Definition
The financial accounting term goodwill refers to the present value of earnings that are in excess of normal profitability for a particular industry. Goodwill is commonly recorded when a business is acquired and the price paid is in excess of the book value of the company.
Calculation
Goodwill = Cost - (Tangible Assets + Identifiable Intangible Assets - Liabilities)
Explanation
Investors are often willing to pay a premium to acquire a company if they're able to demonstrate they can produce profits in excess of what the industry would suggest are "normal," and those excess profits can be reasonably expected to continue into the future. Above average earnings may be a result of a monopoly, customer loyalty or manufacturing efficiency.
Competitive market forces typically limit the ability of any company to generate these excess earnings for more than three to five years. Therefore, the amount of goodwill paid will be less than five times the calculated excess earnings each year. That being said, assigning a goodwill premium to a company is typically a very subjective exercise.
Goodwill is an intangible asset, and as such appears on the company's balance sheet. Amortization is the process of allocating the cost of goodwill to the accounting periods over which it can be expected to provide economic benefit.
Example
Company A wishes to acquire Company B. The total of all tangible and identifiable intangible assets is $10,000,000. Company B's balance sheet indicates liabilities of $6,000,000. Using industry benchmarks, Company A's management team has determined Company B generates excess profits of $100,000 annually. Company A's management team is willing to pay goodwill in the amount of four times the excess profits.
The proposed cost to acquire Company B would be:
= $10,000,000 - $6,000,000 + $100,000 x 4 =$4,000,000 + $400,000, or $4,400,000
Related Terms
The financial accounting term book value refers to the original cost of an asset minus the accumulated depreciation on that same asset. The total book value of all assets can be found on the company's balance sheet.
Moneyzine EditorNovember 6th, 2024
The financial accounting term intangible asset is used to describe those assets that lack physical structure (they cannot be seen or measured), and have a high degree of uncertainty surrounding future benefits to be derived from them. The most common types of intangible assets appearing on the balance sheet are goodwill, copyrights, trademarks, patents, franchises, and organization costs.Moneyzine EditorNovember 6th, 2024- The financial accounting term tangible asset is used to describe assets that have physical substance. Examples of tangible assets include cash, accounts receivable, inventory, land, buildings / real estate, and machinery.Moneyzine EditorSeptember 21st, 2023
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The financial accounting term liability is used to describe the debt of a corporation that results from a transaction involving the transfer of an asset or the provision of a service. Liabilities are reported on a company's balance sheet.Moneyzine EditorNovember 6th, 2024
The financial accounting term depreciation is sometimes defined as a decline in tangible plant's service potential. Depreciation is a method of allocating the cost of a tangible asset in a systematic manner to those time periods that benefit from the use of the asset.Moneyzine EditorJanuary 16th, 2024
The term impairment in value is used to describe an event that suddenly and permanently lowers the value of an asset appearing on the company's balance sheet. When this occurs, companies will write-down the asset to the new market value. Accounts typically affected by impairment include goodwill as well as accounts receivable.Moneyzine EditorNovember 6th, 2024- The term valuation of intangible assets refers to the process of computing and recording their cost on the company's balance sheet. The capitalized costs of an intangible asset can include the purchase price as well as all costs required to ready the asset for its intended use.Moneyzine EditorNovember 6th, 2024
The financial accounting term badwill refers to a condition that arises when the price paid for identifiable assets is lower than their net fair market value. Badwill is more likely to occur when the purchaser acquires a bundle of assets, as is the case when one business acquires another.Moneyzine EditorNovember 6th, 2024
The term excess earning power refers to the difference between what a business earns and what is considered normal for an industry. Excess earning power is often considered when one business acquires another. These potential excess earnings are classified as an intangible asset, and typically included as part of goodwill.Moneyzine EditorJanuary 17th, 2024
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