Goodwill explained

In business parlance, goodwill is friendly, helpful or cooperative feelings or attitude.  The accounting definition is quite different, and the source of much confusion.

Goodwill, an asset on the balance sheet, is additional value recorded when one company acquires another.  It is measured as the difference between the purchase price of the acquisition, and the fair market value of the net identifiable assets (FMVNIA) of the company acquired.  FMVNIA is measured as the fair value of all assets acquired (including intangible assets like trademarks and copyrights) less the fair value of all liabilities acquired.

For example, suppose Parent buys Sub Corp.  Parent pays $1,000,000 for Sub.  During the acquisition process, Parent inventories Sub’s assets, determining that they are worth $500,000.  Parent also determines that Sub owes $50,000 in liabilities.  Hence, the FMVNIA of Sub would be $450,000 ($500,000 – 50,000).  

Goodwill would equal $550,000 ($1,000,000 – $450,000).

An asset on the balance sheet, goodwill must be tested for something called impairment.  This means that the company’s management must periodically check to make sure that the goodwill hasn’t dropped in value.

In financial statement analysis, you can’t compare goodwill from one company to the next.  Some companies record it when buying other companies.  As I explained, that would be an asset on the balance sheet.  However, companies that develop goodwill internally (by being nice to customers, etc.), immediately expense goodwill – it would not be recorded on the balance sheet.  Therefore, when you compare two companies’ financial statements, and see that one company has goodwill on its balance sheet, while the other does not, do not be deceived.  One company recorded the goodwill by acquiring another company.  while the other may have generated even more goodwill internally, and therefore had to expense it, rather than recording it as an asset.

Furthermore, goodwill is not a liquid asset.  It is not easy to sell, and, when sold, might not yield much cash.  It may also lose value quickly, as a company’s products or customer base changes.

Best bet: when analyzing financial statements, just ignore goodwill completely.  Cross it off the balance sheet and assume it’s not there.

[Image: Untitled by dno1967b, on Flickr]

About Mark P. Holtzman

Chair of Accounting Department at Seton Hall University. PhD from The University of Texas at Austin. Worked at Deloitte's New York Office. BSBA from Hofstra University.

4 Responses to “Goodwill explained”

  1. Dear Mr. Holtzman,

    Could you please explain how companies without goodwill on their balance sheet “immediately expense goodwill.” I am not sure I understand that.

    “However, companies that develop goodwill internally (by being nice to customers, etc.), immediately expense goodwill – it would not be recorded on the balance sheet.”

    Thanks,
    Ali Sarwari
    MBA student

    • Ali,

      Thanks for the question. When companies spend money to develop goodwill internally (say, by advertising or giving good customer service), they need to expense those costs immediately. However, if a company buys another company, and pays extra, above and beyond the fair value of its net assets, that extra money is construed as “goodwill” and can go on the balance sheet as an asset.

      Mark

  2. Hi,

    When a company that is carrying goodwill is being acquired, does the acquiring company have to factor that goodwill into the premium that they pay over and above the book value of the acquiree?

    Thanks.

    • The amount of money paid by the company (which includes any premium over book value) should be based on due diligence – understanding the company being acquired – and how much the company is going to have to pay to make the acquisition – a negotiating process. If the company is paying more than book value, then it should think long and hard about what it’s paying for.

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