Goodwill

An intangible asset created when the purchase price is higher than the fair market value

What is Goodwill?

In accounting, goodwill is an intangible asset that is created when a company acquires another company for a price higher than the fair market value of the company’s net assets. Under US GAAP and IFRS Standards, it is an intangible asset with an indefinite life and thus does not need to be amortized. However, it needs to be evaluated for impairment yearly.

 

Goodwill on Amazon's Balance Sheet
Source: amazon.com

 

Accounting Goodwill vs. Economic Goodwill

Accounting goodwill is, as defined above, an intangible asset that is created when a company purchases another company with a price higher than the fair market value of the company’s net assets.

On the other hand, economic goodwill reflects the competitive advantages of a particular company. It is created through branding, exceptional customer service, etc. Warren Buffett uses See’s Candies, which was bought by Blue Chip Stamps in the early 1970s, as an example. See’s reported only $8 million in net tangible assets then but was consistently earning a net profit of $2 million – a 25% return on net tangible assets.

The high return over its competitors resulted from the company’s reputation and exceptional customer service. From Warren Buffett’s 1983 Berkshire Hathaway shareholder letter: “Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill.”

 

Accounting for Goodwill (Journal Entries)

The journal entry is as follows:

 

Purchase of a Company:

 

Goodwill

 

To understand it in more depth, let’s look at an example.

 

Example of Goodwill

Company A reports the following amounts:

 

Example of Goodwill

 

The fair value differs from book value in the example above because:

  • Fair value accounts receivable is lower than book value due to uncollectible accounts.
  • Fair value inventory is lower than book value due to obsolescence.
  • Fair value PPE is higher than book value due to depreciation being greater than the decline in PPE fair value.

 

If Company B purchases Company A for $250,000, the amount of economic goodwill generated would be the purchase price subtract the fair market value of net assets: $250,000 – $209,000 = $41,000.

 

The journal entry for the purchasing company Company B would be as follows:

 

Journal Entry for Purchasing Company

 

Goodwill in Financial Modeling

In financial modeling for mergers and acquisitions (M&A) it’s important to be able to model the goodwill that’s generated as a result of the acquisition. Below is a screenshot of how an analyst would perform the analysis required to calculate the values that go on the balance sheet.

 

Goodwill calculation in financial modeling

 

This screenshot is taken from CFI’s M&A Financial Modeling Course.

 

Steps to calculate goodwill in an M&A model

 

#1 Book Value of Assets

First, get the book value of all assets on the target’s balance sheet. This includes current assets, non-current assets, fixed assets, and intangible assets. You can get these figures from the most recent set of financial statements.

 

#2 Fair Value of Assets

Next, have an accountant determine the fair value of the assets. This process is somewhat subjective, but an accounting firm will be able to perform the necessary analysis to justify a current market value of each asset.

 

#3 Adjustments

Calculate the adjustments by simply taking the difference between the fair value and the book value of each asset.

 

#4 Excess Purchase Price

Next, calculate the Excess Purchase Price by taking the difference between the actual purchase price paid to the target and the Net Book Value of the assets (assets minus liabilities).

 

#5 Calculate Goodwill

With all of the above figures calculated, the last step is to take the Excess Purchase Price and deduct the Fair Value Adjustments. The resulting figure is the Goodwill that will go on the acquirer’s balance sheet when the deal closes.

 

More Resources

CFI is a leading provider of financial analysis courses, including the Financial Modeling & Valuation Analyst (FMVA)™ certification program. To help you advance your career, check out the additional resources below:

Free Accounting Courses

Learn accounting fundamentals and how to read financial statements with CFI's free online accounting classes. These courses will give the confidence you need to perform world-class financial analyst work. Start now!  

Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!