Goodwill is the excess of the acquisition cost over the fair market value of the net assets. This intangible asset arises when a company acquires another company and pays a premium above the fair market value of the target company.
For example, company X paid Rp3 trillion when it acquired company Y, which had a net asset of Rp2.8 trillion in fair value. In this case, an excess of Rp. 200 billion represents goodwill.
Several reasons explain why goodwill arises, and companies are willing to pay more than the book value of the target company.
- Financial statements do not fully reflect the value of the target company. Some items make the company values, but do not appear on the financial statements. Examples are established distribution systems, reputation, brands, customer loyalty, and expertise in research and development. However, the company did not present them because of the limitations of the accounting method.
- The acquisition creates value for the acquirer, regardless of the value of the target company. By buying another company, the acquirer can increase its position against competitors (e.g., increase market share and market power) or provide benefits through synergy.
Types of goodwill
Two kinds of goodwill are:
- Economic goodwill
- Accounting goodwill
Accounting goodwill is related to acquisitions, which appears when the purchase price exceeds the fair value of the net assets (total assets minus total liabilities) of the target company. The company presents it in the financial statements, as applicable accounting standards.
Meanwhile, economic goodwill does not appear on the company’s balance sheet and is not related to acquisitions. It is related to the company’s performance and future prospects. It can arise from reputation, brand equity, and brand loyalty, which makes a company valuable.
Accounting journal entries in the financial statements
The company recognizes and capitalizes accounting goodwill in its financial statements, both under US GAAP and IFRS standards. Every year, because it has an infinite life, the item is not amortized but is tested for impairment. Typically, companies choose to amortize it for 10 years.
If an impairment occurs, the company reports an impairment loss in the current period in its profit and loss statement. Impairment losses reduce current net income and also reduce total assets.
Please note, impairment losses are non-cash items.
Goodwill in a simple calculation
To calculate goodwill, we add the fair value of the target company’s assets and liabilities to the acquirer’s fair value of assets and liabilities. Price excess above the fair value of net assets is presented in a goodwill account.
For example, company A bought company B for Rp2.5 billion, total assets of company B amounted to Rp3.5 billion and total liabilities of Rp1.5 billion.
From this fact, the net asset value of company B is Rp2 billion (Rp3,5-Rp1,5). Meanwhile, goodwill is equal to IDR 0.5 billion = (IDR 2.5 -IDR 2).
In its balance sheet, company A debits goodwill of IDR0.5 billion and assets of IDR3.5 billion . Furthermore, the company credits liabilities in the amount of Rp1.5 billion and cash in the amount of Rp2.5 billion. Thus, the total assets of company A will increase by Rp1.5 billion (Rp3.5 + Rp0.5-Rp2.5).