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When you feel good about something, you’re usually willing to pay more for it. It’s the same concept when one company is considering acquiring another. As a result, acquiring companies are often willing to pay a premium on the transaction. This extra is known as goodwill in accounting: the excess amount paid over the net worth of the acquired company.

Goodwill tends to represent the long-lived intangible assets of the acquisition of one business by another. The company’s best-selling brand products or its long library of intellectual property. Whether this goodwill actually matches the premium paid is what many companies wonder long after the deal is done.

How to Calculate Goodwill in Accounting

Calculating goodwill is tricky, because intangible assets are not easily valued. It involves assessing the fair market value based on the assets and liabilities of the acquired business. The formula is simple, but involved:

Goodwill = P – (A – L)

  • P = Purchase price of the target company
  • A = Fair market value of assets
  • I = Fair market value of liabilities

It is important to note that the value of goodwill may vary depending on when it is evaluated. If a company has strong investor sentiment behind it, goodwill can be high. If the company is in difficulty, the valuation of goodwill may be low. Either way, it’s almost always priced at a premium.

Examples of goodwill

Goodwill is anything that has an intangible value that the business can claim as an asset in an acquisition. Any number of intangible assets may constitute goodwill; some of the most common include:

  • Intellectual property. Trademarks, Patents and Similar Deployable Intangibles.
  • Brand recognition. The influence of a brand or company on its competitors in the market.
  • Company reputation. The positive feeling affiliated with a company or brand.

Many times, goodwill can amount to a substantial sum. For example, a company like Coca-Cola (NYSE: KO) enjoys significant brand recognition. Similarly, a company like the Walt Disney Company (NYSE: DIS) owns thousands of intellectual property titles.

These are two examples of assets, since they ultimately contribute to companies’ ability to generate income. If they were acquired, their goodwill would be substantial, resulting in a much higher premium.

Acquisition

Goodwill tends to show up on a balance sheet after an acquisition as the premium one company pays for another. For example, software giant Salesforce.com (NYSE: CRM) acquired messaging startup Slack in 2020, pay more than 10% above Slack’s last high rating and more than 60% above its market capitalization at the time. This premium represents goodwill.

Write-downs

When a company overpays for an acquisition or the deal fails, it can lead to goodwill impairment. For example, in 2019 Kraft Heinz Co. (NASDAQ: KHC) made headlines when it recorded a goodwill impairment of $7.3 billion— the largest in more than a decade. The impairment effectively represents a revaluation of the market value of the intangible asset in accordance with generally accepted accounting principles (GAAP).

Other intangible property

It is important to realize that goodwill is distinct from other intangible assets in that it is specifically associated with the acquisition.

What does goodwill say to investors?

In acquisition, goodwill represents the acquirer’s confidence in the business or asset it is buying. For example, if company ABC has a valuation of $20 billion and company XYZ acquires it for $22 billion, that means company XYZ thinks it is worth that much or soon will be. Often, this premium is represented relative to the book value of the target company.

Goodwill can also tell a lot about the performance of a company’s intangible assets. For example, if a company claims impairment of goodwill on a brand under its umbrella, it signals to investors that the impaired brand is not performing well. This, in turn, provides additional context for other financial data on the income statement or balance sheet.

The problem of depreciation and depreciations

Goodwill is inherently an amount greater than the fair market price. This means that it is subject to depreciation if it does not meet this premium within a certain period of time. However, goodwill impairments are often controversial. They involve many intangible and non-demonstrable assessments and are forward-looking. It is therefore very easy to overestimate goodwill, a situation that leads to impairment of goodwill.

Impairment of goodwill occurs when the value of an intangible asset falls below its historical cost. In effect, this means that the cost paid to acquire the asset was not worth it. Companies must prove this either through the income approach or the market approach to asset valuation. The net difference in the new value is the depreciation and the amount of the write-down.

Impairments may result in a decline in the value of the business based on a fair revaluation of goodwill. This is a situation that impacts shareholders and creates irregularities in financial reporting. And while writedowns are common and often relatively innocuous, large writedowns or ones that occur long after acquisition tend to anger investors.

Goodwill is a tricky concept

Intangible assets are difficult to value, especially in a volatile market. For many companies, goodwill is not just what they think an acquisition target is worth: it is the premium they need to pay to beat its competitors. This becomes paradoxical: a company pays above fair market value to acquire an asset that it could then revalue at a lower value closer to its real value.

Of course, not all goodwill acquisitions end in impairment. Many end in substantial cash flow for the acquiring company. They capitalize on the acquirer’s intellectual property, strong reputation or brand recognition and use them to bolster their revenue. After all, that’s the point of an acquisition. To advance your investment education, register for the U investment e-letter below. These daily newsletters provide stock tips, financial news and more!