Do You Know What Goodwill Is?
I have a client who was discussing the value of her business with a family member. The family member asked her why there was no Goodwill on her balance sheet – that surely her business value would be higher if she were to include that. She posed that question to me and in the following discussion I came to realize that for many people outside of the accounting world, the idea of Goodwill, where it comes from and how to include it on your financial reports, is not very clear.
What is Goodwill?
Investopedia: Goodwill is an intangible asset associated with the purchase of one company by another. Specifically, goodwill is recorded in a situation in which the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets purchased in the acquisition and the liabilities assumed in the process. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology represent some examples of goodwill.
Wikipedia: Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business. Goodwill represents assets that are not separately identifiable. Goodwill does not include identifiable assets that are capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability regardless of whether the entity intends to do so. Goodwill also does not include contractual or other legal rights regardless of whether those are transferable or separable from the entity or other rights and obligations. The goodwill amounts to the excess of the “purchase consideration” (the money paid to purchase the asset or business) over the total value of the assets and liabilities. It is classified as an intangible asset on the balance sheet, since it can neither be seen nor touched.
What is an intangible asset – and what other kinds of assets are there?
Intangible assets are those that are non-physical, but identifiable. You can describe it and it is real, but you can’t pick it up and move it to another room. Most assets are tangible – meaning they are physical assets, things you can touch. Tangible assets include cash, office furniture, production assets (for manufacturing, like mixers, bagging equipment, tractors), and things like money that other people owe your business – loans you have made or trade receivables – money your customers owe you.
Goodwill is not the same as other intangible assets. Goodwill is a premium paid over fair value during a transaction and cannot be bought or sold independently. Other intangible assets include things like patents and licenses and can be bought or sold independently.
There are accounting rules related to the ongoing treatment of goodwill on your balance sheet – impairment – amortization – but that is not what this article is about – you can learn the correct accounting treatment when you get to the point of recording goodwill on your balance sheet. This article is intended to help business owners understand how they create goodwill, what it is and why they may not actually be able to “see” it in the financial reports.
When does goodwill show up on a balance sheet (and when does it not)?
Goodwill only appears on your balance sheet if you buy it, by buying an existing business. For all of you who have started a business and built it into a successful company with employees, returning and loyal customers, products and services – your company most likely has goodwill, but your financial reports will never include it. You won’t know until you sell your business just how much goodwill you have built.
Goodwill is essentially the difference between the value of your business as an operating company and the value of the tangible assets your business owns. I’ll use my client’s business as an example. As a service business, she does not have a lot of tangible assets – there is no inventory. Her customers owe her money (Accounts Receivable), and she has a bunch of laptops and desks. That’s about all that is in the asset section of her balance sheet – not worth much. But if she were to sell her business, she would never sell for the value of her assets – her business has a strong reputation and is a leader in her industry. Her business has an extensive client list – many of which have been clients for years. The business has many very experienced employees who also perform services for her clients. The business has a method of serving clients that is unique within the industry. All of this added together is Goodwill.
If she were to sell her business (it’s not for sale), the buyer would have goodwill on the balance sheet.
Is goodwill the same thing as blue sky?
These terms are similar but are not really identical. Both represent unrealized value in a business. The term blue sky is often used to describe a larger unknown future value – some business professionals tend to consider blue sky to be the same as pie in the sky – something that is very unlikely to be realized. Goodwill is a standard accounting term that the industry has accepted to fill the gap between a purchase price of a business and the tangible asset value. “Blue sky” is an informal term that means, according to Merriam-Webster, “having little or no value” and “not grounded in the realities of the present.” Blue sky is what business owners hope will be realized, goodwill represents what they have built through hard work, planning, and successful execution.
What creates goodwill?
Goodwill is created by running a successful business. Customer loyalty, brand reputation, and other non-quantifiable assets count as goodwill. A company’s record of innovation and research and development and the experience of its management team can also be goodwill. Other examples of goodwill include; value that has been built up within a company as a result of delivering amazing customer service, unique management, the company’s reputation, size and loyalty of the customer base, number of years in business, market penetration and brand awareness, or any intangible situation in a business which gives the business some competitive advantage. Goodwill is not necessarily specific and identifiable but is the accumulation of successfully running a competitive and viable business.
Why you want goodwill – even if it is invisible.
As a business owner, the knowledge that you are building goodwill is the knowledge that your business will be worth money to someone in the future, you intentionally develop aspects of your business that will be valuable to a new owner – aspects of your business that are worth money even without your participation. The amount of goodwill that you build will not be something you can measure by putting it on your balance sheet as you build it – it won’t be measured or even fully evident until the day you sell your business.
Not all goodwill adds value to your business. There is such a thing as personal goodwill that does not have external value. As a business owner, you probably have personal goodwill as well as business goodwill – or you may only have personal goodwill. Personal (or professional) goodwill is linked to individual business owners and their abilities to generate future income. It often attaches to a professional person because of confidence in that person’s skills and credentials.
An example of personal goodwill is my own consulting practice. My business (by design) is not structured to have any value outside of my own personal goodwill. I have not created a business that has value to a third party – at least not now.
Contrast that to my client that has a business that does have business goodwill. She has intentionally built a company that will have value to another person. No doubt she also has personal goodwill, but she can be separated from her business and the business will provide value to a new owner.
Whether you have goodwill on your balance sheet due to a business acquisition, or you don’t have goodwill on your balance sheet, it is important for your business value (and your financial future) to build goodwill. Create a business that is valuable without your direct participation. How that looks for your business may be different than how it looks for someone else’s business, but it is important none the less. Create a business plan that will develop goodwill – a business that has value beyond the value of your tangible business assets – in order to create a company that someone else can benefit from owning.
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