Goodwill represents the subjective value of certain desirable corporate qualities that can't be precisely quantified, e.g., a well-respected business name, good customer relations, high employee morale, brand name products, patents, proprietary technology, excellent reputation and other such factors that are anticipated to translate into greater than normal earning power.
Goodwill is an account located in the assets section of a company's balance sheet. Goodwill typically arises as an issue when a company is acquired. In the acquisition, the amount paid for the company that is in excess of the actual book value includes the target firm's intangible assets, such as goodwill. Goodwill is represented as an intangible asset on the balance sheet because it is not a physical asset, such as buildings and equipment.
Goodwill is generated when a company pays more than the accounting value of a firm's assets, as adjusted for its debts. That's because the Financial Accounting Standards Board (FASB), the body charged with establishing generally accepted accounting standards, mandates that companies post goodwill as an asset to their balance sheet when making an acquisition for above net asset value. Periods of heavy merger and acquisition activity tend to generate large amounts of goodwill.
The stock of many well-known companies that are household names is worth more than the value of their assets. To cite notable examples, the majority of Coca-Cola's share value is not in its brick-and-mortar bottling plants, but instead in the brand name and "secret formula" of it storied soft drink brand.
Investors should be wary when they see goodwill, as reflected when a company pays more money for another company than the fair market value of its net assets. The "appropriate" amount of goodwill is very hard to define.