Businesses will often pay a premium to acquire another company, handing over more money than the company being purchased is worth. Why pay more than the fair market value? In a word, goodwill.
We’ll explain how goodwill is defined, how it’s handled on a company’s financial statements, and outline the pros and cons of goodwill for investors. We'll also provide examples of how goodwill has affected recent business transactions.
Overview
What is goodwill?
Goodwill is an intangible asset that represents the value of a brand, its reputation, patents, specialized workforce, customer service, or possible synergies from the acquisition.
When one company acquires another, it might pay more than the fair market value of the company being acquired. The reason often is that the acquiring company can add goodwill as an asset.
Calculating goodwill is generally a straightforward exercise. You can calculate goodwill as follows:
Company's purchase price - fair market value of assets and liabilities = Goodwill acquired.
For example, suppose Company A pays $1 million for Company B, which has $750,000 in cash holdings, inventory, accounts receivable, and assets. The amount of goodwill acquired by the purchase of Company B is $250,000.
Accounting for goodwill
Accounting for goodwill
Even though it’s an intangible asset, goodwill must be carefully recorded on a company’s financial statements. It generally appears as a non-current asset (meaning it's expected to last more than one year) on a balance sheet.
Because its value isn’t expected to dwindle over time, it’s important to note that goodwill is no longer amortized under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). Instead, both sets of accounting standards require that goodwill be tested annually for impairment and its value adjusted as needed.
A company can also be viewed as having negative goodwill when the purchase price for an acquired company exceeds its assets.
Pros and cons
Pros and cons of goodwill
The idea of goodwill has become increasingly common in a modern economy where creative services are expanding faster than traditional businesses, such as manufacturing and retail.
The bottom-line figure on a balance sheet doesn’t always accurately reflect the value of a company. Goodwill can balance the scales to ensure that intangible assets are part of the equation.
Investors, however, should consider the amount of goodwill on balance sheets before becoming too committed to a particular company. Gauging the value of goodwill is a subjective exercise, and goodwill isn’t always guaranteed to increase.
General Electric (GE 3.25%), for example, was forced to write down $22.1 billion in goodwill in 2019 after its poorly thought-out 2015 acquisition of power and grid units owned by Alstom (ALSMY 1.56%).
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Examples
Examples of goodwill
As tech-related companies have become integral parts of the economy, mergers and acquisitions have become common -- and with them, goodwill has been included in the balance sheets. Three examples stand out:
- Google and YouTube (2006). Before it became part of Alphabet (GOOG -0.28%)(GOOGL -0.29%), Google acquired video-sharing channel YouTube for $1.65 billion. At the time, YouTube had few tangible assets, so much of the value involved in the stock-for-stock purchase was considered goodwill.
- Disney and Pixar (2006). The same year as the YouTube acquisition, Walt Disney (DIS 0.74%) bought Pixar, the film animation studio that had created beloved hits like Toy Story and Finding Nemo. Pixar’s intellectual property, creative and talented workforce, and potential synergies with Disney’s entertainment empire made up a large part of the $7.4 billion purchase price.
- Microsoft and LinkedIn (2018). After watching social media giants like Facebook (META 0.53%) and Twitter gain enormous audiences, Microsoft (MSFT 0.07%) jumped into the social media space with its $25 billion acquisition of LinkedIn. More than $16 billion of the transaction was attributed to goodwill.
