When looking to grow a business, having a full understanding of finances and account principles is very important. One accounting principle that is very important for all businesses, especially those that are looking to acquire businesses or make other capital investments, is goodwill accounting.
Goodwill is a relatively complex accounting principle that will affect millions of businesses of all sizes. This article will explain what goodwill accounting is and how to calculate it. You can also see how it will impact financial statements, and how to manage it to the advantage of the business.
What Is Goodwill Accounting?
Goodwill is the process of accounting for an intangible asset that occurs when a company buys another business. It also applies to when it makes a capital purchase or investment.
Money that makes goodwill = Amount in excess of purchase price – Value of assets and company liabilities.
When analyzing a company balance sheet, many typically consider this amount an intangible asset.
How to Calculate Goodwill
While goodwill accounting is a somewhat complex accounting principle, the process of calculating it is relatively simple. When a company decides to purchase an asset or liability they will come up with a full purchase price for what they want to buy. However, this many not necessarily equal the current value of the assets, less liabilities, of what is being acquired.
The Calculation Steps
- To complete goodwill accounting on something that your company buys, the first thing that will need to be done is determine the value of what you are buying. If you are buying cash, A/R, inventory, and other liquid assets, determining the value is somewhat easy. Cash should be valued at 100% while A/R and inventory should be sensitized to account for a small percentage of uncollectible debt or bad inventory. Some of the assets that can be more complicated to value would include capital equipment, intellectual property, and other items that are not easily liquidated. However, there are appraisal processes that can be done to properly account for this.
- After figuring out the asset value that you are buying, you will then need to figure out the liabilities of what you are buying. Liabilities should include any debt that you are taking on. These can include loans, accounts payable, accrued expenses, and anything else that will be an out of pocket expense.
- Once you have determined the asset and liability value, goodwill accounting is somewhat easy. For goodwill accounting you will need to start with the start with the purchase price, back out the value of the assets, and add back the value of the liabilities. For example, if you were to buy a company for $100, it has asset value of $80, and liabilities of $5, the goodwill accounting will calculate total goodwill of $25 ($100 – $80 + $5 = $25).
What Impact Does It Have on Financial Statements?
When you calculate goodwill, it can have an impact on financial statements a number of different ways.
- When making an investment that results in goodwill, it likely will not have an impact on the income statement or cash flow statement. However, it will have a big impact on your balance sheet.
- When going through the goodwill accounting process, you will record goodwill on the assets side of the financial statement. Goodwill will normally appear as an intangible asset. Also, it appears separately away from the core assets that the company bought. The value of the goodwill will then flow down to the total asset line and be accounted for 100% when determining the overall equity or net worth of the company.
- When a company has an audit following the acquisition of the company or assets, the accountants will typically provide reconciliation for the calculation of goodwill. This will also include a quick synopsis of the transaction that resulted in the goodwill.
- Whenever a business is going through the process of applying for a loan, raising capital, or going through any other credit review process, goodwill always adjusts. Companies typically will calculate tangible net worth of an organization and will use that metric as a means to test the overall strength of the firm.
What Is the Future Impact of Goodwill Accounting?
It is important to understand how goodwill will impact accounting in the moment that you make the acquisition. However, you also need to see how it will impact the future. Goodwill will continue to remain in place during the time that the asset remains in place as well. Many assets depreciate over time on a balance sheet and income statement. However, the goodwill balance that appears on the balance sheet of the company will remain constant. This happens until the asset is off the books completely through a sale.
- The one situation in which goodwill could change is if there is impairment of the asset. Most businesses will spend time on an annual basis considering the value of all of its assets. In most situations, this process will include determining whether assets have increased in value or decreased. If the asset decreases in value, the goodwill behind the asset will adjust negatively accordingly.
- Along with this, the business and accounting staff will have to create an impairment expense. This one will appear on the income statement. This can have a negative affect on the overall income and equity of the company. Yet, it will not have any impact on actual cash flow. Furthermore, since goodwill is not accounted for in its calculation, tangible net worth will not change at all.
To the Sum
In conclusion, one of the more complex accounting principles is goodwill accounting. Goodwill accounting comes into play when you buy an asset or business for more than the current value.
This article explained what goodwill accounting is and how to calculate it. We mentioned how it can impact the underlying financial statements. Also, you can now see how it can affect the future if there is an impairment of the underlying assets.
The images are from depositphotos.com.