Goodwill: Meaning, Valuation, and Importance

The term ‘goodwill’ is often heard in business circles and even in normal conversations between buyers and sellers at any local market. As students of commerce, you probably already know that it is an intangible asset. But, several other aspects comprise goodwill meaning, the details of which are given below.

Defining Goodwill

Goodwill is an intangible asset that exists between two companies when one is in the process of buying the other. It may also exist between a business and consumer, but for the sake of simplicity in understanding goodwill meaning, only the former condition is chosen. When company ‘A’ is willing to purchase company ‘B’ at a sum greater than ‘B’s tangible assets, goodwill exists. Such assets will comprise various aspects including brand value, fair employee and customer relations, Intellectual Property and patents, among others.

How is Goodwill Calculated?

The following is a common goodwill formula used for its calculation.

Goodwill = P - (A+L)

Where, 

• P represents the price of the company being acquired,

• A represents the fair/justified asset value, and

• L represents the fair/justified liabilities outstanding.

Types of Goodwill

Two types of goodwill are commonly found in the world of business.

1. Purchased Goodwill: When a company acquires another as a ‘going concern’ and pays a value including the latter’s total assets but barring its outstanding liabilities, it is declared as purchased goodwill.

2. Inherent Goodwill: When a company purchases another but makes no distinction between the assets and liabilities, and yet pays a sum higher than the latter’s fair market price, it is a classic example of inherent goodwill.

Utilising Goodwill

For many investors, assessing goodwill is a difficult but necessary skill. After all, it might be difficult to establish whether a company's claimed goodwill is justified when looking at its balance sheet. For example, a corporation may claim that its goodwill is based on the acquired company's brand awareness and customer loyalty. Investors will investigate what is underlying a company's declared goodwill when looking at its balance sheet to see if that goodwill will need to be wiped down in the future. Investors may believe that the underlying worth of a company's goodwill is larger than that represented on its balance sheet in various instances.

Other Intangibles vs Goodwill

Other intangible assets are not the same as goodwill. Goodwill is a premium provided beyond fair market value during a transaction that cannot be purchased or sold on its own. Meanwhile, other intangible assets, such as licences, can be purchased or sold on their own. Goodwill has an endless useful life, but other intangibles do not.

Impairment of Goodwill

When the market value of an asset falls below its historical cost, it is said to be impaired. This might happen as a result of a variety of factors, including diminishing cash flows, a more competitive environment, or an economic downturn, to name a few. An impairment test on the intangible asset is used to determine if an impairment is required.

The income approach and the market approach are the two most often utilised strategies for determining impairments. Estimated future cash flows are discounted to present value using the income technique. The assets and liabilities of similar firms operating in the same industry are assessed using the market method.

The goodwill account on the balance sheet is reduced as a result of the impairment. On the income statement, the item is likewise shown as a loss, lowering net income for the year. As a result, earnings per share (EPS) and the stock price of the firm suffer.

The Financial Accounting Standards Board (FASB), which develops GAAP regulations, is contemplating changing the way goodwill impairment is assessed. Because of the subjective nature of goodwill impairment and the high expense of assessing impairment, FASB is contemplating returning to an earlier system known as "goodwill amortisation," in which the value of goodwill is gradually lowered over time.

Real-World Example of Goodwill

A classic example of the nature of goodwill and how it affects businesses was observed in 2018 when the US telecom giant T-Mobile acquired Sprint. With the new entity to be named ‘New T-Mobile’ the deal was cleared only in late 2020 after regulatory wrangling. The S-4 filing revealed that as of March 31, 2018, the deal was valued at $35.85 billion. 

Key Points

• Goodwill is an intangible asset that accounts for a company's excess purchasing price.

• Proprietary or intellectual property, as well as brand awareness, are examples of non-quantifiable goodwill.

• Goodwill is computed by deducting the difference between the fair market value of the assets and liabilities from the company's acquisition price.

• At least once a year, companies must examine the value of goodwill on their financial statements and reflect any impairments. Goodwill is unique among intangible assets in that it has an infinite existence, whereas most other intangible assets have a finite useful life.

Shortcoming of Goodwill

Goodwill is difficult to evaluate, and negative goodwill can emerge when an acquirer pays less than fair market value for a firm. This frequently happens when the target firm is unable or unwilling to negotiate a reasonable purchase price. In distressed sales, negative goodwill is common and is represented as income on the acquirer's income statement.

There's also the possibility that a formerly successful business would go bankrupt. When this happens, investors subtract goodwill from their residual equity calculations. The reason for this is that the company's past goodwill has no market value at the moment of insolvency.

Conclusion

Goodwill is an intangible asset that exists between two companies. When company 'A' is willing to purchase company 'B' at a sum greater than 'B's tangible assets, goodwill exists. Such assets will comprise various aspects including brand value, fair employee and customer relations.