DEFINITION: As the term is used in the context of business and economics, “goodwill” is an intangible asset of a company.
More specifically, goodwill is a type of value consisting of such nonphysical but economically significant things as a company’s name, brand, customer base, and reputation for the excellence of its products, customer service, employee relations, and proprietary technology, among others.
Goodwill may also be given a more exact, technical definition, suitable for use in mathematical calculations.
Namely, within the context of the acquisition of one company by another one, goodwill may be defined as the economic value obtained by the acquiring company, defined as the excess portion of the purchase price over the value of the acquired assets less the liabilities assumed during the acquisition.
Thus, the concept of goodwill explains why such a value (price) in excess of the acquired net assets exists at all. That is, obtaining goodwill is the reason why one company may pay a premium to acquire another.
ETYMOLOGY: The English word “goodwill” is attested from the eleventh century. However, its use in the economic sense discussed here is of much more recent vintage.
The term is of course made up of the two component words, “good” and “will.”
The word “good” derives, via Middle English, from the Old English word gōd (“good”), which is akin to the Old High German guot, also meaning “good.”
The word “will” derives, via Middle English, from the Old English word willa, meaning, in the relevant sense, “disposition” or “inclination.”
USAGE: While goodwill exists independently of any particular economic transaction, it is commonly most commercially relevant during the process of acquisition.
The goodwill possessed by the acquired company is revealed, as it were, by the purchase price, or, more specifically, by the portion of the purchase price that is in excess of the net market value of the assets, as already explained.
In this way, the rather abstract notion of goodwill may be ascribed a precise economic value.
When the acquiring company pays less than the acquired company’s book value, it is said to obtain negative goodwill, meaning that the purchase was made at a discounted price.
On the acquiring company’s balance sheet, goodwill is documented as an intangible asset, categorized under the long-term assets account.
Goodwill is classified as an intangible (or non-current) asset because it lacks physical form, unlike tangible assets like equipment and buildings.
According to generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS), companies must assess the value of goodwill in their financial statements at least annually, acknowledging any impairments to their goodwill relative to the past.
Calculating goodwill is relatively straightforward in theory but can be difficult in practice.
To calculate goodwill using a simple formula, one should deduct the fair market value of the acquired company’s net assets from the purchase price, to wit:
Goodwill = P − (A − L)
where:
P = Purchase price of the acquired company
A = Fair market value of assets
L = Fair market value of liabilities
While this formula makes the calculation of goodwill appear very simple, difficulties may arise because goodwill may involve estimating future cash flows and other uncertain or unknown quantities.
While these problems may not be very serious in most cases, they may become significant for certain purposes—for instance, when accountants need to compare the reported assets or net income of an acquired company to those of a company that has never been acquired.