You Might Be Worth More Than Your Books Indicate: Why You Need to Consider Goodwill in Accounting

You may have read reports of mergers or corporate sales where a company sells for more money than its net identifiable assets. The net identifiable assets is the sum total of a company’s assets minus its liabilities on its balance sheet. Think of sales like AT&T’s $85 billion purchase of Time Warner in 2018, or JetBlue’s $3.8 billion bid for Spirit Airlines in the summer of 2022. These prices exceeded the trading price of these companies on stock exchanges. Some might ask: Did the acquiring companies overpay? 

When a company sells at an unexpected premium, the excess purchase price is often due to an intangible asset known as business goodwill. Understanding the accounting treatment of business goodwill can help investors and entrepreneurs understand how to assess the fair market value of companies in particular industries, such as finance, retail, and manufacturing.

What is goodwill in accounting?

In the world of accounting, goodwill refers to extra monetary value that exceeds the net book value on a company’s balance sheet. The net book value is the value of all combined assets, with consideration for any accumulated depreciation. Some private companies have intangible assets that may not directly correlate with a fixed dollar amount. Yet they add obvious value to the company. Examples include a dedicated customer base, a strong industry reputation, and a committed workforce. While none of these come with a fixed price tag, they are valuable enough to acquiring companies that they can lead to net fair value adjustments—processes that reconcile the difference between an asset’s book price and its selling price—when such companies are sold.

All goodwill assets are intangible. However, not every intangible asset is a goodwill asset. The distinction between the two is:

• Non-goodwill assets. Possessions like intellectual property, domain names, patents, and copyrights tend to have quantifiable values and can be amortized over time. They also may have historical costs that help establish their value on a financial statement. That makes these intangible assets have a clear value on a balance sheet—one that isn’t tied to a buyer’s personal perception of the company.
• Goodwill assets. A goodwill asset—like brand reputation—has a less quantifiable price tag, yet it matters enough to affect a brand’s resale value. Crucially, these goodwill assets cannot be separated from the company. A business can sell off its patents; it cannot sell off its brand reputation. Despite this, the brand reputation adds value to the company, and thus enhances the company’s sale price.

5 Examples of goodwill

There are many ways that goodwill can bolster a company’s net assets, calculated by deducting total assets from total liabilities. They include:

• Talent. A company’s workforce talent counts as goodwill. If the workforce is continually innovative and competent, it improves the chances of long-term success and higher future cash flows.
• Company reputation. A company’s reputation helps it hire new talent, reach new markets, garner good feedback, and win trust.
• Customer loyalty. When calculating goodwill, many accounting firms gauge a company’s customer loyalty. Whether the brand has a rabid fan base or a low-key stable of customers who intrinsically trust it, loyalty adds value to the company.
• Trade secrets. Some companies have a deep working knowledge of their industry, harboring skills that the average worker might not know. This particularly applies to technical fields, like manufacturing and resource extraction, that have high barriers to entry.
• Brand recognition. Some brands are nearly synonymous with their industries. Think of Kleenex and tissues or Band-Aid and bandages with a sticky backing. When the public automatically associates your company with your industry, your company has monetizable goodwill.

How to calculate goodwill

Accountants, investors, and financial analysts use the following formula to calculate goodwill:

Goodwill = Cost of acquisition – Value of net assets

For instance, if a company sells for $2.75 million but its book assets only have a net value of $2.125 million, then its goodwill was worth $625,000 to the purchaser.

To find the monetary value of goodwill, you must start by tabulating the company’s tangible assets—such as cash on hand, real estate, machinery, and inventory—and its intangible assets like patents and copyrights. From there, subtract current liabilities, long-term debt, and residual equity (total equity minus liabilities, debt, and equity already held by preferred stockholders). You then arrive at the value of net assets. For goodwill to exist, these net assets must have a value less than the cost of acquisition. If the acquisition cost is the same or less than the value of net assets, the company does not enjoy monetizable goodwill.

Notably, goodwill does not typically appear as a line item on a balance sheet. Under generally accepted accounting principles (GAAP), speculation cannot influence the reporting of financial data. However, when a company sells for more than the value of its net assets, goodwill may appear on the acquirer’s balance sheet. The goodwill line item helps explain to investors and stakeholders why the acquirer paid a premium to buy the company.