A Super Simple Guide to Goodwill in Accounting
Selling or acquiring a business is a long process that involves multiple meetings, lots of paperwork and a lot of headaches!
One of the most common causes of these headaches is attempting to value intangible assets. Sellers will think they’re worth more, whereas buyers will think they’re worth less!
When something is intangible, it means it’s not physical and this can make valuing the asset(s) rather challenging.
Some intangible assets are easy to value, for example, contracts between businesses will have a cash value. However, there are assets, like the value of the brand itself, which are a little more ambiguous in their value.
These assets are known as goodwill and can act as stumbling blocks in the sale of a business as it’s difficult to value their worth.
Getting your head round the concept of goodwill can be challenging so in this article we will:
- Break down the concept of goodwill in accounting and explain it in super simple terms
- Assess how it interacts with the sale of a business
- Explain how companies value their goodwill.
- Demonstrate how everything works in an example
What is goodwill in accounting?
Now, if you’re like me and had never heard of goodwill, your initial thoughts might have been:
“This refers to the process of accounting for products or services you give away for free, as that is known as a gesture of goodwill”
Turns out, I was wrong.
Goodwill in accounting is a fair bit more complicated, so let’s break it down.
Goodwill refers to the difference between the purchase/sale price of a company and the value of its net assets (assets minus liabilities).
Now it’s easy to think that surely the purchase price of a business is simply the value of its assets minus its liabilities.
For example: If a company has £1m of assets and £650,000 of liabilities, the company is worth £350,000.
Now, this would be correct, that is if you aren’t accounting for intangible assets that are difficult to value.
Buyers will often pay over the price of £350,000 to account for these intangible assets.
Top tip: These intangible assets for goodwill include:
- The brand itself
- Other intellectual properties that they might own.
- Its technology
- Customer base
- And relationship with those customers
For example, if you were buying Nike, valuing the “tick” is difficult.
But it’s worth something, right?
In fact, it’s worth quite a lot – but how much exactly, is another question.
Valuing intangible assets for goodwill
Goodwill is considered an intangible asset and needs to be recorded on the balance sheet each year.
Companies will estimate the value of their goodwill. It works differently from other intangible assets in that it has an indefinite lifespan and will not depreciate.
This doesn’t mean that the goodwill is a fixed value for its lifetime. Despite not being susceptible to depreciation, it is still subject to market forces which cause its value to fluctuate.
An example of this would be:
A company has a strong trading year and gained 20% more market share. However, a controversy happens and the public image of the company is badly tarnished and unlikely to recover within several years.
This strong trading year and market share increase will have increased the goodwill value, but the brand name being tarnished will have had a significant effect too.
How much this decreases the value of the brand is often determined by accountants in the company, although the stock price (if the company is trading publicly) is a usually good indicator.
How to calculate goodwill
In a sale, the goodwill price is calculated by taking purchase price – (assets – liabilities).
Here’s the formula:
As discussed in the previous section, it is up to the company to decide how much their goodwill is worth.
This needs to be calculated in a fair manner as any inflation is likely to be disputed by the buyer, as many companies will inflate their worth – this can cause tensions during buyouts.
What role does goodwill have in a company buyout?
Goodwill is one of the main negotiating factors in a company buyout.
Because it is one of the only factors involved in a buyout that is somewhat subjective.
How do you even begin to value something like a brand and its intellectual properties?
Naturally, this is a topic for debate between the buyer and seller – but other circumstances often affect goodwill.
Occasionally a company will be sold for less than its fair market value, resulting in negative goodwill.
Negative goodwill happens when a company’s market value is lower than the value of its net assets, often the result of a desperate sale.
This is commonly seen in buyouts of struggling companies but is not limited to just this.
It can also happen when a company is faced with insolvency, as in this case their goodwill is often reduced to nil.
Company A wants to buy Company B.
Company B has:
- Assets equating to £2.5m.
- Liabilities equating to £1m.
This means that the company has approximately £1.5m of net value.
Company A agrees to purchase Company B for £2m.
This means that the goodwill for Company B was agreed to be £500,000.
It is £500,000 because that is the difference between the purchase price and the total of assets minus liabilities.
This goodwill would be recognised on the balance sheet as £500,000.
Calculating a fair price for goodwill
So what’s to stop a business just adding as many 0s as they can in their sale price?
In a sale, and in normal business operations, the value of goodwill must be justified.
Coming up with a fair price can be difficult. You need to try and separate the art and science.
The science in this case being the ability to forecast or model the future of the business.
The art being the art of a salesperson.
Any business who hopes to pass the due diligence checks of any prospective buyer will need to back up their accounting for goodwill with well-reasoned, explainable data.
In this case, one of the key factors is the projected income of the business over the next 3, 5 and 10 years.
A financial forecast that includes not just a Cash Flow, but a Balance Sheet can tell you what the company is likely to be worth over these time periods. A Balance Sheet forecast can also demonstrate how much the business needs to rely on borrowing or other liabilities to fund its projected growth.
The higher the demonstrable value of your company’s future operations, the higher you can justify your company’s goodwill.
You can’t just put together a 10 year forecast with unreasonable expectations on how your business will perform just to inflate the price though. It needs to be backed up.
With a 10 year forecast, there is always some degree of guesswork, however, if the forecast is clearly laid out, and using historical data to back up the findings, it provides a much more reasonable foundation for what you can expect your business to achieve.
A good financial forecast is essential for any business, whether or not you plan on selling it.
Not only is it necessary to have an accurate goodwill estimate on your balance sheet annually, but a financial forecast gives you a roadmap for your business, allowing you to make more informed decisions on the paths you take.
You can find out more about the importance of financial forecasting here.
What we’ve covered here is the basics of goodwill and enough to get you going – but in practice it can be more complex than this.
Let’s recap what we’ve been through in this article:
- Goodwill refers to the difference between the purchase/sale price of a company and the estimated value of its assets and liabilities.
- Goodwill can include but is not limited to:
- The brand itself
- Other intellectual properties that they might own.
- Its potential
- Goodwill is calculated by taking the purchase price of a company from the total of assets minus liabilities.
- Valuing a company’s goodwill is a difficult process and is subject to market forces like the brand’s public image.
- Goodwill plays an important role in the buyout of a company, and often determines the final sale price.
- Calculating a fair price for goodwill can be tricky, but can be informed by a robust financial forecast which is built on historical data and realistic predictions about your business.