EFA (32): Goodwill

Goodwill sounds like something positive. And in most cases it is. But it can also cause problems, particularly for companies.

What exactly is goodwill, however? This is the subject of the 32nd item in our Economics for Amateurs (EFA) series, which you can find here every Monday.

The Oxford Dictionary of English gives two definitions of goodwill. The first one is its everyday usage:

• friendly, helpful or cooperative feelings or attitudes.
  

For example, we talk about goodwill being essential for the success of a project. Or, if somebody does something particularly helpful, which wasn't really required of them, we can call this a gesture of goodwill.

In the business, context, however, it is the second meaning of goodwill that is relevant:

• the established reputation of a business regarded as a quantifiable asset and calculated as part of its value when it is sold.

The key point is that a successful company is worth more than simply the book value of its physical or financial assets. Its reputation, customer base, patents, etc. are also of value.

This is why, when one company takes over another, the buying price is often considerably higher than the current value of the tangible assets. In effect, the buyer is paying a premium for the "ongoing success" of the purchased firm.

So far, so good. But a problem arises when companies realize that the firms they have bought are not going to be as successful as they thought. In other words, the goodwill is not worth as much as they paid.

This often happens in times of takeover booms. And many companies now face the prospect of writing down huge sums of non-existent goodwill. This special form of depreciation is called amortization.

International accounting rules require companies to check at least once a year — through an "impairment test" — whether the value of goodwill in their accounts reflects the realistic prospecs of future success.

If not, companies have to correct (downwards) the value of this goodwill in their accounts. And, like all depreciation, this reduces the current level of profits.