Business goodwill is defined as an intangible asset that increases a business’s value above and beyond its current market value.
Business goodwill arises when one company is acquired by another at a premium, above market or book value price.
Goodwill can be attributed to a number of factors, including the company’s well-known brand name, outstanding customer relations, a solid customer base, any patents or unique technology, proprietary processes, trade secrets, licenses, custom software systems, training programs, proprietary databases, published articles, or any of a number of other intangible assets not recorded as such on the company’s books.
Types of Goodwill
Generally, goodwill is evaluated by a business’s ability to generate superior income. For the purposes of small business valuation, two types of goodwill are common: institutional goodwill and professional practice goodwill.
Institutional goodwill – applies to the business and its position in the market, as well as how it is able to serve its customers.
Professional practice goodwill- applies to professional services, such as doctors, lawyers, architects, CPAs, and engineers. Professional practice goodwill is separated into two components: practitioner goodwill (the skill, reputation, and reliability of the practitioner), and practice goodwill (the reputation, location, and operating procedures of the practice).
Accounting for Business Goodwill
Business Goodwill is recorded generally only if it is acquired as a part of an acquisition or purchase. In this case, goodwill (calculated by subtracting the fair market value from the purchase price) is recorded on the balance sheet in the assets section as a non-current asset. Until 2001, it was required that business goodwill be amortized. Today, companies can elect to not amortize goodwill, but must instead undergo annual impairment tests.
Because business goodwill is subjective, it can be difficult to determine what the dollar amount of a company’s goodwill is. It is not uncommon for the acquiring company to overvalue or undervalue goodwill. An overvaluation of goodwill is bad news for shareholders, particularly if and when the acquiring company needs to write down goodwill. In this case, share values are likely to drop also.
Although goodwill is difficult to price, it is an important component that makes a company more valuable than its tangible assets would suggest. It is also a very important aspect of the negotiations when buying or selling a business because of the possible tax implications for both parties.