How to Calculate Goodwill (A Step-by-Step Guide)

Goodwill is an intangible asset that represents the value of a business beyond its tangible assets.

It includes factors such as brand recognition, customer relationships, and reputation, which contribute to the company’s overall value. Goodwill is important to calculate for accounting purposes because it can have a significant impact on a company’s financial performance and potential for future growth.

Accurately valuing goodwill is essential for investors, analysts, and business owners who want to understand the true worth of a company and make informed decisions about buying or selling it.

Calculating goodwill is also necessary for financial reporting purposes, as it is required to be reported on a company’s balance sheet under generally accepted accounting principles (GAAP).

Overall, the calculation of goodwill is an important aspect of business valuation and accounting that provides valuable insights into a company’s financial health and potential for long-term success.

Let’s see how you can calculate goodwill.

Overview of the steps involved in calculating goodwill

1. Calculating goodwill involves several steps, including:

Determine the purchase price

This includes determining the amount of money paid by the buyer to acquire the company or its assets, including any liabilities assumed by the buyer.

2. Identify the components of the purchase price

Before calculating goodwill, it’s important to identify the different components that make up the purchase prices, such as brand, customer relationships, and reputation.

3. Calculate the fair market value of net assets

This involves determining the fair market value of the company’s tangible and intangible assets, such as property, equipment, and patents.

4. Subtract the fair market value of net assets from the purchase price

This step involves subtracting the fair market value of net assets from the purchase price to arrive at the value of goodwill.

5. Adjust for non-controlling interest

If there is any non-controlling interest in the company, the value of goodwill may need to be adjusted to reflect this.

6. Review and verify the calculation

It’s important to review and verify the calculation of goodwill to ensure accuracy and avoid common mistakes.

Goodwill Calculation Formula

G = PP – A – L

 

PP – Purchase price in acquisition

A – Fair Market Value (FMV) of Assets

L – Fair Market Value (FMV) of Liabilities

 

A = II + T

 

II – FMV of Identifiable Intangibles

T – FMV of Tangible Assets

 

Goodwill = unidentifiable intangible assets

Determine the Purchase Price

The purchase price is the amount of money that a buyer pays to acquire a company or its assets in an acquisition. It typically includes the fair market value of the company’s tangible and intangible assets, such as property, equipment, patents, and goodwill. In addition to these assets, the purchase price may also include any liabilities assumed by the buyer, such as outstanding loans or accounts payable.

To determine the purchase price, the buyer will usually conduct a thorough valuation of the company’s assets and liabilities. This may involve working with appraisers, accountants, and other professionals to determine the fair market value of each asset and liability.

It’s important to include all relevant costs and liabilities in the calculation of the purchase price. This may include transaction costs, such as legal fees and due diligence expenses, as well as any contingencies or earnouts that are part of the acquisition agreement. Failing to account for all relevant costs and liabilities can lead to an inaccurate valuation of the company and an incomplete understanding of the true cost of the acquisition.

III. Calculate the Fair Market Value of Intangible Assets

Typical intangible assets that can be indemnified in company acquisition are trademarks, customer relationships,s and technology (software). As they significant part in goodwill calculation, let’s see how to make a valuation of those assets separately.

FMV of Trademark

Valuing a trademark in purchase price allocation in order to come to Goodwill requires a systematic approach to ensure that the value of the asset is accurately assessed. There are several methods used for trademark valuation, including the following:

Relief from Royalty Method

Under income approach valuation, this method is based on the premise that a company would need to pay a royalty fee if it did not own the trademark. The value of the trademark is calculated by estimating the royalty fee that the company would have to pay to license the trademark from a third party.

Market-Based Methods

These methods involve analyzing the prices of similar trademarks in the market. The value of the trademark is determined by comparing the price of similar trademarks to the one being valued.

Cost-Based Approach

This method involves estimating the cost of developing or acquiring a similar trademark. This can include costs such as research and development, marketing, and legal fees.

