Published in: Accounting

Is Goodwill debit or credit?

Author Obotu Agape Oguche

Published on: November 4, 2022

Is goodwill debit or credit? Goodwill is a kind of intangible asset that may arise when a company buys another company entirely. Because acquisitions are structured to increase the value of the combined company, the purchase price that is paid for the company sometimes usually exceeds the book value of the acquired company. Hence, the difference between the price of the acquired company and the book value is known as goodwill.

Recording this goodwill is necessary to keep the parent company’s books balanced. Therefore, learning how to account for goodwill will enable one to account properly for acquisitions. In this article, we will discuss goodwill, the debit and credit rules applicable to it, and its journal entries.

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The value of a company’s name, good employee relations, loyal customer base, brand reputation, solid customer service, and proprietary technology represents the aspects of goodwill. This value is what a company may pay a premium for in order to acquire another company. Hence, the amount that an acquiring company pays for the target company which is above the target’s net assets at fair value is what is accounted for as the value of the target’s goodwill. If an acquiring company pays less than the target’s book value, it gains negative goodwill which means that it purchased the company in a distress sale at a bargain price.

On the acquiring company’s balance sheet, goodwill is reported as an intangible asset under the long-term (fixed) assets account. It is considered an intangible asset because it is not a physical asset like buildings, property, equipment, machinery, or vehicles. Tangible assets have a finite monetary value and are usually in physical form. They are always transacted for some monetary value whereas intangible assets are not physical and have a theorized value rather than a transactional exchange value. Hence, unlike tangible assets, goodwill as an intangible asset cannot be touched which includes other assets such as brand names, copyrights, patents, trademarks, etc.

Under the International Financial Reporting Standards (IFRS) and generally accepted accounting principles (GAAP), companies are required at least once a year to evaluate the value of goodwill on their financial statements and record any impairments. The process for calculating goodwill is quite straightforward in principle but can be fairly complex in practice. Calculating goodwill is done with a simple formula whereby the net fair market value of identifiable assets and liabilities is subtracted from the purchase price of a company.

Goodwill = P − (A − L)

where:

• P = Purchase price of the company
• A = Fair market value of assets
• L = Fair market value of liabilities

Goodwill explained

In order to understand goodwill, one has to have an understanding of book value. The book value of a company is its tangible assets minus its liabilities. It is referred to as the book value because it is usually the value of the company that is being carried on the balance sheet. Take, for example, a company with tangible assets of $2 million, intangible assets of $500,000, and liabilities of $1 million. This means that the book value of this company would be $1 million (i.e $2 million of tangible assets minus the $1 million of liabilities).

The value of a company’s assets is equal to the cost that was originally paid for them. However, take note that the book value of a company is not necessarily equal to the market value (also known as fair value) of the company, or what the market would be willing to pay for the company. For instance, in the above example, the company has a book value of $1 million, but the market may be willing to pay up to $3 million.

When a company is purchased, the goodwill is equal to the amount at which the purchase price is above the book value of the company. For instance, assume a company wants to acquire another company for $1 million. Let’s say the book value of the company to be purchased is $500,000. In this case, the goodwill would equal $500,000 which is the amount that the purchase exceeds the book value. Goodwill can exist for many reasons such as a company being willing to pay more than the book value because the company in question may have exceptional future profit growth prospects, great profit margins, or a major competitive advantage.

Let’s consider a hypothetical example of an investor who purchases a small consumer goods company that is very popular in their local town. The investor agreed to pay $1.2 million for the company even though the company only had net assets of $1 million, which results in $200,000 of goodwill being reflected in the balance sheet. The investor in explaining this decision could point to the strong brand and consumer following of the company as a major justification for the goodwill that he paid. However, if the value of the brand were to decline, then the investor may need to write off some or all of that goodwill in the future.

Now, that we have an understanding of what goodwill is; is goodwill debit or credit? Let’s look at the debit and credit rules that are applicable when recording goodwill.

See also: Is Land Debit or Credit?

Debit and credit rules (applicable to goodwill)

Every business transaction that is measured in monetary terms has to be accounted for in the company’s accounting books. Hence, in order to record business transactions, a system of debit and credit is used, which reports each transaction through two different accounts. That is, whenever a business transaction takes place, at least two accounts are always impacted either by a debit or credit entry.

