Goodwill may have an indirect impact on stockholder’s equity because it is based on the perception that the business has a solid reputation, popularity and or a better product than the competition. This competitive edge has the potential to result in increased sales and increased retained earnings that could be distributed among stockholders. Because goodwill does not directly affect earning activities, it does not become a retained earning and cannot be distributed to stockholders.
Goodwill is an intangible asset that is determined based on the reputation and income potential of a business. It is subjective based on the perceived value of the business. For example, if a prospective buyer is considering purchasing a retail store that generates considerable traffic based on historical sales as well as perceived popularity, he or she would be willing to offer a price higher than the fair market value of the assets. Goodwill is equal to the purchase price less the total assets.
The owners of a business have a financial investment or interest in the company. Contributions made by owners or partners plus retained earnings make up stockholder equity. The contributions, or owner investment, are also referred to as common stock. Retained earnings equal income less expenses for a given period and are usually a closing accounting entry that occurs at the end of a fiscal or calendar year. Since retained earnings are essentially the net income of the company, it is up to the stockholders to determine if these earnings will be distributed or reinvested into the business.
Direct Impact of Goodwill on Stockholder’s Equity
Tangible assets plus goodwill are equal to the total of liabilities and equity. Since goodwill is not an asset that is created from income activities, it does not become part of retained earnings. As a result, it cannot be distributed among stockholders. Goodwill does not directly affect stockholder equity.
Financial Statements and Goodwill
Financial statements of all business entities are represented through the accounting equation that defines the relationship between the assets, liabilities and equity of the entity. Assets are equal to liabilities plus equity. Liabilities are amounts owed by the business in the form of loans, lines of credit or accounts payable. Equity is the stakeholders' financial interest in the company, based on contributions and retained earnings.The balance sheet is the financial statement that shows this relationship clearly. Assets include cash, accounts receivable, property or equipment owned by the business, and goodwill. Of these, goodwill is considered intangible as it does not have an objective fair market value.
- Fundamental Financial Accounting Concepts; Thomas P. Edmonds and Cindy Edmonds and Frances McNair et al