When using the Relief from Royalty Method, the following steps are typically involved:

  • Estimate the hypothetical royalty rate that would be paid for the trademark if it were licensed from a third party.
  • Estimate the expected revenue generated by the trademark over a certain period.
  • Multiply the estimated revenue by the hypothetical royalty rate to arrive at the estimated value of the trademark.

It’s important to note that the method used for trademark valuation may depend on various factors, including the nature of the business, the industry, and the specific characteristics of the trademark being valued.

FMV of Customer relationship

When it comes to customer relationship valuation in goodwill calculation, there are several methods used, including the following:

Multi-Period Excess Earnings Method (MPEEM)

This method involves estimating the expected cash flows generated by the customer relationships over a period of time. The present value of these cash flows is then calculated to arrive at the estimated value of the customer relationships.

Replacement Cost Method

This method involves estimating the cost of acquiring new customers to replace the existing ones. The value of the customer relationships is then determined by calculating the difference between the cost of acquiring new customers and the cost of retaining the existing ones.

Option Pricing Method

This method involves treating customer relationships as call options, where the buyer has the right to exercise the option and receive the expected cash flows from the customer relationships. The value of the customer relationships is then determined by estimating the option price.

As the MPEEM is most usual, we will provide more info about this method. When using the MPEEM method, the following steps are typically involved:

  • Estimate the expected cash flows generated by the customer relationships over a period of time.
  • Estimate the discount rate that reflects the risk associated with these cash flows.
  • Calculate the present value of the expected cash flows using the discount rate.
  • Subtract the fair market value of the assets and liabilities from the purchase price to arrive at the residual value.
  • Allocate the residual value to the customer relationships based on their relative contribution to the expected cash flows.

It’s important to note that the method used for customer relationship valuation may depend on various factors, including the nature of the business, the industry, and the specific characteristics of

FMV of Technology

There are several methods used for technology valuation, including the following:

Replacement Cost Method

This method involves estimating the cost of developing or acquiring similar technology. This can include costs such as research and development, engineering, and design. The value of the technology is then determined by calculating the difference between the cost of developing or acquiring new technology and the cost of maintaining or upgrading the existing technology.

When using the Replacement Cost Method, the following steps are typically involved:

  • Estimate the cost of developing or acquiring similar technology including cost of salaries, operating expenses and usual service markup.
  • Determine the remaining useful life of the technology and any maintenance or upgrade costs required to keep the technology current.
  • Calculate the value of the technology by subtracting the estimated maintenance or upgrade costs from the cost of developing or acquiring new technology.
  • Adjust the calculated value of the technology for any obsolescence or functional problems that may affect its value.
Income based methods

These methods involve estimating the future income generated by the technology and calculating the present value of those future cash flows. This can be done using methods such as discounted cash flow analysis or capitalization of earnings. The value of the technology is then determined by the present value of the estimated future cash flows.

Market-Based methods

These methods involve analyzing the prices of similar technologies in the market. The value of the technology is determined by comparing the price of similar technologies to the one being valued.

III. Calculate the Fair Market Value of Tangible Assets

Here’s an explanation of how to determine their fair market value of some usual assets:

Property and plant

To determine the fair market value of the property, it is important to obtain an appraisal from a qualified appraiser. The appraiser will consider various factors such as location, condition, and age of the property to arrive at an estimate of the fair market value.

Equipment

The fair market value of equipment can be determined by either using the cost approach or the market approach. The cost approach involves estimating the cost of replacing the equipment with similar equipment at current market prices. The market approach involves analyzing the prices of similar equipment in the market.

Receivables

The fair market value of receivables is typically determined by analyzing their collectability. This can involve analyzing historical collection rates, assessing the creditworthiness of the customers, and estimating the time it will take to collect the receivables.

In addition to these methods, it is important to consider any relevant factors that may affect the fair market value of the assets. These factors may include economic conditions, changes in market demand, and any legal or regulatory changes that may affect the assets.

Subtract the Fair Market Value of Net Assets from the Purchase Price

Once you have all components of Purchase Price, except Goodwill, you need just to substrate the FMW of net Assets and get a Goodwill Value. As such, goodwill represents unidentifiable intangible assets.

