When a company or small business is acquired, to evaluate the fair market value the buyer will look at the company's intangible assets, the goodwill, on top of their tangible assets (such as equipment and stock) to determine the price at which the business is sold. Intangible assets can include a variety of factors, such as the loyalty of clients, brand value, the expertise of their employees, or other intangible assets. All of these are subsumed in the overall cost of the business during acquisition as goodwill.
Examples of goodwill
- Brand value: If travel services Company A is buying Company B, Company B's brand - so if it eg is one of the main travel service providers - has to be taken into account when determining the sales price of Company B.
- Customer loyalty: In the previous example, if Company B had a loyal customer base that always books their holidays with them, this would be an intangible, yet important asset. This means it would have to be considered when determining the price of the acquisition.
- Staff talent: If Company B's workforce is a talented and driven team, this will be a significant asset to Company A when buying. While being an intangible asset, driven and skillful employees are a crucial success factor in (small) businesses.
Recording goodwill in financial statements
(Small) business owners might want to record their intangible assets on financial statements (eg balance sheet). As they are intangible, they need to be logged as noncurrent assets. Noncurrent assets refer to assets that are long-term investments and whose full value cannot be realized at this point. During an acquisition, the (small) business owner and buyer will record all tangible assets as well as the goodwill on top. The difference is accounted for under goodwill on the financial statement.
Goodwill in accounting
When companies buying up other companies are analyzing the current value of each of their acquisitions, this tests (goodwill) impairment and is called “impairment testing”. This is done to evaluate whether the companies bought up are still worth the value entered on the balance sheet. If the goodwill value remains the same or increases, nothing needs to be done. If the goodwill has declined, the amount of decline needs to be recorded in the balance sheet and possibly declared as an impairment expense.