It’s no secret that how people perceive a company and the company’s standing in the marketplace have a profound effect on its overall financial success. Just look at the positive reputation enjoyed by companies like Apple and Starbucks, and how it affects the prices of goods sold. These companies can increase the purchase price of their products because of the public’s perception of their brand.
As a small business owner, wouldn’t it be great to assign a dollar value to the positive reputation that your firm carries? One that you could use as part of your business valuation? What if there was a way to “quantify” the strong brand and positive image that you’ve worked to achieve for your business?
You can, and it’s called “goodwill” or “business goodwill.” A crucial asset when determining a company’s overall valuation, goodwill reflects the portion of a company’s value that owners can’t ascribe to cash or physical assets. In this sense, a business’s true worth is often far more than the value of its individual —tangible — parts.
Recognising goodwill accounting practices could be worthwhile for small businesses because it could allow you to more accurately determine the fair value of your company. This, in turn, would make you more attractive to potential investors.
In this article, we’ll answer important questions like, “What is goodwill in accounting?”, “What is goodwill in business?” and “What is goodwill on the balance sheet?” By the end of this article, you should have a much clearer understanding of what goodwill is and how it can impact your company’s financial statements.
Goodwill is an intangible asset used to explain the positive difference between the purchase price of a company and the company’s perceived fair value. Goodwill typically only comes into play when one company purchases another. If the purchase price is higher than the company’s fair value, the acquiring company can explain the excess purchase price on its financial statements through goodwill. Only the acquiring company recognises goodwill.
Determining the fair value of the company being purchased is simple. All you have to do is total the business assets offered by the purchased company and subtract any liabilities that the purchaser is taking on. If the acquiring company pays more than this sum, there would need to be a “goodwill” accounting transaction.
Although goodwill is generally regarded as an intangible asset, businesses purchasing a company with “goodwill” are required to value it annually and record any impairments. Goodwill impairments are instances in which the value of assets declines after being purchased by an acquiring company.
So, for instance, imagine that the book value of a company being sold is $10,000,000. But the market value is $15,000,000. The acquiring company adds goodwill to the balance sheet for $5,000,000. But after acquiring the company, the market value decreases to $14,000,000. The acquiring company would need a goodwill impairment of $1,000,000 to explain this loss in value.
One of the other terms that seem to come up during the sale of a company is “going concern value.” Business goodwill is distinct from “going concern value,” which refers to those assets that contribute to the production of income and may include equipment, facilities, and other tangible assets owned by the company.
Going concern value is more of a financial projection into the future and an estimate of how much a company’s acquired assets will continue to earn. When business goodwill value and going concern value are combined, you have a rough estimate of the business’s overall valuation.
Various factors affect a company’s business goodwill. When calculating goodwill for your company, it’s essential to take all the applicable assets into account. Some of the assets that can be categorised as goodwill include:
The above is only a partial list of the factors that affect a business’s goodwill value. Combined with going concern value, companies should be sure to include all possible value propositions to arrive at the fairest and most accurate number.
Accounting for business goodwill in your books requires that you subtract the fair market value of tangible assets from the total worth of the business. Goodwill is, therefore, equal to the cost of acquisition minus the value of net assets.
While it’s possible to estimate goodwill, there’s no need to until the completion of the sale. Goodwill is an adjusting entry on the balance sheet to help explain why the cash spent to acquire a company is greater than the assets received in return.
To calculate the value of net identifiable assets, subtract the liabilities from the identifiable assets. This approach may not be applicable for assets like patents or client lists that lack an exact market rate. For such investments, one may need to estimate future cash flows using techniques like discounted cash flow (DCF) to determine their value.
Additionally, professional companies like doctors’ offices and law firms will need to account for both practitioner goodwill (i.e., the value of the practitioner’s talents and abilities) and practice goodwill (i.e., the value of the business as a whole).
For instance, if a highly-esteemed partner leaves a law firm, the value of the firm could decline significantly. Goodwill should account for individuals whose talents and reputations bring value to the firm.
If a doctor’s office has two practicing healthcare professionals, one of whom is very new and in training, there’s a strong chance that a lot of the office’s value is tied up in the older doctor who has been practicing for years.
Some businesses use a cost approach to valuing business goodwill. Under this system, companies estimate the financial cost of recreating the current level of goodwill from scratch.
Additionally, companies can utilise comparative data from sales of similar businesses in the industry. Doing this allows businesses to calculate goodwill as a percentage of the sale price.