Adjust for Non-Controlling Interest

When a company acquires another company, it may not acquire 100% ownership of the company. In some cases, the acquired company may have minority shareholders or non-controlling interests. In these situations, it’s important to adjust the value of goodwill to reflect the non-controlling interest in the acquired company.

The adjustment to goodwill is necessary to accurately reflect the true value of the company. Without the adjustment, the value of goodwill would be overstated, leading to inaccurate financial statements and misleading information for investors and stakeholders.

The adjustment is typically made by multiplying the total goodwill by the percentage of the company that is owned by the acquiring company. The resulting amount is then reduced by the value of the non-controlling interest in the acquired company. The adjusted goodwill amount is then recorded on the balance sheet as an intangible asset.

For example, let’s say Company A acquires 80% ownership of Company B for a purchase price of $10 million. The fair market value of Company B’s net assets is determined to be $8 million. Therefore, the excess purchase price of $2 million represents goodwill. However, Company B has a 20% non-controlling interest.

To adjust the value of goodwill, Company A would first multiply the total goodwill amount by its percentage ownership of Company B (80%).

Goodwill adjustment = $2 million x 80%

Goodwill adjustment = $1.6 million

Then, Company A would subtract the value of the non-controlling interest from the adjusted goodwill amount.

Goodwill adjustment – Non-controlling interest = Adjusted goodwill

$1.6 million – $0.4 million = $1.2 million

Testing on impairment

Over time, the value of goodwill may change due to changes in the company’s operations, market conditions, or other factors. If the fair value of the reporting unit, which includes goodwill, has decreased, then the carrying value of the goodwill may exceed its fair value. In this case, an impairment loss must be recognized in the income statement to adjust the value of goodwill to its fair value.

Under GAAP (such as IFRS or US GAAP), goodwill is considered to have an indefinite useful life, which means it is not amortized like other intangible assets. Instead, it is subject to an annual impairment test to determine if its value has decreased below its carrying value.

GAAP requires companies to test goodwill for impairment at least annually or whenever there is a triggering event that may indicate that the fair value of the reporting unit has decreased. This is because goodwill is an intangible asset that represents the excess purchase price paid for a company over the fair market value of its net assets, and its value may change over time.

Goodwill FAQ

Q: What is goodwill?

A: Goodwill is an intangible asset that represents the excess purchase price paid for a company over the fair market value of its net assets.

Q: How is goodwill calculated?

A: Goodwill is calculated by subtracting the fair market value of a company’s net assets from the purchase price paid for the company.

Q: Why is goodwill important?

A: Goodwill is important because it represents the value of a company’s reputation, brand, customer base, and other intangible assets that cannot be easily measured. Goodwill can have a significant impact on a company’s financial statements and can be an important factor in mergers and acquisitions.

Q: How is goodwill tested for impairment?

A: Goodwill is tested for impairment at least annually or whenever there is a triggering event that may indicate that the fair value of the reporting unit has decreased. The impairment testing involves comparing the carrying value of the goodwill to its fair value. If the carrying value exceeds the fair value, then an impairment loss must be recognized in the income statement.

Q: Can goodwill have a negative value?

A: Yes, goodwill can have a negative value if the fair value of a company’s net assets is greater than the purchase price paid for the company. In this case, the negative goodwill is recognized as a gain on the income statement.

Q: What is the difference between purchased goodwill and internally generated goodwill?

A: Purchased goodwill is the goodwill that arises from an acquisition, while internally generated goodwill is the goodwill that arises from a company’s own operations or activities. Purchased goodwill is recognized as an intangible asset on the balance sheet, while internally generated goodwill is not recognized as an asset.

Q: How does non-controlling interest affect goodwill?

A: Non-controlling interest affects goodwill by requiring an adjustment to the value of goodwill to reflect the true value of the company. The adjustment is typically made by multiplying the total goodwill by the percentage of the company that is owned by the acquiring company and then reducing the resulting amount by the value of the non-controlling interest.

How to Calculate Goodwill (A Step-by-Step Guide)