I often get asked about goodwill – its importance as well as how to value it. It’s complex. Goodwill is intangible. Hard to quantify but an important asset none the less.
Goodwill is defined as the amount of money someone is willing to pay for a company over and above the value of the assets within the company. The company’s book value is the equity within the company as listed on the balance sheet. Any money paid above the book value is considered goodwill. It’s the difference between cash received during the purchase and the actual value of the company.
It seems pretty straight forward. But goodwill is an intangible asset that is not tied to any real property or other asset. This provides a feeling of uncertainty for lenders or investors who see it listed on a balance sheet. One reason is the value of goodwill at the time of the sale is not a true depiction of the value of the company at any given point in the future. Months or years after the purchase, the company’s performance is not tied to the historical price paid. Goodwill could be a hindrance in making a sound lending or investing decision. Overstating goodwill will overvalue the company and vice versa with understating it.
Goodwill is amortized on the balance sheet and must be evaluated and adjusted on a regular basis. Prior to 2002, goodwill was amortized in a straight line or equal portions over a 40-year period. However, this didn’t provide an accurate picture of the value of the company. The accounting standards changed in 2001. Any goodwill originating in 2002 forward is subject to reevaluation using the company’s fair market value. If the carrying value of the goodwill is more than the fair value, then goodwill is said to be impaired and the difference should be written down to the fair value.
Carrying value is calculated by taking the cost that was originally paid for the business assets, minus its debts. If a company originally paid $2 million for its assets, and has $1 million in debts, then the carrying value would be $1 million. Goodwill is equal to the purchase price of the business minus the fair market value. Let’s assume the carrying value is $1 million, as in the example above, and accountants determine that the fair market value is $1.5 million. If someone on the open market was willing to pay $2 million for this company, the goodwill created would be $500,000. ($2 million - $1.5 million)
After the purchase the company is required to test goodwill each year for impairment. Business values fluctuate year over year as the performance of the company moves up or down. If the company is deemed to be worth less if sold, then you must reduce goodwill by the difference in carrying value and fair value. In the above example, the carrying value of the company is $1 million. For example, a new competitor entered the market and hurt your company’s sales. During the year-end review, you determine your company is now worth $500,000 on the open market. In this case, you need to reduce or impair your goodwill amount by $500,000. ($1 million - $500,000)
The accounting journal entry will show a debit for the loss of $500,000 in the goodwill account, reducing or crediting goodwill by that amount. By debiting loss in goodwill impairment, you are recording the fact that a loss occurred. This loss will help the company by showing up as a business expense on the profit and loss statement for that reporting period. Help? Actually, yes. The change in market conditions created a loss of value within the company means it can be written off as an expense, much like depreciation or amortization.
One thing to remember is that goodwill can only be impaired as a loss. The only way it can increase during a new acquisition transaction. New value cannot be created in the original goodwill account beyond the actual purchase price that created the goodwill.
Goodwill works the same way in a business as it does in an interpersonal relationship. Goodwill is an emotion you feel during an interaction. When the purchase of a new business feels right, the goodwill is recorded in the form of additional dollars. It stands for the value of the business and what it stands for in a community, such as its employees, relationships with suppliers and vendors, the brand name or sentiments attached to the company. It has to be earned through the process of operating a profitable and efficient business.