Definition: Goodwill is a company’s value that exceeds its assets minus its liabilities. In other words, goodwill shows that a business has value beyond its actually physical assets and liabilities. This value can be created from the excellence of management, customer loyalty, brand recognition, favorable location, or even the quality of employees. Anything that adds value to the company beyond its excess assets over liabilities is considered goodwill.
What Does Goodwill Mean?
Even though goodwill is technically considered an asset, it is not always reported on the balance sheet. Why not, because valuing a business is very subjective and can’t be measured easily or accurately.
For example, how much would you value a two-year-old company that distributes it products for free and has never made a penny of revenue? Not much, right? Well, Facebook thought Instagram was worth $1 billion. To other firms, Instragram might have only been worth $500 million. Who can put a specific value on a company like that? No one can.
This is why GAAP requires that goodwill can only be recorded when an entire business or business segment is purchased. An actual figure or dollar amount must exist in order to record and report it as an intangible asset on the balance sheet. Estimating the full amount is not allowed. Let’s take a look at an example.
Going back to our Facebook example, Instagram was purchased for $1 billion. Since Facebook purchased the entire company, it must record goodwill as the excess purchase price over the fair market value of Instagram’s assets.
Facebook can calculate the goodwill by subtracting the fair market value of all assets from the purchase price of the company. In essence, this is the amount that Facebook over paid for Instagram’s assets. This number is recorded in the general ledger, reported on the balance sheet as an intangible asset, and tested for impairment annually.