financial position. If the non-controlling interest is recorded at fair value, then a percentage of impairment will be allocated to them (based on the percentage owned in the subsidiary), with the remainder being allocated to the group. If the non-controlling interest is held at the proportionate method, then the entire impairment is allocated to the group due to the fact that no goodwill has been attributed to the non-controlling interest.
The valuing of goodwill ahead of an acquisition can be a complex topic. There are many factors to consider when effectively deciding on what premium to pay for an asset. This is part of the reason that Mergers and Acquisitions is such a specialist subject sector of the financial services market.