Goodwill

Goodwill in accounting is an Intangible Asset generated when one company purchases another company at a price that is higher than that of the sum of the fair value of net identifiable assets of the company at the time of acquisition.

It is calculated by subtracting the fair value of net identifiable assets of the company from the total purchase price. Under the accounting standards of US GAAP and IFRShttps://www.wallstreetmojo.com/ifrs-vs-us-gaap/, it is identified as an intangible asset with an indefinite life. It is not amortized; however, it is periodically (yearly) checked for impairment.

The term goodwill refers to the good name of faith and trust of customers that an organization gains after given outstanding level of products and services consistently, resulting in an increase in the valuation of the business. This is an intangible asset.

This asset is the extra value of the acquired business, over and above the actual fair price of it. It can be generated due to a steady increase in the number of customers, very good level of customer satisfaction, low competition, name and fame of the brand and faith of the customers towards the brand, good employee satisfaction within the organization, etc. All the above adds up to the concept of goodwill, which is not easily measurable.

As a result of it, the value of the business increases during goodwill in accounting. The management benefits from it through greater share of the market, higher price of shares trading in exchanges and more opportunity for growth and expansion.

Each year it is necessary that the company does an evaluation of the goodwill to check if there is any decrease in its value so that the reduced value can be determined and the management can arrive at the correct valuation figure of the company.

Let us understand the various features of the concept of goodwill in accounting in detail.

• The primary feature of this concept is that it is intangible in nature, similar to trademark, patent or copyright, etc. Thus, it cannot be touched or seen but organization can ony feel it through overall development, good brand name or customer support. It is commonly identified when the business is acquired or sold to another business. The acquirer pays a value which is more than the value of its assets, thus identifying goodwill of the target company.
• The value will not remain the same through the lifetime of the business. It will keep on changing as per the changes in the company as well as the market performance and condition. It is an invisible asset that may increase when the company earns good revenue but falls when the revenue level decreases.
• Every company strives to earn this value as much as possible through good sales and revenue, good marketing efforts, supply of best quality products and services and meeting demand of the customers on time. Thus, it is an instigation for giving the best to help the business rise and grow, providing a reputation and brand name.
• There are some methods that are used for calculation of goodwill, like the average profits’ method, super profits method or capitalization method.

Thus, the above are the common features of the concept.

We will learn calculation of goodwill, step by step with the help of an example. Let us assume that company A acquired company B for a total consideration of $480 million.

Let us now look at the steps -

It is important to understand what the different types of the concept are. There are mainly two types during valuation of goodwill, as follows:

• Purchased – This type refers to the situation where a company purchases another company, and the target company is purchased at a value which is higher than the actual value of its assets. Thus, this difference is due to the value of goodwill that exists for the target company in the market.
• Inherent – This type refers to the situation where there may not be actual acquisition of sale of the business, but due to good customer satisfaction, best quality of products, financial stability, satisfaction of employees and many other factors, the business gains some inherent value. This is, in other words, a result of good reputation. However, this can either be a positive value or a negative value, depending on what is the company situation in the market.

Thus, the above are the two common types of the concept existing in the market.

source: Google SEC Filings

We note from the above example; Google acquired Apigee Corp for $571 million in cash.

Here is the breakup of the acquisition amount

• $127 million was attributed to Intangible Assets
• $41 million was cash acquired.
• $27 million was the net assets acquired
• Remaining $376 million was attributed to Goodwill.

It generally is recorded in the journal books of account only when some consideration in money or money worth is paid for it.

The journal entry is generally posted as follows:

Acquired asset                             Dr                            XXX

Goodwill                                      Dr                            XXX

Cash/Bank                                   Cr                            XXX

Let us take an example to understand the goodwill journal entries.  The fair value of net assets acquired by ABC & Co in an acquisition is $10 million, and the amount paid is $12 million, then the journal entry is as follows.

Assets (Fixed assets/current assets)      Dr       $10 million

Goodwill (12Mn-10Mn)                                          Dr         $2 million

To Bank/cash/Shares                                 Cr        12 million

It is not recognized as an asset because it is not an identifiable asset controlled by an enterprise that can be measured reliably at cost. The subsequent expenditure on intangible assets like brands, publishing titles, and items of similar nature are recognized as an expense to avoid any internally generated goodwill.

As per international accounting standards, it is no longer amortized or depreciated. Instead, it should be tested for impairment every year, as explained below. However, as per Indian accounting standards, goodwill amalgamation or merger is amortized over its useful life. Since it is difficult to estimate the useful life with reasonable certainty, it is suggested to be amortized over a period not exceeding five years unless a somewhat longer period is justified.

Investors generally deduct Goodwill from any calculation when a business is expected to wind up or be insolvent because it will likely have no resale value.

Each year Goodwill needs to be tested for impairment. Impairment occurs when the market value of assets declines below the book value. Then it needs to be reduced by the amount the market value falls below book value.

For example, ABC Co purchased a company for $12 million, where $5 million is Goodwill. After running the business for so many years with losses, you feel the market value of assets acquired through the acquisition of ABC company is very less, and it is now $9 million only. In this case, the market value of assets acquired dropped by $3 million, and it needs to be reduced by the same amount.

In this case, the entry for impairing is as follows,

Loss on impairment A/c       Dr                 3 million

Goodwill A/c                         Cr                      3 million

(Goodwill impaired for the drop in the market value of assets acquired by the acquisition of ABC Co)

If, in subsequent years, the fair value decreases further, then it is recognized to the extent of only $5 million. If the fair value decreases further, then a decrease in fair value is apportioned among all the assets.

Reversal of impairment:

When the reversal of impairment happens due to an increase in the fair value of assets, then reversal is allocated to carrying the number of assets first to assets other than Goodwill on a pro-rata basis and then allocated later to Goodwill.

For example, In the above example, ABC Co acquired assets for $12 million, where $5 million is from Goodwill. When the market value of assets drops to $6 million, then $6 million (12-6) has to be impaired. Then it is impaired for the entire $5 million, and other assets acquired are proportionately by $1 million.

In this case, two years later, the market value of assets acquired increased by $4 million. Then the value of $4 million is to be first apportioned to assets up to $12 million, and if a balance is still left, that has to be allocated to Goodwill.

This concept has a lot of important or benefits in the industrial world. It gives a boost to the brand name and loyalty. Customers are more attracted towards purchasing the goods related to this brand and even competitors want to enter into contracts with such branded companies in order to gain market share or enhance their own market image.

Good brands find it easy to enter into the market with new type of products and easily gain market share even if the product is new. Customers easily trust them and are ready to test their products. This, they face less competition because there is a lack of companies that are able to compete with their levels.

Customers recommend the goods and services of these companies. This helps in marketing and increase in sales and revenue. This also helps in bringing down the overall cost of production, which in turn increases profitability.

Therefore we can see that such companies with a high amount of goodwill tends to stand out from the crowd and create a market of their own through hard work and perseverance. This acts as a differentiating factor that attracts customers, get appreciation form them and grow in reputation.

This has been a guide to Goodwill and its definition. We explain how to calculate it, its impairment, example, journal entry, features, amortization & types. You can learn more about Accounting from the following articles –

• Goodwill Formula
• Goodwill Amortization Journal Entries
• Capital Expenditure
• Deferred Tax Assets Meaning