Goodwill is an intangible asset that arises at the time of business acquisition when the price paid for the business exceeds the fair value of the net identifiable assets.
In most cases a business is worth more than the replacement cost of its net identifiable assets and that is why the acquiring company pays more than the fair value of the acquired company's net identifiable assets. At the time of acquisition, the fair value of the acquired company's assets and liabilities are added to the fair value of acquiring company's assets and liabilities. The excess of price over the fair value of net identifiable assets (assets minus liabilities) is recorded as a separate asset called goodwill.
It is an asset because it represents the economic value which is not captured by other assets for example the reputation of the business, the value of its human capital, its future growth potential, its professional management, etc.
Company A purchases Company B for $15 Million. The statements of financial positions of Company A and Company B with their book values and fair values are given below (all amounts are in $ '000').
|Book Value||Fair Value|
|Company A||Company B||Company A||Company B|
|Liabilities and Equity|
The goodwill on acquisition of Company B is calculated below:
|Price paid for Company B||15,000|
|Fair Value of Company B's Net Assets:|
|Long-term liabilities||− 7,500|
|Current liabilities||− 4,500|
The statement of financial position of Company A after acquisition would show the goodwill $4 million as an asset
|Liabilities and Equity:|