From an accounting perspective, both tangible and intangible assets are recorded on the balance sheet, since both types of assets have value.
For example, assume there is a business with tangible assets of $2 million, intangible assets of $500 thousand, and liabilities of $1 million. This would mean the book value is equal to $1 million ($2 million of tangible assets minus $1 million of liabilities). The value of business’s assets are equal to the cost that was originally paid for them. Note that the book value of the business is not necessarily equal to the market value (also known as fair value) of the business, or what the market would be willing to pay. For example, the above business has a book value of $1 million, but the market may be willing to pay $3 million.
For example, pretend Company A wants to buy Company B for $1 million. Assume the book value of Company B is $500,000. Since goodwill is equal to the amount the purchase exceeds the book value, the goodwill in this case would equal $500,000. Goodwill can exist for many reasons. A business may be willing to pay more than the book value because the business in question may have great profit margins, exceptional future profit growth prospects, or a major competitive advantage.
For example, the book value of the business being purchased may be $1 million. However, due to recent strong market conditions, the market value may be slightly higher, at $1. 5 million. This means people would pay $1. 5 million for those $1 million in assets. Calculating market value is usually fairly complex and requires plenty of background knowledge, and as a result, the fair value of a business is usually calculated by a certified professional, such an accountant, financial analyst, or appraiser. Typically, figuring out market value will involve looking at what other similar assets or businesses are selling for. One approach is to average the value of similar businesses being sold, and then price the value of the business being purchased above or below the average depending on the quality of the business. The term “market value” is interchangeable with “fair value” for the purpose of this article.
The fair value of the business’s assets would therefore be $1. 5 million.
This simply means that if you subtract the business’s assets from their liabilities to get a book value, and you determine what the market would pay in theory for those assets, the result in this case would be $1 million.
For example, consider a firm that acquires another firm for $1,000,000. If the book value of the acquired firm totals $800,000, then the amount of goodwill realized is (1,000,000 - 800,000) or $200,000.
Continuing with the above example, the firm would credit the acquired asset account for $800,000, credit Goodwill for $200,000, and debit the Cash account for $1,000,000. Goodwill is an intangible asset account on the balance sheet. This series of entries adds the $800,000 in assets to the books, adds the $200,000 in Goodwill, and subtracts $1 million in cash from the books to reflect cash leaving to fund the purchase.
For example, assume you made a purchase for $1. 5 million, where $500,000 is Goodwill, and the book value of the assets are $1 million. If sales drop dramatically, those $1 million of assets will not have a market value of $1 million anymore. If the market value drops to $800,000, would would need to reduce Goodwill by $200,000 to reflect the drop in the value of the assets.
