What Is Goodwill in Accounting? (Definition and How to Calculate)

By Indeed Editorial Team

Published November 30, 2021

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If you work in accounting, you may calculate the goodwill of a company. This occurs when a company acquires or merges with another business. Knowing more about goodwill and how to calculate it can help improve your accounting skills and knowledge. In this article, we answer the question, "What is goodwill in accounting?" discuss the different types of goodwill and what to consider when calculating it, and explain how to calculate goodwill using three different methods.

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What is goodwill in accounting?

When a company acquires or merges with other businesses, they often account for goodwill values that represent intangible assets when purchase prices exceed fair market values. Goodwill occurs when the purchase price for a subsidiary is higher than the total fair values of both its tangible and intangible assets and the liabilities the purchasing company assumes in the transaction. Here are some examples of goodwill:

  • reputation

  • permits and licenses

  • patents

  • copyrights

  • brand identity

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Types of goodwill

There are different types of goodwill you can consider, such as the following three:

  • Business goodwill: Business goodwill is the intangible assets a business has. This can include assets, such as market share, customer base, position, or brand reputation.

  • Inherent goodwill: Inherent goodwill refers to a business' value above the fair value of its net identifiable assets. They generate this internally, typically from their positive or negative reputation.

  • Purchased goodwill: This occurs when a company purchases subsidiaries above the fair value of identifiable net assets. This allows the purchasing company to include the goodwill as an asset on their balance sheet.

What to consider when you calculate goodwill

When you're calculating goodwill, it's important to consider the following elements:

Consideration payment

Your contract may include consideration payments, which is an exchange of services or goods that are of value to both parties. This can include money, stock, or an intangible asset, such as a customer base. No matter what the type of payment is, it meets the standards of contingency that both parties establish during the acquisition or merger.

Non-controlling interest

Non-controlling interest, also known as minority interest, is when a shareholder owns less than 50% of a company's shares. This means they can't control any of the decisions the company makes, such as the decision to purchase or sell stocks. When this occurs during an acquisition or merger, the purchasing company subtracts this value from the net identifiable assets. Then, the subsidiary can choose to continue its ownership of these liabilities or include them as part of the business agreement.

Net identifiable assets at acquisition

Net identifiable assets are the assets the purchasing company gains during the merger or acquisition. This includes tangible and intangible assets. As assets are the earnings the purchasing company is receiving, they deduct all liabilities and non-controlling interest first, then note the net identifiable assets on their balance sheet.

Impairment of goodwill

Goodwill impairment occurs when the fair value of goodwill goes lower than the original fair value at the time of the merger or acquisition. This typically happens when the intangible or tangible assets the purchasing company is gaining no longer meet the financial expectations they had initially. The purchasing company notes this impairment on their income statement as a loss and reduction to the goodwill account.

Methods for goodwill valuation

There are three methods for calculating goodwill, and they are:

Purchase of average profit method

This method takes the average profit for a certain time period prior to the acquisition, such as two years, and multiplies it by the number of years the purchasing company expects to acquire this amount. Here is the formula to calculate goodwill using the purchase of average profit method:

Goodwill = average profit x years of acquisition, where:

  • Average profit = the subsidiary's total profits for a specified time period

  • Years of acquisition = the number of years the purchasing company owns the subsidiary

Purchase of weighted average profit method

This method is similar to the average profit method, but it uses a weighted average instead. A weighted average considers the importance of each number in the data set. For example, a company may value certain assets higher than others. This valuation method uses the formula:

Goodwill = weighted average x years of acquisition, where:

  • Weighted average = the weight of all average profits for a specified time period

  • Years of acquisition = the number of years of ownership

Capitalization method

This method uses the normal return rate and net tangible assets of the subsidiary to evaluate the difference between capitalizing on the average net profit companies expect. You can use this formula to calculate goodwill using the capitalization method:

Goodwill = capitalized average net profit - net tangible assets, where:

  • Capitalized average net profit = the capitalized profit from dividing the average profit times 100 by the normal rate of return

  • Net tangible assets = the total tangible assets minus the total liabilities

How to calculate the goodwill of a company

To calculate the goodwill of a company using the different valuation methods, follow the steps below:

Calculate goodwill with purchase of average profit method

To calculate goodwill with the purchase of average profit method, follow these steps:

1. Find the average profit of the subsidiary

To find the average profit of the subsidiary, add all profit values for the periods agreed upon by both parties. For example, assume both parties agree to average the profits from the last four years. If the total profits are $50,000, $182,000, $165,000, and $136,000 for the first, second, third, and fourth years respectively, this results in an average profit of $133,250 after you add the profits together and divide them by four.

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2. Determine the number of years of acquisition

The number of years of acquisition results from an agreement between both parties during the acquisition or merger. It can also be the amount of time the purchasing company had ownership of the subsidiary. For example, if the purchasing company acquired the subsidiary three years ago, you'd substitute "years of acquisition" in the formula with the number three.

3. Apply the values to the formula

After you determine the subsidiary's average profit and the number of years of acquisition, you can apply these numbers to the formula below. For instance, assume a purchasing company calculates the average profit as $600,000 and agrees that the current ownership period amounts to seven years. You can input these numbers into the below formula for an approximate goodwill value of:

Goodwill = average profit x years of acquisition =

Goodwill = ($600,000) x (7) = $4,200,000

Find goodwill value using the weighted average profit

To calculate the goodwill of a company using the weighted average profit, follow these steps:

1. Find the weighted average of net profits

Find the weighted average of net profits for each period before the acquisition by multiplying each year's earnings by the weighted factor you assign. For instance, suppose a purchasing company wants to determine the weighted average net profit for three years previous to its ownership of the subsidiary. Assuming the company's total weighted earnings are $900,000 and its total years are three, the company's accountants divide these numbers to get a weighted average net profit of $300,000.

2. Determine the number of years of ownership

Once you know the weighted average net profit, determine the time period of acquisition of the subsidiary. To do this, estimate the number of whole years the parent company owned its subsidiary. For example, if the company owned its subsidiary for 8.6 years, the total years of ownership would be eight.

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3. Use the average profit formula

After evaluating the weighted average profits and the total years of acquisition, use the formula below to determine the average profit. For instance, you calculated a weighted average net profit for a purchasing company at $150,000 and estimated nine total years of ownership. Using the average profit method to find the goodwill value, your formula and answer look like this:

Goodwill = weighted average profit x years of acquisition =

Goodwill = ($150,000) x (9) = $1,350,000

Use the capitalization method to evaluate goodwill

To calculate goodwill of a company with the capitalization method, use the following formula and steps:

1. Find the capitalized average net profit

Find the capitalized average net profit by multiplying the average profit by 100 then dividing it by the normal rate of return. For example, assume a purchasing company uses this method and calculates an average profit of $900,000 for a normal rate of return of 20%. When you input these numbers into the formula, it looks like this: ($900,000 x 100) / 0.20 = $450,000,000.

2. Determine the net tangible assets

The net tangible assets represent the total value of a company after you subtract all its intangible assets from its tangible assets. For instance, you have $70,000 in tangible assets with $15,000 in intangible assets. When you subtract the intangible assets, you're left with $55,000 as your net tangible asset value.

3. Calculate goodwill using the formula

Once you know the capitalized average net profit and the net tangible assets, you can input the numbers into the formula below. For instance, if you have $500,000 in capitalized average net profits and $150,000 in tangible net assets, your formula and answer look like this:

Goodwill = capitalized average net profit - net tangible assets

Goodwill = ($500,000) - ($150,000) = $350,000

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