A business has various assets that are items of value, and they provide future benefits to the business. Some examples of assets are stock, raw materials, cash, and goodwill.
Goodwill is the asset of a business purchased by one company from the other. It is a part of purchase consideration that is higher than the sum of the business's net fair value and liabilities. The goodwill of a business exists due to several reasons. Such reasons are – a strong customer base, company's brand name, good relations with employees, good customer relationships, and proprietary technology.
Did You Know?
Though goodwill is an important asset of a business, it can be negative as well.
What is Goodwill?
There are two kinds of assets in a business: Tangible assets and Intangible Assets. The assets that we can see feel, and touch is known as tangible assets. They have physical existence. The assets that we cannot see, feel, and touch is intangible assets. They don't have any physical existence.
What is Goodwill in Accounting?
Goodwill in accounting is a kind of intangible asset since it is not a physical asset like cash, building, etc. Goodwill arises at the time of acquisition of a business enterprise. The total amount paid by the acquiring company over the net assets of the selling company at its fair market value is known as goodwill. However, if the amount paid by the acquiring company is less than the net assets, then it gains negative goodwill.
In the balance sheet of the company, goodwill comes under the head of the long-term assets account as an item of intangible asset. As per the International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP), companies must evaluate the goodwill of their financial statements at least once a year. The companies also need to amortise goodwill over a period of time, and the amortisation period is generally 10 years for private companies.
Essential Features of Goodwill
Goodwill is the brand name and the reputation of the firm. Following are some essential features of goodwill –
1. It is a part of business and cannot be distinguished from it. It means that it cannot be sold individually like other identifiable assets without selling the business.
2. It is an intangible asset and a non-fictitious asset.
3. The goodwill of a business doesn't depend on the cost incurred or the amount invested in setting up a business.
4. The valuation of goodwill depends entirely on the valuation of the management and is highly subjective.
5. There can be fluctuations in the amount of goodwill. The value of goodwill can fluctuate based on the environment's internal and external factors.
6. The exact value of goodwill is difficult to ascertain.
7. Goodwill helps the business enterprise to earn supernatural profits.
8. Maintaining goodwill is necessary to maintain the business at the present and future capacity of the firms.
Types of Goodwill
Goodwill of a business is of two types. The two types of goodwill are –
1. Purchased goodwill
2. Inherent goodwill
Purchased goodwill is generated when the purchase acquisition of the business is higher than the fair value of the net assets of the company. This kind of goodwill is always recorded in the books of accounts and is shown as an item of assets on the company's balance sheet. At the same time, other kinds of goodwill are not recorded in the accounts.
Inherited goodwill means the value of the business over the net assets of the business. Inherent goodwill is naturally generated goodwill. It is earned as a result of the business's reputation over a period of time. It can be positive as well as negative. Inherited goodwill takes time to be generated, but it offers many benefits to the business. Various external factors can have an impact on inherited goodwill.
How to Calculate Goodwill?
The goodwill of a business is calculated by adding the fair value of assets and liabilities of the acquired business to the fair value of assets and liabilities of the existing business.
Goodwill = (consideration paid on acquisition, fair value of non-controlling interests and fair value of equity interests) – fair value of net identifiable assets.
Calculation of Goodwill at the Time of Acquisition
1. Calculate the book value of all the assets. These assets include fixed assets, current assets, intangible assets, and non-current assets.
2. Now, calculate the fair value of all the assets.
3. Find the difference between the book value and the fair value of the assets and make the necessary adjustments in the books of accounts.
4. Now calculate the excess purchase price. It is the difference between the price paid to the seller company and the net book value of the assets.
5. Now calculate goodwill by deducting the fair value adjustments from the purchase price. This amount of goodwill is recorded in the books of accounts of the acquirer company.
Methods of Valuation of Goodwill
The need for valuation of goodwill arises in the following cases –
1. When there is a change in profit sharing ratio of the partnership
2. The admission of a new partner
3. Death or retirement of an existing partner
4. Dissolution of a partnership firm
5. Amalgamation of two or more partnership firms
There are various methods of calculation of goodwill. The commonly used methods are the Average Profits Method, Super Profit Method, and Capitalization of Profits.
• Average Profits Method
Simple Average – Under this method of calculation of Goodwill, Goodwill is calculated by equalising the average profits of a particular period. It is calculated by multiplying the number of years of purchase by the average profits of a certain number of years.
Now, goodwill = future maintainable profit after tax X no. of years of purchase.
Weighted Average – The difference in this method is that the profits of previous years are taken on a weighted average basis. This method is commonly used when there is an increasing or decreasing trend in the profits of the previous years.
Weighted Average Profit = (sum of profits X weights) / sum of weights
Goodwill = weighted average profit X no. of years of purchase
• Super Profits Method
Super profits are the excess of estimated future profits over the average profits. Under this method of calculation of goodwill, you need to compute the average profits of the previous years.
Super Profit = Average maintainable profits – normal profits
Goodwill = Super profit X no. of years of purchase
• Capitalization of Profits
Capitalisation means how much capital is required for the business to earn average or super-profits, assuming that the business can earn a normal interest rate. This capital is known as the capitalised value of profits. Now goodwill is calculated as the excess amount of capital over the total capital employed.
Capitalized value of average profits/super profits = (average/super profits X 100) / normal rate of return
Goodwill = capitalised value of super-profits – capital employed.
Example of Goodwill
Company X has total assets of a book value of ₹30 lakhs. Company Y has acquired all the stocks of company X with the purchase consideration of ₹50 lakhs. This means that company Y has paid the amount of ₹20 lakhs as the amount of goodwill.
Also Read: What is Double Entry System of Accounting
Factors Affecting Goodwill of a Firm
1.The quality of products and services offered by the business - The quality of products and services has a direct impact on its goodwill. Offering better quality products and services helps to attract more customers. Hence, it creates more goodwill. Whereas on the other hand, if the business doesn't improve its products, it will lose its goodwill.
2. Location of the business - If the business is set up in an area with a large number of competitors, then it may be difficult to maintain its goodwill.
3. Nature of the business
4. Efficiency level of the business
5. Favorable contacts in the business
The name and reputation that a business earns is the goodwill of that firm. It cannot be seen or touched and is regarded as an intangible asset. It is very important for business enterprises to maintain their goodwill and follow proper accounts to record goodwill in their books. Maintaining goodwill helps the business to earn the trust of the customers. It results from the past efforts that the business has made to earn higher profits in its future. Goodwill plays a very important role for the business to survive and create its dominance in the market.
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