That is, a debit entry is recorded against one account and a credit entry is recorded against another account to offset the debit entry. This is referred to as double-entry bookkeeping. In this accounting system, there are debit and credit rules that need to be followed when recording every transaction in your books, which are:

1. The debit and credit entries made in the impacted accounts must balance
2. Debit the receiver and credit the giver, for personal accounts
3. Debit what comes in and credit what goes out, for real accounts
4. Debit all expenses and losses and credit all incomes and profits, for nominal accounts
5. A debit entry increases assets, dividends, and expenses accounts
6. A credit entry increases liabilities, equity, and revenue accounts
7. Contra accounts offset the natural debit or credit balance of the paired accounts

The following are the main journal entries of Goodwill in accordance with the debit and credit rules:

When a company buys another company and pays the amount for goodwill

When a company is bought and the amount for goodwill is paid, this goodwill as an intangible asset will have to be recorded as a debit and not a credit. According to one of the rules stated above, debit what comes in and credit what goes out, for real accounts. A real account is an account that contains transactions related to the assets or liabilities of the company. Hence, according to this rule, when something comes into your business (for instance an asset like goodwill), debit the account.

Goodwill will come into the business and as such should be debited. Also, according to one of the rules, a debit entry increases assets, dividends, and expense accounts. Hence, goodwill as an asset will increase by a debit. This means that goodwill is a debit and not a credit. The offsetting entry would be a credit to the Cash account. According to the rules, when something goes out of your business, credit the account. Hence, since cash goes out from the business for the purchase of a company, the Cash account will be credited which decreases the account.

For example, if Company ABC has bought Company XYZ and has paid $500,000 for the goodwill. According to the debit and credit rules, the journal entry would be:

Debit and credit journal entry for goodwill when a company acquires another company

When a company sells the company (goodwill) and gets the amount for the goodwill

There is no guarantee that a company will get the same amount of goodwill that is showing in its books or balance sheet because time is changing. Hence, if the company has sold the goodwill with its business, it can get an excess or low amount of goodwill difference. This difference will be the profit or loss on the selling of goodwill.

According to one of the debit and credit rules stated, debit the receiver and credit the giver. The company in this case has received cash by selling goodwill. Hence, it will increase its cash assets, by a debit. If the company gets a loss, it will also be a debit because the loss will decrease the company’s invested capital. Moreover, one of the rules is that you should debit all expenses and losses and credit all incomes and profits. The Goodwill account, on the other hand, will be credited because it will decrease the asset of goodwill. Also, if the company is gaining profit from the sale of goodwill, this will be a credit.

For example, if Company ABC sold the same Company XYZ after buying it, to Company RST at $600,000 but the book value is the same as $500,000. In accordance with the rules, the journal entry would be:

Debit and credit journal entry for goodwill when a company sells the goodwill of a company

When goodwill will be impaired

An example of goodwill impairment occurs when the market value of the asset drops below historical cost which can be a result of an adverse event such as declining cash flows, an increasingly competitive environment, economic depression, etc.

If a company assesses that the amount of goodwill was overstated, then the company must impair or do a write-down on the value of the goodwill on the balance sheet. This impairment expense is calculated as the difference between the current market value of the intangible asset and the purchase price. Hence, the impairment results in a decrease in the goodwill account on the balance sheet. Also, this expense is recognized as a loss on the income statement, which directly reduces net income for the year.

Since goodwill is an intangible asset, we do not depreciate its value after spending time. However, if the goodwill’s book value is high and the market value is low, it means, the goodwill’s value has decreased. Hence, it has to be written off by transferring it to the profit and loss account’s debit side. According to the rule- debit all expenses and losses; the loss of goodwill impairment will be a debit which is the decrease in the value of goodwill. The Goodwill account, on the other hand, will be credited because the company’s assets will decrease due to a loss in its value.

