Fact checked by Timothy Li
Goodwill refers to non-physical items that can increase a company’s market valuation. It comes in a variety of forms, including reputation, brand, domain names, intellectual property, commercial secrets, among other intangible assets.
Assigning a numeric value to goodwill can be challenging because these assets are non-quantifiable. However, the need for determining goodwill often arises when one company buys another firm, a subsidiary of another firm, or some intangible aspect of that firm’s business.
Key Takeaways
- Goodwill is an intangible asset, and it comes in a variety of forms, including reputation, brand, domain names, and intellectual property.
- The need for determining goodwill often arises when one company buys another.
- Goodwill is calculated as the difference between the amount of consideration transferred from acquirer to acquiree and net identifiable assets acquired.
History of Goodwill
The concept of goodwill in business affairs goes back at least a century. One of the first definitions of it appeared in “Halsbury’s Laws of England,” a comprehensive encyclopedia that dates from 1907. The current “Halsbury’s” (4th edition, Vol. 35), states that:
“The goodwill of a business is the whole advantage of the reputation and connection with customers together with the circumstances, whether of habit or otherwise, which tend to make that connection permanent. It represents in connection with any business or business product the value of the attraction to the customers which the name and reputation possess.”
In listing goodwill on financial statements today, accountants rely on the more prosaic and limited terms of the International Financial Reporting Standards (IFRS). IAS 38, “Intangible Assets,” does not allow the recognizing of internally created goodwill (in-house-generated brands, mastheads, publishing titles, customer lists, and items similar in substance). The only accepted form of goodwill is the one that is acquired externally, through business combinations, purchases, or acquisitions.
For example, in 2010, Facebook (META), now Meta, bought the domain name fb.com for $8.5 million from the American Farm Bureau Federation. A domain name’s sole value is the name, or (in this case) the initials. That means the entire amount paid for it can be considered goodwill, and Facebook would have recognized it as such on its balance sheet. However, before the acquisition, the American Farm Bureau Federation could not recognize fb.com as goodwill on its balance sheet—goodwill has to spring from an external source (not an internal one).
Calculating Goodwill
According to IFRS 3, “Business Combinations,” goodwill is calculated as the difference between the amount of consideration transferred from acquirer to acquiree and net identifiable assets acquired. The general formula to calculate goodwill under IFRS is:
Goodwill=(C+NCI+FV)−NAwhere:C=Consideration transferredNCI=Amount of non-controlling interestFV=Fair value of previous equity interestsNA=Net identifiable assets
Non-Controlling Interests in the Goodwill Calculation
The method to calculate goodwill is straightforward, but challenges can occur when measuring one of the variables: non-controlling interest (NCI). The amount of NCI plays a significant role in the goodwill-calculation formula. A non-controlling interest is a minority ownership position in a company—meaning the position is not substantial enough to exercise control over the company.
Under IFRS 3, there are two methods for measuring non-controlling interest:
- Fair value or full goodwill method
- Non-controlling interest’s proportionate share of the acquiree’s net identifiable assets
These two methods can yield different results.
For example, suppose company A Inc. acquires B Inc., agreeing to pay $150 million (the consideration transferred) to obtain a 90% interest in B Inc. The fair value of the non-controlling interest is $16 million. Assume that the fair value of net identifiable assets to be acquired is $140 million and that no previous equity interests exist.
Using the first method of measuring NCI, the amount of the goodwill is $26 million ($150m + $16m – $140m).
Under the second method of measuring the NCI, we take into account the 10% of B Inc. that A Inc. didn’t acquire. As a result, the goodwill value is $24 million ($150m + [140m x 0.1] – $140m). Thus, there is a difference of $2 million between the amount of the goodwill calculated under the two methods.
Special Considerations
Although goodwill is the premium paid over the fair value of an entity during a transaction, goodwill’s value cannot be sold or bought as an intangible asset by itself.
It can be challenging to determine the price of goodwill because it is composed of subjective values. Transactions involving goodwill may have a substantial amount of risk that the acquiring company could overvalue the goodwill in the acquisition—and, ultimately, pay too much for the entity being acquired.
However, despite being intangible, goodwill is quantifiable and is a very important part of a company’s valuation.
What Is the Formula for Calculating Goodwill?
According to IFRS 3, “Business Combinations,” the formula for calculating goodwill is: Goodwill = (Consideration Transferred + Non-Controlling Interest + Fair Value of Previous Equity Interests) – Net Identifiable Assets
How Is Goodwill Different From Other Assets?
Like other assets, goodwill can show up on a company’s balance sheet (but only when two companies complete a merger or acquisition). However, unlike some other assets, goodwill is intangible. It is not a physical asset like buildings or machinery. Another difference is that it has an indefinite life (as long as the company operates). Other assets have a definite useful life, and, as such, they are amortized: A fixed amount is marked down every year, resulting in a simultaneous charge against earnings.
What Is an Intangible Asset?
Goodwill refers to the value of certain non-monetary, non-physical resources, such as customer loyalty and brand reputation. While customer loyalty and brand reputation are certainly intangible, on a company’s balance sheet, an intangible asset refers to something else. An intangible asset is non-physical but identifiable. Examples include a company’s proprietary technology (computer software, etc.), copyrights, patents, licensing agreements, and website domain names.
The Bottom Line
Goodwill is a non-physical item, such as a brand name or intellectual property, that contributes to the value of a company. It is assessed when a firm buys another firm or buys some part of that firm’s business; it cannot be sold, purchased, or transferred separately. The formula for calculating goodwill is: Goodwill = (Consideration Transferred + Non-Controlling Interest + Fair Value of Previous Equity Interests) – Net Identifiable Assets.