Goodwill

From Financial Literacy Wiki

Goodwill is an accounting term used to reflect the portion of the book value of a business entity not directly attributable to its net assets; it normally arises only in case of an acquisition. It reflects the ability of the entity to make a higher profit than would be derived from selling the tangible assets. Goodwill is considered an intangible asset.

Goodwill will usually be higher in services- or people-oriented companies as the primary cash-generating business comes from people or contacts and not tangible assets like machines.

Negative goodwill is also possible in this case the purchase price is less than the net assets (at book value). This is usually when companies purchase loss-making companies.

The basic goodwill formula

• Goodwill = Purchase Price – Fair Market Value of Net Assets
• Fair Market Value of Net Assets = Net Tangible Assets + Write-up of Net Assets
• Net Tangible Assets = Assets – Target's Existing Goodwill – Liabilities

As can be seen, a merger destroys the target's "old" goodwill and creates "new" goodwill to appear in consolidated books. Net assets write-up is prepared through a qualified appraisal in a process known as a Purchase Price Allocation.