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Contents

  1. 1. What is goodwill?
  2. 2. Examples of goodwill
  3. 3. What is goodwill in accounting?
  4. 4. How is goodwill calculated?
  5. 5. Why does goodwill matter to small businesses?

What is goodwill and how is it accounted for?

January 25, 2023
If you’re buying a new business, you expect to purchase its contracts, stock, equipment and any premises. But, alongside this will be other key assets that are much more difficult to put a price on, such as brand, location and customer base.Whether you’re looking to acquire a business, or you’re in the market to sell your own, it’s important to have a good understanding of goodwill. In this article, we’ll provide a goodwill definition, explain why it matters for small businesses, as well as give you the lowdown how to calculate goodwill on a balance sheet.

What is goodwill?

Under International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP), goodwill is a non-physical asset or intangible asset that represents any future economic benefits that come from one business acquiring another. As a result, the value of goodwill in the purchase price is higher than the net value of all the tangible assets and liabilities included in the sale.Since goodwill has an indefinite life, unlike other intangible assets it isn’t subject to amortization — or, in simple terms, you won’t need to decrease the value of the intangible assets included in goodwill over time.However, you’ll have to evaluate the value of goodwill on your financial statements and record any impairments (the reduction of either a fixed or intangible asset’s value) on an annual basis.

Why is goodwill not shown in final accounts?

As it can be difficult to assign a specific value to goodwill, as it is unique to each business and can also fluctuate, goodwill isn’t shown in company accounts.The only time a set value will be placed on goodwill is when it is acquired (or purchased), and it will then be worth what someone is prepared to pay for it.

Examples of goodwill

As payment for a business with goodwill is typically above the price of its net assets, goodwill reflects that you’re buying a going concern with everything in place for you to continue to run the business profitably.With this in mind, when you’re calculating goodwill, the purchase price can be affected by the following types of goodwill:
    Customer loyalty, with an established and ongoing relationship with customers and suppliersProtected intellectual property, such as trade secrets and copyrights, that gives you a competitive advantage in the market placeA good location with a long and secure leaseGood cash flow and little to no debtClearly documented processes and systems that a new owner will be able to pick up easilyCompany talent, made up of loyal, knowledgeable staffBrand recognition, such as a strong brand name and reputation
Goodwill doesn’t always form part of acquiring a business. However, if the cost of purchasing a business exceeds the fair value of its assets and liabilities, it must be recorded in your company’s general ledger.

What is goodwill in accounting?

Goodwill accounting is defined as the process of calculating and accounting for the value of an intangible asset that forms part of a company’s value.As many existing businesses are purchased at least in part for the value of its intangible assets, the purchase price frequently exceeds what would be classed as its book value (the net difference between a company’s total assets and total liabilities).Since the process for calculating goodwill isn’t that straightforward, why not schedule a call with one of our qualified accountants to sort it for you?

How is goodwill calculated?

To calculate goodwill, the fair market value of the assets and the liabilities of the business being acquired is added to the fair value of its assets and liabilities. Any excess of the net identifiable assets is known as goodwill.Or, more simply:To use this formula, take the following steps:Step 1: Obtain the book value of the business’s assets. This can be worked out by subtracting existing liabilities from the total value of the assets, including fixed assets, intangible assets, current assets and non-current assets.Step 2: Find the fair market value, taking factors, such as depreciation, into account.Step 3: Work out the difference between the book value and fair value of the assets, noting the figure in the book of accounts.Step 4: Calculate the difference between the purchase price and net book value to find the excess purchase price.Step 5: Take the excess purchase price and deduct the fair value adjustments to get your final figure for goodwill.As already mentioned, working out the price of goodwill can be a complicated process and this is just one way to calculate it.There are other ways and each method can bring varying results, with other methods for calculating goodwill outlined below. The value will ultimately be what either the marketplace or a buyer is willing to pay.

Calculating goodwill in accounting using average profits

This is arguably both the simplest and one of the most common methods used to calculate goodwill, where goodwill is equal to the average profits for a given time period, multiplied by the number of years you think the previous owner’s goodwill be valid for:Goodwill = Average Profits x Number of YearsBelow are the steps for how to calculate goodwill using this method:Step 1:  Review your company’s profit and loss sheet to determine an average profit for the past few years. As well as checking your numbers, make sure you take the following into account:
    Abnormal profits: One-off sales or large contracts that have come to an end, should be deducted from the net profit in the year that they were earnedAbnormal losses: The write-off of any obsolete equipment should be added back to the net profit in the year they were incurred.Non-operating income: Income from investments that aren’t a part of normal business should be deducted.
Step 2:  Estimate how long you believe the ‘goodwill’ of the current business will last.If the business is a ‘turn key’ business where it’ll be profitable for around 3-5 years without you needing to make any changes, you’ll need to multiply the average profit by 3-5 to arrive at a goodwill amount.A business can have a zero goodwill value if it has little or no profit and needs significant improvements.It’s also worth bearing in mind that you don’t have to pay goodwill. If you’re buying a business and the goodwill is excessive, you might find it better to start from scratch.

Alternative ways to calculate goodwill

Other valuation methods for calculating goodwill in accounting include market valuation less net assets, where you subtract the value of the net assets from any valuation provided by a business broker.Another method is an industry profit multiplier which is often applied to businesses that are bought and sold on a regular basis. For instance, if a business’s sales are typically 1 to 2 times its cash flow, you could predict something similar. You can then deduct the net assets from this to calculate what you are paying for goodwill.

Goodwill impairment

As goodwill is typically sold at an excess purchase price when the target company is acquired, it’s worth looking into what happens when the value of the intangible assets drop after its sale.Impairment occurs when the market value of an asset drops below its previous cost, due to anything from declining cash flows to an economic depression.If the acquiring company finds that the net assets acquired from the target company fall below the book value, the asset will need to be impaired on the acquiring company’s balance sheet.

Problems calculating goodwill

Goodwill is often considered to be one of the most subjective issues in financial reporting, due to the nature of the intangible assets in question, such as brand name, company reputation and customer base. As a result, it can be hard to settle on a figure, especially if some of the information needed to calculate goodwill is missing.If you’re a company looking to sell your business, you might also find that you’ll end up with negative goodwill if you have to sell your company assets at a lower price than they’re worth.

Why does goodwill matter to small businesses?

As your customer base grows, so will the value of your business. It can be difficult to put a price tag on the value of intangible assets, such as brand identity or intellectual property, but both of these are reflected in goodwill.Understanding goodwill in accounting is key to planning for the future. Although your business may be small today, your sales and market share may grow to the point where you may start looking to acquire one of your competitors.
Caroline Wire
Caroline WireFreelance Copywriter

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