The value of goodwill becomes apparent when a business is being acquired or sold. The amount an acquiring company pays over the target company’s net assets accounts for the value of positive goodwill.
What is goodwill?
Goodwill is an intangible asset that is built over time by the owner of a business. Tangible assets (buildings, equipment, land) are relatively simple to value. The calculation of goodwill is more complex and highly subjective, as goodwill doesn’t independently generate cash flow. The value of goodwill is determined by:
- a company’s good name and positive reputation
- brand name
- solid customer base
- good customer relations
- intellectual property/patents/copyrights
- domain name(s)
- functioning consumer associations
- good employee relations
- excellence of management
- proprietary technology
- favourable contracts in place
Goodwill and Accounting:
Goodwill is an intangible asset that is listed under the long-term assets of a company’s balance sheet. It cannot be sold or transferred separately from the business as a whole. The value of goodwill is difficult to define as it doesn’t generate any cash flow for the business. Consequently, accounting standards require that a company regularly test its goodwill asset for impairment (a permanent decline in the value) and write down the asset if impairment can be proven. Companies must evaluate the level of their goodwill, at least once per year.
Types of Goodwill:
- Purchased goodwill refers to when a business concern is purchased for an amount above the fair value of its net assets. It’s shown on the balance sheet as an asset.
- Inherent goodwill is the opposite of purchased goodwill and represents the value of a business more than the fair value of its net assets. This type of goodwill is internally generated and arises over time due to reputation. It can be either positive or negative.
- Business Goodwill is associated with the business, its position in the marketplace, and its customer service.
- Professional Practice Goodwill relates to professional practices such as doctors, engineers, lawyers and accountants. It is classified as practitioner goodwill which is related to the reputation and skill of the individual professional and practice goodwill which arises from the practitioner’s track record, institutional reputation, location and operating procedures.
Factors affecting goodwill:
- Location of the business: A business that is located in a suitable area has a more favourable chance of higher goodwill than a business located in a remote location.
- Quality of goods and services: A business that is providing a high quality of goods and services has a great chance of earning more goodwill than competitors who provide inferior goods and services.
- The efficiency of management: Efficient management results in an increase in profit for the business, enhancing goodwill.
- Business Risk: A business having lesser risk has a better chance of creating goodwill than a high-risk business.
- Nature of business refers to the type of products that a business deals with, the level of competition in the market, demand for the products and the regulations impacting the business. A business having a favourable outcome in all these areas will have greater goodwill.
- Favourable Contracts: A firm will enjoy higher goodwill if it has access to favourable contracts for the sale of products.
- Possession of trade-mark and patents: Firms that have patents and trademarks enjoy a monopoly in the market, which contributes to an increase of goodwill.
- Capital: A firm with a higher return on investment along with lesser capital investment will be considered by buyers as more profitable and have more goodwill.
How to Calculate It?
In principle, the goodwill calculation technique looks simple. However, it’s incredibly complicated. Goodwill Formula = Consideration paid + Fair value of non-controlling interests + Fair value of equity previous interests – Fair value of net assets recognized.
Goodwill can be calculated by using the following five simple steps:
- Determine the consideration paid by the acquirer to the seller as part of the deal contract. The consideration is valued either by a fair valuation method or the share-based payment method. The consideration may be paid in the form of stocks, cash or cash-in-kind.
- Determine the fair value of the non-controlling interest in the acquired company. It’s the portion of equity ownership in a subsidiary that is not attributable to the parent company.
- Determine the fair value of equity in previous interests.
- Figure out the fair value of the net assets recognized in the acquired company. This is the net of the fair value of assets and the fair value of liabilities. It’s available on the balance sheet.
- The goodwill equation is calculated by adding the consideration paid (step 1), non-controlling interests (step 2), and the fair value of previous equity interests (step 3) and then deducting the net assets of the company (step 4).
Goodwill encapsulates the value of the reputation of a company built over a significant period of time. It’s challenging to determine because it’s composed of subjective values. Transactions involving goodwill have a substantial amount of risk that the acquiring company could overvalue the goodwill in the acquisition and ultimately pay too much for the company being acquired.
Need help understanding the complexities of calculating goodwill? Are you acquiring/selling a company and have questions regarding the determination of the goodwill value? Contact Cook and Company Accountants. Whether you operate a sole proprietorship or a sizable corporation with multiple subsidiaries, we use our experience and expertise to assist you. Contact us to request a meeting.