One of the Intangible Assets that bring value to businesses is goodwill. Goodwill represents the reputation and prestige of a business that has been operating on the market for considerable amount of time.
Specifically, goodwill is the value of the business that a buyer is willing to pay for that business above the worth of its physical Net Assets.
How to calculate goodwill?
Goodwill is the difference between the purchase price of the business and the real value of that business – its equity, or wealth. Goodwill is only realized when an acquisition, a takeover or merger has taken place with the buyer paying a premium for the purchase of the business. This premium represents goodwill:
Goodwill = Purchase price of the business – Net Assets
or:
Goodwill = Purchase price of the business – Equity
or:
Goodwill = Purchase price of the business – (Total Assets – Total Liabilities)
Let’s take a look at the following example.
Company A buys out Company B for USD$1,000,000, yet the Net Asset value of Company B is only USD$800,000. This means that Company A has paid that extra USD$200,000 for the goodwill of Company B. It means that Company A is willing to pay USD$200,000 for the reputation of Company B.
What counts as goodwill?
Goodwill has considerable value when the business that is being offered for sale is:
- Well-known: high brand awareness and wide brand recognition.
- Well-established: strong reputation, positive brand image and no legal issues.
- Has qualified workforce: knowledgeable, skilled and experienced employees.
- Has loyal customers: repeated purchases over time.
- Has good relationships with suppliers: quality raw materials, timely deliveries, trade credit availabilities.
Hence, other firms are prepared to pay a price exceeding the value of Net Assets in order to purchase this goodwill. It is worth noticing that a newly formed start-up business does not have any goodwill yet.
Accounting goodwill in Balance Sheet
There are two accounting conventions regarding goodwill.
- Adding goodwill into Balance Sheet. Goodwill of a business should normally only feature just after it has been purchased. Or, when the business is being prepared for sale. Goodwill arises when a business is valued at or sold for more than the value of Net Assets.
- Removing goodwill from Balance Sheet. At other times, goodwill will not appear as it is ‘written off’ as soon as possible if it has been included in the purchase of another company. It should not appear as an asset of an existing business because it is very difficult to value properly. Also, business reputation and good brand name can disappear very rapidly, e.g. with a scare over products that risk consumers’ health or an accident that damages the environment and destroys a firm’s reputation. Goodwill is not permanent and just because it was worth something last year does not mean that the reputation and customer contacts are still worth that amount this year.
There is no doubt that Intangible Assets add value to a business beyond the value of its Net Assets. Uncertainty lies in how to place an accurate value on them. It is because sometimes inaccurately adding Intangible Assets into Balance Sheet can be seen as a form of window dressing to artificially inflate the value of a business.
