Just like the soft skills that can make or break an individual’s career, companies have an intangible that can add to their value. ‘Goodwill’ is the name, and when it decreases, it can have devastating consequences for companies and investors. Look no further than Kraft-Heinz’s recent multi-billion-dollar loss if you want to understand what goodwill is and why every company wants it.

When goodwill is an accounting concept

You may know it as a thrift store or a neighborly feeling, but goodwill is also an accounting concept. This intangible appears as a line item on a company’s balance sheet and is critical when two companies merge. Goodwill is the amount recorded if the price paid for a company or good is higher than its combined assets, minus any liabilities the acquiring company assumes.

To get an idea of what that would like in practice, here’s the example certified management accountant Asit Sharma gave in a “Motley Fool” podcast: “Vince has a frisbee to sell me, and I decide that I really like this frisbee because I play ultimate frisbee,” Sharma said. “It’s selling for $2 on the market. But I really like this frisbee. And Vince knows that I really like it. And he and I agree that I’m going to buy it for $10. So, once the transaction takes place…I record that there was an outlay of $10 cash. That’s one side of the ledger, $10 goes out… I put the asset on my books at $2, and there’s an $8 hole to fill on my balance sheet, and I book that to an intangible asset called goodwill.”

In the case of the frisbee, the $8 difference between the strictest market value and the amount overpaid might represent a future valuation that’s much higher. In big business, a goodwill value could come from being an established brand, having a well-known positive relationship with its employees or having a loyal customer base.

Intangible but visible

Don’t get the wrong idea about goodwill. While you can’t see it or hold it in your hand, it’s not the same as other intangible assets like patents or licenses. Those intangibles can be sold without selling the entire company. Goodwill is a premium a buyer pays that is more than fair value. It only applies during the transaction, when a whole company is changing hands.

Also, companies can’t randomly decide how they’ll account for goodwill. It’s recorded when a company buys another company, right there on the balance sheet. International Financial Reporting Standards mandate that goodwill be evaluated on a company’s financial statement at least annually. At that time, any “impairments,” aka “write-downs,” are also recorded. Those don’t sound good, and they’re not. Impairment expense is any difference between a company’s current market value and the amount the acquiring company paid for it. Impairments decrease the goodwill amount on the balance sheet and also become a loss on the company’s income statement. That, in turn, zaps the company’s net income for the year. It’s bad news for the investors, too, because it reduces earnings per share and the company’s stock price. That’s a lot of potentially negative impact for an intangible asset.

When Heinz’ goodwill oozed away

Kraft Heinz became a sort of poster child for the evils of impaired goodwill recently. It formed in 2015 as the world’s fifth-largest food and beverage company, and goodwill was included on the resulting balance sheet. But in February 2019, Kraft Heinz shares reached record lows, and goodwill impairments played a part. Their accounting departments had to make goodwill impairment write-downs adding up to a staggering $15.4 billion total. That played out as a $12.6 billion after-tax loss. The really wild thing is that even that loss, enough to fund a small town of millionaires, made the Kraft Heinz impairment charge only the seventh-largest since 2009.