what is the meaning of goodwill

A meaning of goodwill refers to an entity’s prestige, or its good name, before third parties

When we talk about companies like Coca-Cola, Pepsi, Google, or Apple, it is easily understandable that this type of entity owns a reputation recognizes globally.

For this reason, the economic valuation of these big brands tends to be very significant.

However, if we look at the companies’ financial statements mentioned above, we do not find an asset called goodwill.

This is so because paragraph 48 of IAS 38 establishes that any goodwill internally generated is not recognized as an asset.

According to International Accounting Standards Board, an entity shouldn’t recognize internally generated goodwill because it is impossible to distinguish between disbursements to operate a business and disbursements to generate a brand.

For example, if an entity incurs 500,000 on advertising, and hires ten sales agents to promote a product, or conducts a marketing campaign to boost the company’s brand, it is not possible to distinguish which part of these expenditures will bring more reputation to the brand, or which part of these resources are necessary for the entity to continue operating.

In other words, selling a product requires a series of advertising expenses.

This means that if the product is sold satisfactorily, the entity will be able to continue operating; still, at the same time, if the product is recognized for its quality and prestige, the value of the brand will increase.

For this reason, these expenditures should be recognized in profit and loss according to IAS 38; otherwise, many preparers of financial statements could argue that all or the vast majority of these expenditures could increase the value of your brand.

The consequence of this would be an overvaluation of the entity’s assets.

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Goodwill recognized as part of a business combination

When we talk about the meaning of goodwill, also we must refer to a business combination.

IFRS 3 allows an entity to recognize goodwill when a process of this nature occurs.

A business combination is the union of separate entities or businesses into a single reporting entity.

To determine the goodwill generated in a business combination, it is necessary to compare the net assets and liabilities of the acquired entity versus the consideration paid by an investor.

For example, company A acquires 100% of the equity interest of entity B for $100,000.

On the other hand, the net assets and liabilities at a fair value of the acquired entity amount to 80,000.

For this reason, company A must recognize goodwill of 20,000 for this difference generated.

Generally, in a business combination, there are two aspects to consider.

On the one hand, the economic valuation of the acquired company, and on the other hand, its identifiable assets and liabilities at fair value.

Regarding the valuation of an acquired company, if this is carried out using discounted cash flows for example, it is probable that the value resulting from this operation will be higher than the identifiable net assets and liabilities of this entity.

Therefore, the value that a company must recognize as goodwill will be the difference between the valuation of the acquired entity and the net assets and liabilities at fair value.

It is important to say that the result of the financial valuation of the acquired company will be the value of the consideration that an acquirer entity must pay for the assets and liabilities of the acquiree company.

To recognize goodwill, the consideration paid must be greater than the net assets and liabilities of the acquired entity.

In conclusion, the meaning of goodwill can be analyzed from two perspectives.

On the one hand, from the point of view of international accounting standards and, on the other hand, from the commercial perspective.

In other words, to analyze the recognition of goodwill from an accounting point of view, we must review IAS 38 and IFRS 3.