What is goodwill in accounting?

November 17, 2011

Learn about goodwill and accounting for it in a business combination.

1. Reasons for existence of goodwill

Companies routinely purchase intangible assets such as licenses, software, domain names, and so forth. Intangible assets lack physical existence, and their value comes from the rights and privileges that they provide to their owners. Such assets are recognized on the balance sheet and amortized over their useful lives. One intangible asset, however, cannot be recognized without a purchase of another company. This asset is goodwill.

Goodwill arises when one company purchases another company. When this happens (called a business combination), the company-seller transfers assets and liabilities to the company-buyer and in return receives a payment. The assets transferred in a business combination include tangible assets and intangible assets. Tangible assets may include inventory, accounts receivable, prepaid expenses, and fixed assets. Intangible assets may include software, licenses, trademarks, and so on. Note that in a business combination the company-buyer can also recognize on its books intangible assets which didn’t exist on the company-seller’s books. For example, the company-seller may not have had customer lists or non-compete agreements on its book, but such assets – if they exist – would be recognized on the company-buyer’s books.

The process of recognizing tangible and intangible assets is usually accompanied by valuation of assets acquired and liabilities assumed. Normally such assets and liabilities are recorded at their fair values. It is in this valuation that new intangible assets can be recognized on the company-buyer’s books.

Even though there are intangible assets to which a valuation specialist can assign values, there are also assets that are not easily valued. For example, the company-seller may have a strong and successful management team, experienced and talented work force, and established reputation with customers. The company-seller could not recognize such intangible assets on its books because costs associated with such assets were expensed when incurred according to the generally accepted accounting principles. The only time when such intangible assets can be recognized is in a business combination. Such assets are grouped into one category called goodwill. The goodwill amount can be calculated as the difference between (a) the tangible and intangible assets acquired and liabilities assumed by the company-buyer and (b) the payment transferred by the company-buyer. So, goodwill is basically a plug number (see below for an example of how goodwill is calculated).

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