Updated September 2019
Goodwill is an intangible asset, which means it can be found on a company's balance sheet in its annual accounts. It is generated as the result of an acquisition. When one company buys another, it will typically pay a premium to the "fair value" (which is essentially an adjusted version of book value the value of a company's assets minus its liabilities). Goodwill is the difference between the acquired company's fair value and the actual price paid.
Say Company A buys Company B for £10m. The fair value of Company B's assets is £8m. The "excess" £2m paid is then listed in Company A's balance sheet as "goodwill". What does this difference represent? The value of certain intangible assets such as patents or intellectual property can be estimated, and potentially sold separately to the rest of the business.
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However, other "soft" assets, such as a strong brand, a highly trained workforce, a solid record of research and development, or a loyal customer base, for example, are much harder to value. They certainly have value, but they arise from the business as a whole being more than the sum of its parts. Goodwill effectively represents the value of these assets to Company A. You could almost argue that goodwill is the value that Company A places on Company B's competitive "moat", or on its potential future growth.
Unlike most other assets, the value of goodwill does not have to be written down (amortised) every year. Instead, accounting rules state that the value of goodwill must be reviewed each year, and "impaired" (ie, written down) if necessary. Writedowns are deducted from a company's profit-and-loss account, although they don't affect cash flow.
If a company pays less than the fair value for an acquisition perhaps as the result of a distressed sale then it has negative goodwill. This happens rarely, as it implies that the acquirer has bagged a bargain.
Watch Tim Bennett's video tutorial: What is goodwill?
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