Goodwill explained in three words

Goodwill represents those ‘unidentified flying assets’ that can’t be individually identified.

Goodwill is one of those slippery concepts that accounting students can find confusing.  Accounting for goodwill brings the student in front of a number of difficult questions and misconceptions in accounting, such as the nature of an asset and the different accounting treatment of definite-life and indefinite-life assets.  

Goodwill is not a new word; it was in general use in the 1300s in the sense of ability or willingness. The Oxford English Dictionary records its use in a business context in 1571 as ‘a transferable privilege allowing the new owner of the business to continue to trade as an established business.’ 

It is worth saying now that lawyers and accountants have very different ideas about what goodwill is and these ideas themselves vary by country. (In the US, less so in the UK, goodwill is inextricably linked with trade marks.) To add to the mix, sometimes accounting textbooks talk about the difference between ‘inherent goodwill’ and ‘purchased goodwill’ and then go on to say that only purchased goodwill can be shown in financial statements.  

Which rather begs the question, isn’t ‘purchased goodwill’ just ‘goodwill’? 

For the purpose of producing a statement of financial position, yes it is.  IFRS 3 defines goodwill as ‘an asset representing the future economic benefits arising from other assets acquired in a business combination (note the emphasis) that are not individually identified and separately recognised’.

In other words, when you account for an acquisition, in the consolidated financial statements, tot up the individually identifiable assets and work out the total.  The amount paid for the business will usually be greater than this first figure. Why? Because there will be other sources of value that can’t be individually identified and recognised as assets, like the propensity of customers to repurchase, well-trained staff, the benefits of increased market share and so on.  

These other sources of value, or future economic benefits,  can be thought of as floating around on top of the separately identified assets – definitely there but difficult to grab hold of and see inside. They are ‘unidentified flying assets’.  

Photo by Albert Antony on Unsplash

These three words are obviously a very simplified explanation of goodwill, but I find that students get the idea very quickly. They then more readily accept the accounting treatment for goodwill and can take part in a more nuanced debate about the quality of different assets.

Later on, we can explore the arguments for and against amortising goodwill and what would happen if the amount paid to acquire a business was actually less than the value of the identifiable assets and liabilities.  

4 thoughts on “Goodwill explained in three words”

  1. This is great Paul – thank you. Goodwill is such a problematic asset and not just for students. Not even our regulators can settle on an agreed accounting treatment.

    I don’t have an answer to that, but perhaps renaming goodwill to your three word term would be a good start.

  2. Another couple of thoughts that make accounting for goodwill even uglier:

    (1) If there are “unidentified flying assets” then presumably there are also “unidentifiable flying liabilities”, so in effect we are setting off assets and liabilities when recognising goodwill. Tom Selling explains this beautifully in his Accounting Onion blog: https://accountingonion.com/2008/02/what-good-comes.html

    (2) IFRS3 allows a choice of recognising the non-controlling interest at “fair value” or “net assets” which, as Tom Clendon points out in his recent blog, is horribly inconsistent with other assets and liabilities: https://tomclendon.co.uk/measuring-nci/

    1. Very good points. Unidentifiable flying liabilities certainly exist, as do unidentifiable flying contingencies… it would be more appropriate to say that goodwill is unidentifiable flying net assets, and then one could explain that identifiable *and* unidentifiable assets *and* liabilities affect the amount of goodwill. An interesting case would be if the unidentifiable flying liabilities exceeded the unidentifiable flying assets, and I would argue that this is conceptually different from a gain on a bargain purchase (ie the latter is a only a subset of the former).

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