Definition of Goodwill
In accounting, goodwill is an intangible asset associated with a business combination. Goodwill is recorded when a company acquires (purchases) another company and the purchase price is greater than 1) the fair value of the identifiable tangible and intangible assets acquired, minus 2) the liabilities that were assumed.
Goodwill is reported on the balance sheet as a long-term or noncurrent asset. Since 2001, U.S. companies are no longer required to amortize the recorded amount of goodwill. However, the amount of goodwill is subject to a goodwill impairment test at least once per year. (Beginning in 2015, private companies may opt to amortize goodwill generally over a 10-year period and thereby minimize the cost and complexity involved with testing for impairment.)
Outside of accounting, goodwill might be referring to some value that has been built up within a company as a result of delivering amazing customer service, unique management, teamwork, etc. However, this goodwill is unrelated to a business combination and cannot be recorded or reported on the company's balance sheet.
Example of Goodwill
Let's assume that Company A acquires Business X for $5 million based on Business X's annual net income X 10. The fair value of Business X's identifiable assets was $4 million and its liabilities were $1 million. Therefore, Company A is paying $5 million for identifiable assets and liabilities having a value of $3 million ($4 million of assets minus $1 million of liabilities). When Company A records the transaction, it will:
- Debit various asset accounts for $4 million
- Credit various liability accounts for $1 million
- Credit Cash for $5 million
- Debit Goodwill for $2 million
The $2 million, that was over and above the fair value of the identifiable assets minus the liabilities, must have been for something else. We refer to that something else as goodwill.