For example, if a company and its employees do not talk courteously and properly to customers, their customers will decrease. This decrease in the number of customers will decrease the company’s goodwill. That is, in a day, the company may have just 1 customer while its competitor has 20,000 customers in a day. Say, in the past, the company’s sale was 20,000, but due to the employee’s bad behavior, the sale has now dropped and the company’s goodwill value decreased in the market. So, this will show in the balance sheet through a journal entry:

Related: Is Notes Payable a Debit or a Credit?

When accounting for Goodwill, we need the values of the purchase price of the company, the fair market value of assets, and the fair market value of liabilities. Here is how goodwill is accounted for:

Determine the book value of the company

The book value of a company is its tangible assets minus its liabilities. It is referred to as the book value because it is usually the value of the company that is being carried on the balance sheet. However, the book value of a company does not always equal the market value (also known as fair value) of the company, or what the market would be willing to pay for the company.

The first step in calculating goodwill is to determine the book value of the company (which is the assets minus the liabilities), and figure out what the market value of those net assets is. Once the fair value of the assets has been determined, you can then add them together. For example, assume a company being purchased has $500,000 in cash, $200,000 in property, plant, and equipment, and $800,000 in inventory. The fair value of the company’s assets would therefore be $1.5 million.

After calculating the fair value of the company’s assets, subtract the company’s liabilities from the assets. For instance, if the company has liabilities of $500,000, this amount should be subtracted from the company’s assets of $1.5 million. This means that the fair value of the company’s assets is $1 million. This simply means that if you subtract the company’s assets from its liabilities to get a book value, the result in this case would be $1 million.

Calculate Goodwill: Subtract the book value from the purchase price

Once the book value of the company is determined, the next thing is to calculate the goodwill by subtracting the book value from the purchase price. This will give us the price paid in excess of the company’s fair value. For instance, assume a company acquires another company for $1,000,000. If the book value of the acquired company is $800,000, then the amount of goodwill realized would be $200,000 (which is $1,000,000 – $800,000).

Make a journal entry to recognize the acquisition of the company

Once the amount of Goodwill is determined, the next thing is to record a journal entry to recognize the acquisition of the company. In order to recognize acquisition, goodwill is recorded as a debit and not a credit. Continuing with the preceding example, the company would debit the acquired asset account for $800,000, debit Goodwill for $200,000, and credit the Cash account for $1,000,000.

Debit and credit journal entry for goodwill to recognize the acquisition

The journal entries made will add the $800,000 in assets to the books, add the $200,000 in Goodwill, and subtract $1 million in cash from the books to reflect cash that has left to fund the purchase of the company.

Test the goodwill account for impairment each year

Each year, Goodwill needs to be tested for impairment. Impairment occurs when something bad happens to a company. This occurrence causes the market value of the company’s assets to decline below the book value. When such occurs, goodwill needs to be reduced by the amount of the market value that falls below the book value.

For instance, a company made a purchase for $1.5 million, where $500,000 is the goodwill, and the book value of the assets is $1 million. In a case where sales drop dramatically, the $1 million of assets will not have a market value of $1 million anymore. If, for instance, the market value drops to $800,000, the company would need to reduce Goodwill by $200,000 to reflect the drop in the value of the assets.

Therefore, if the goodwill account needs to be impaired, a journal entry is needed in the general journal to recognize the goodwill impairment. In order to record the entry, credit the Loss on Impairment by the impairment amount and debit the Goodwill account by the same amount. This accounts for a reduction in Goodwill by using the contra-asset account- Loss on Impairment.

Debit and credit journal entry for goodwill to recognize any goodwill impairment

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Goodwill: debit and credit entry example

Let’s assume that a company, Techbuddy acquires ABC Ltd for $5 million. The fair value of ABC Ltd’s identifiable assets was $4 million and its liabilities were $1 million. Therefore, Techbuddy is paying $5 million for ABC Ltd which has a book value of $3 million ($4 million of assets minus $1 million of liabilities). This means that the goodwill is $2 million, which is the amount that was over the fair value of ABC Ltd’s book value (i.e $5 million minus $3 million).

When Techbuddy records the acquisition of ABC Ltd, it will record it as:

Debit and credit journal entry for goodwill to recognize the acquisition of ABC Ltd

See also: Notes receivable debit or credit?