Goodwill is a type of intangible business asset. It is defined as the difference between the fair market value of a company's assets (less its liabilities) and the market price or asking price for the overall company. In other words, goodwill is the amount in excess of the company's book value that a purchaser would be willing to pay to acquire it. "For example, a happy combination of advertising, research, management talent, and timing may give a particular company a dominant market position for which another company is willing to pay dearly," Charles T. Horngren and Gary L. Sundem explained in their book Introduction to Financial Accounting. "This ability to command a premium price for the total business is goodwill."
The sale of a business may involve a number of intangible assets. Some of these may be specifically identifiable intangibles—such as trademarks, patents, copyrights, licensing agreements—that can be assigned a value. The remaining intangibles—which may include the business's reputation, brand names, customer lists, unique market position, knowledge of new technology, good location, and special skills or operating methods—are usually lumped into the category of goodwill. Although these factors that contribute to goodwill do not necessarily have an assignable value, they nonetheless add to the overall value of the business by convincing the purchaser that the company will be able to generate abnormally high future earnings.
Although goodwill undoubtedly has value, it is still an intangible asset and as such is not recorded on a company's books. In fact, many companies use a value of one dollar for goodwill in their everyday accounting procedures. "There are many owners who could obtain a premium price for their companies. But such goodwill is never recorded," Horngren and Sundem wrote. "Only the goodwill arising from an actual acquisition with arm's-length bargaining is shown as an asset on the purchaser's records." The acquisition price determines the amount of goodwill that is recorded following the purchase of a company. For example, if a small business with assets of $40,000 is purchased for $50,000, then the purchaser records $10,000 of goodwill.
In general, determining the sales price of a business begins with an assessment of its equity, which includes tangible assets such as real estate, equipment, inventory, and supplies. Then an additional amount is added on for intangible assets (sometimes called a "blue sky" amount), which may include things like patent rights, a trade name, a noncompete clause, and goodwill. Experts note that in small business sales, the combined total of "blue sky" additions should rarely be more than a year's net income, because few purchasers are willing to work longer than that for free. For public companies, the amount of goodwill is often dependent on the vagaries of the stock market. Since the share price determines the purchase price, the value attributed to goodwill may fluctuate wildly during the course of an acquisition.
Standard accounting procedures state that, following an acquisition, the purchaser should amortize goodwill over a period of 15 years using the straight-line method. In other words, one-fifteenth of the original amount attributed to goodwill is deducted each year. Since this writeoff period is longer than that required for most tangible assets, it is usually a good idea to allocate as much of the purchase price as possible to business equipment. The shorter depreciation period would enable the purchaser to accelerate deductions and thus achieve earlier tax savings.
Over the years, there has been some dissatisfaction expressed with the way that goodwill is handled for accounting purposes. First, since goodwill is sometimes a huge component of a company's acquisition price (particularly in the case of large public companies), the amortization of goodwill can have a significant negative effect on the purchaser's net income. Second, the treatment of goodwill under U.S. law differs from many other countries, which sometimes puts American companies at a disadvantage in international mergers and acquisitions.