What is positive goodwill?

Goodwill is an intangible asset that represents the non-physical factors that contribute to a company’s value. It includes aspects such as brand recognition, customer loyalty, proprietary technology, and excellent employee relationships. Positive goodwill refers specifically to the goodwill that enhances a company’s reputation and performance.

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What are some examples of positive goodwill?

Here are some examples of positive goodwill:

A strong, recognizable brand – When consumers trust and identify with a brand, they are more likely to continue buying its products. Brands like Coca-Cola and Apple enjoy substantial positive goodwill.

Customer loyalty programs – Initiatives like frequent buyer rewards engender goodwill by making customers feel valued.
Corporate social responsibility – Philanthropic giving and ethical business practices build goodwill by enhancing a company’s public image.
Quality customer service – Going above and beyond for customers generates goodwill in the form of positive word-of-mouth and repeat business.

Investing in employees – Competitive compensation and benefits, training programs, and a great company culture build goodwill with employees.
Commitment to quality – Consistently delivering high-quality, reliable products creates goodwill by meeting and exceeding customer expectations.

Why does positive goodwill matter for a business?

Positive goodwill provides several advantages that can improve a company’s performance and valuation:

Increases sales and profits – The trust and social capital generated by goodwill makes customers more likely to buy and promote the company’s products and services.
Attracts investors – Investors view goodwill as an indicator of strong future earnings potential.
Lowers marketing costs – Companies with substantial goodwill do not need to spend as much on advertising and promotions to attract customers.

Allows premium pricing – The perception of quality and brand status fostered by goodwill enables companies to charge higher prices than the competition.
Improves access to capital – Lenders and investors favor companies with valuable intangible assets like goodwill.
Aids recruiting – Positive reputations and corporate culture make it easier to attract talented employees.

In short, by boosting brand equity and cultivating lasting relationships with key stakeholders, positive goodwill provides strategic and financial value that fuels business success.

How do companies measure goodwill?

Goodwill is calculated as the excess value of a company above its identifiable tangible assets. It appears on a company’s balance sheet after an acquisition or merger takes place in which the buyer pays more than the target’s net assets are worth. The specific goodwill formula is:

Goodwill = Purchase price of the target – Fair market value of the target’s identifiable net assets

Companies assess the value of goodwill annually and determine if any impairment, or reduction in value, has occurred. If goodwill becomes impaired, its carrying value on the balance sheet is reduced accordingly through an impairment charge expense.

What are some strategies for building positive goodwill?

Companies can employ several strategies to increase the goodwill that stakeholders feel toward their brand and products:

Focus on customer satisfaction – Provide high quality products, responsive support, and service recovery for mistakes.

Build brand identity – Define and communicate a distinct brand personality and promise.
Cultivate loyalty programs – Engage customers through points, tiers, and special offers to keep them coming back.
Prioritize company culture – Create an inspiring, collaborative workplace where employees feel valued and empowered.

Give back – Establish meaningful community partnerships and philanthropy programs.
Promote transparency – Openly communicate business practices and changes that affect stakeholders.
Champion social causes – Support important issues like sustainability, inclusion, and health/wellness.

Making an authentic, visible commitment to corporate social responsibility and ethical values is especially impactful for establishing goodwill and trust.

How does goodwill get transferred in an acquisition?

In the purchase method of accounting for a business combination, the buyer essentially purchases the target company’s assets and assumes its liabilities. Some assets like property and equipment are tangible and easy to value. Others like brands, intellectual property, and customer relationships are intangible assets without a clear market value.

Goodwill arises when the buyer is willing to pay more for the target than the combined fair market value of its identifiable tangible and intangible assets. This premium reflects the additional elements of the target’s value like its reputation, buyer synergies, and expected future cash flows. The amount the purchase price exceeds the target’s net asset value is recorded as goodwill on the buyer’s balance sheet.

For example, if Company A acquires Company B for $5 million, but Company B’s net assets are only valued at $3 million, Company A records $2 million in goodwill. This goodwill is an intangible asset that transfers over and stays on Company A’s books until it is later impaired.

What happens when a company sells part of its business?

When a company divests or sells a business segment, a portion of its recorded goodwill is also divested. The amount divested is based on the relative fair values of the business being sold and the portion of the company retained. This ensures goodwill stays with the associated business and assets.

For example, if a company sells a business segment for $100 million and its entire business including goodwill was valued at $1 billion pre-divestiture, 10% of the company’s total goodwill would be divested along with the business segment. The remaining 90% of goodwill would stay with the retained business assets.

Can you write off goodwill as an expense?

Unlike other intangible assets like patents or trademarks, goodwill cannot be amortized or expensed over time on the income statement. It instead remains on the balance sheet indefinitely as long as it retains its value. This is because goodwill does not have an identifiable useful life or set term of existence.

