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Goodwill is an accounting term used to reflect the portion of the market value of a business entity not directly attributable to its assets and liabilities; it normally arises only in case of an acquisition. It reflects the ability of the entity to make a higher profit than would be derived from selling the tangible assets. Goodwill is also known as an intangible asset.

Goodwill as a term was originally used to reflect the fact that an ongoing business had some "intrinsic value" beyond its assets, such as the reputation the firm enjoyed with its clients. The accounting sense of goodwill followed as a plausible explanation of why a firm sells for more than the value of its net assets.

Goodwill in financial statements arises when a company is purchased for more than the book value of the company. The difference between the purchase price and the sum of the fair value of the net assets is by definition the value of the "goodwill" of the purchased company. The acquiring company must recognize goodwill as an asset on its financial statements and present it as a separate line item on the balance sheet, according to the current purchase accounting method. In this sense, goodwill serves as the balancing sum that allows one firm to provide accounting information regarding its purchase of another firm for a price substantially different from its book value. Goodwill cannot be negative, instead you would write down the assets to the appropriate level.

For example, a software company may have net assets (consisting primarily of miscellaneous equipment, and assuming no debt) valued at $1 million, but the company's overall value (including brand, customer, intellectual capital) is valued at $10 million. Anybody buying that company would book $10 million in total assets acquired, comprising $1 million physical assets, and $9 million in goodwill. Goodwill has no predetermined value prior to the acquisition; its magnitude depends on the two other variables by definition.

The carrying value of an asset with associated goodwill may subsequently be adjusted by management, either by amortization or by means of occasional adjustments of the estimated value of the associated assets (primarily based upon their ability to generate cashflow and profits). The exact treatment and other details, particularly amortization, will depend on the accounting standards applied.

• Goodwill = Purchase Price – Fair Market Value of Net Assets
• Fair Market Value = Net Tangible Assets + Write-up of Net Assets
• Net Tangible Assets = Assets – Target's Existing Goodwill – Liabilities

As can be seen, a merger destroys the target's "old" goodwill and creates "new" goodwill to appear in consolidated books. Net assets write-up is prepared by qualified appraisals.

Previously, companies could structure many acquisition transactions to determine the choice between two accounting methods to record a business combination: purchase accounting or pooling-of-interests accounting. Pooling-of-interests method combined the book value of assets and liabilities of the two companies to create the new balance sheet of the combined companies. It therefore did not distinguish between who is buying whom. It also did not record the price the acquiring company had to pay for the acquisition. U.S. Generally Accepted Accounting Principles (FAS 141) no longer allows Pooling-of-interests method.

Goodwill is no longer amortized under U.S. GAAP (FAS 142). Companies objected to the removal of the option to use Pooling-of-interests, so amortization was removed by Financial Accounting Standards Board as a concession. As of 2005-01-01, it is also forbidden under International Accounting Standards. Goodwill can now only be impaired (impairment-only approach).

Instead of deducting the value of goodwill annually over a period of maximal 40 years, companies are now required to value fair value of the reporting units, using present value of future cash flow, and compare it to their carrying value (booked value of assets plus goodwill minus liabilities.) If the fair value is less than carrying value (impaired), the goodwill value needs to be reduced so the fair value is equal to carrying value. The impairment loss is reported as a separate line item on the income statement, and new adjusted value of goodwill is reported in the balance sheet.

Since, in general, intellectual property (IP) is part of goodwill [in its lay, not accounting sense], one of the most important assets of knowledge-based companies does not appear at all on formal balance sheets. As for these companies it is the IP that generates profit, not the buildings or the cash they hold, this may lead to a misleading valuation, discouraging investors who do not understand the company's value.

When the business is in trouble, with the threat of insolvency, investors will deduct the goodwill from any calculation of residual equity because it will likely have no resale value.