However, goodwill must be tested at least annually for impairment. If the fair value of a reporting unit falls below its carrying amount on the balance sheet, an impairment charge is recorded. This noncash charge reduces the goodwill account through an expense on the income statement. It has no direct cash flow impact but indicates that goodwill’s earning potential has declined.

How is goodwill treated in accounting?

There are several important goodwill accounting rules under generally accepted accounting principles (GAAP):

Goodwill is only recognized in acquisitions accounted for as business combinations, not asset purchases.
It is recorded as a non-current, indefinite-lived intangible asset on the balance sheet rather than expensed.
Goodwill balances are tested at least annually for impairment, resulting in a write-down if warranted.

Negative goodwill is recorded as a bargain purchase gain on the income statement rather than as a liability.
Goodwill is allocated to reporting units for impairment testing based on expected synergies.
Goodwill cannot be written off directly – it can only be reduced via impairment.

Adhering to these rules provides consistency in goodwill accounting between companies and across accounting periods.

What are the tax implications of goodwill?

For tax purposes, goodwill is treated as a capital asset. The initial recognition of goodwill when acquiring a company does not result in a deductible expense or taxable gain. However, tax deductions are allowed for losses recognized from goodwill impairment.

When a company calculates its income tax expense, it adds back any impairment losses taken on goodwill during the period. Since goodwill itself is not deductible, impairments make that portion of the asset tax deductible. This creates a deferred tax asset on the balance sheet that can be used to shield income.

In addition, the gain on disposal of goodwill is a taxable capital gain. When a business segment with allocated goodwill is sold, the difference between the goodwill’s tax basis and sale amount is taxable income to the seller.

What are the international accounting standards for goodwill?

Under International Financial Reporting Standards (IFRS), the accounting treatment of goodwill is generally similar to GAAP with a few key differences:

Goodwill is amortized on a straight-line basis over its useful life up to a maximum of 10 years.

Acquired goodwill is not tested annually for impairment – only when impairment indicators arise.
More frequent goodwill impairment testing is required after acquisition and when transitions occur.
A one-step impairment test is used rather than the two-step GAAP test.

Reversals of prior goodwill impairments are allowed under certain conditions.

The threshold for impairing goodwill tends to be lower under IFRS compared to GAAP. However, both sets of standards aim to reflect goodwill at its fair value on an ongoing basis.

What are the limitations and critiques of goodwill accounting?

Several criticisms and drawbacks exist regarding goodwill accounting practices:

Subjectivity in valuation – Goodwill amounts are based on buyer assumptions and projections that can be optimistic.
Lack of transparency – Failing to amortize goodwill reduces indicators of declining value.
Ease of manipulation – Managers can distort goodwill balances and impairments to smooth earnings.

Reduced comparability – Goodwill varies significantly between companies and industries.
Complexity – Impairment testing models and assumptions introduce complexity.
Instability – Writedowns often trigger investor selloffs and share price declines.

To address these issues, some analysts advocate for limiting goodwill recognition or returning to goodwill amortization. However, most agree that impairment testing provides the best option for reflecting goodwill’s fair value on balance sheets.

What are key indicators of goodwill impairment?

Certain events or circumstances may suggest that goodwill has become impaired and should be tested for a writedown. Key impairment triggers include:

Falling revenues or cash flows from an acquired business segment

Difficulty integrating acquisitions or realizing expected synergies
Loss of major customers, contracts, or key employees
New competitive pressures or disruptive technologies

Regulatory changes that adversely impact operations or profits
An economic slowdown in markets that heavily purchase the company’s products
Sustained decline in share price or market capitalization

Since goodwill is associated with expectations of future income, any development that casts doubt on realistic earnability warrants impairment consideration.

How is goodwill impairment testing performed?

Goodwill must be allocated to individual reporting units for the purpose of impairment testing. This allocation is typically based on synergies between the acquired assets and those of the reporting unit.

The most direct method for determining impairment is comparing the reporting unit’s fair value to its carrying amount on the balance sheet. Fair value reflects the price a willing buyer would pay for the unit as a whole. If fair value has dropped below carrying value, goodwill has become impaired.

Because fair value is often difficult to measure directly, a two-step quantitative test is also allowed:

Compare reporting unit fair value to carrying value. If fair value exceeds carrying value, no impairment.
If fair value is less than carrying value, determine implied goodwill by deducting the unit’s assets and liabilities. Compare implied goodwill to recorded goodwill.

If implied goodwill is less than recorded goodwill in the second step, an impairment loss is recognized for the difference. This writedown reduces goodwill on the balance sheet and creates a corresponding impairment expense on the income statement.

Conclusion

Positive goodwill represents the coveted intangible assets like reputation and brand equity that allow companies to generate greater profits. It arises in acquisitions and becomes an accounting balance valued through impairment testing. While recording and tracking goodwill involves challenges and subjectivity, properly accounting for goodwill remains vital for measuring the fair value of companies.