In this blog we are going to discuss about what is Goodwill in Accounting, Types of Goodwill in Accounting, Importance of Goodwill and calculation process of Goodwill.
What is Goodwill in Accounting ?
In accounting, goodwill is defined as the value of a business that exceeds its assets minus liabilities. Goodwill is recorded when the purchase price exceeds the sum of the fair value of identifiable assets and liabilities.
Goodwill is an intangible asset that represents the extra acquisition price of another company. Goodwill include proprietary or intellectual property, brand awareness, and other qualities of a business that are valuable but not immediately quantified.
It is calculated by subtracting a company’s purchase price from the fair market value of its assets and liabilities. Companies must examine the value of goodwill on their financial statements at least once a year and report any impairments.
Goodwill has an unlimited lifespan. Most other intangible assets have a limited useful life.
Types of Goodwill in Accounting
There are two types of Goodwill in Accounting. These are –
- Purchased Goodwill
- Inherent Goodwill
1. Purchased Goodwill
Purchased goodwill is the difference between the amount paid for an enterprise as a continuing concern and the sum of its assets minus the sum of its liabilities, each of which has been independently recognized and valued.
This type of goodwill is recognized in accounting because it represents the premium paid for a company’s intangible benefits during the purchase. Purchased goodwill is recorded as an asset on the balance sheet and is subject to annual impairment testing to ensure it reflects current market value.
2. Inherent Goodwill
Inherent goodwill, also known as “self-generated” or “internal” goodwill, builds organically when a business expands its brand recognition, client base, and relationships. It is not purchased in an external transaction.
It is referred to as internally produced goodwill and develops over time as a result of a company’s positive reputation. It might also be referred to as self-generated or unpurchased goodwill.
Inherent goodwill does not have a measurable purchase cost, it is not shown on the balance sheet.
Importance of Goodwill in Accounting
Reflects a business’s true value in addition to its physical assets. A high goodwill metric could imply a strong brand or great client happiness. However, spending too much for a purchase might lead to inflated goodwill and future impairment.
- Goodwill Reflects true value of business in addition to it’s physical assets.
- High goodwill indicates that a company is trusted and respected in the market,that Helps investors to build trust on a company.
- It plays a big role in business mergers and acquisitions ,when buying a strong goodwill business buyers often pay more for business.
How to Calculate Goodwill in Accounting ?
To calculate goodwill in accounting follow the given below steps.
- Determine the book value of each asset on the balance sheet.
- Determine the fair value of assets.
- Find the fair value adjustment,that is the difference between the fair value and book value of the assets.
- Calculate the excess purchase price by determining the difference between the price paid to purchase the targeted business and the net book value of its assets.
- The Goodwill is calculated by, taking excess purchase price and subtracting the fair value adjustment.
Formula For Calculating Goodwill in Accounting
Goodwill = P – (A – L)
where,
P : Purchase value
A : Fair market value of Asset
L : Fair market value of liabilities
Examples of Goodwill Calculation
Example: 1
A XYZ plastic factory acquires a another ABC plastic factory for Rs 325 to expand its business.
After a detailed calculation, XYZ factory found that the fair market value of asset and liabilities of ABC factory is Rs 900 crores and Rs 700 crores respectively.
P= 325 crores
A= 900 crores
L= 700 crores
Then Goodwill ,
Goodwill= P – (A -L)
Goodwill= 325 – (900-700)
Goodwill= Rs 125 crores
Example: 2
A SPL clothing factory acquires a MNO clothing factory for Rs 500 crores to expand its business.
After Calculation, SPL factory found that the fair market value of assets and liabilities of MNO clothing factory is Rs 700 crores and Rs 500 crores respectively.
P= 500 crores
A=700 crores
L=500 crores
Then Goodwill ,
Goodwill= P – (A – L)
Goodwill = 500-(700-500)
Goodwill = Rs 300 crores
Example :3
A Naira named cosmetic products company acquires a Beauty plus cosmetic company for Rs.1500 crores to expand business.
After Calculation, Naira company found that the fair market value of assets and liabilities of Beauty plus company is Rs.3000 crores and Rs. 2200 crores respectively.
P = 1500 crores
A = 3000 crores
L = 2200 crores
Then Goodwill ,
Goodwill = P -(A – L)
Goodwill = 1500 – (3000-2200)
Goodwill = 700 crores
Key Component of Goodwill in Accounting
Key components of Goodwill in Accounting are –
- Brand Value
- Skilled Workforce
- Customer Relationship
- Market Position
- Proprietary Technology
Goodwill Impairment
Goodwill impairment happens when the current value of an acquired company’s Goodwill is less than the amount reported on the balance sheet.
This frequently indicates an acquisition that did not perform as intended,or changes in the external environment that impair the value of the acquired business.
For business owners and financial experts , goodwill impairment can be difficult since it raises questions about earlier purchase decisions and investor trust.
Factors Effecting Goodwill
1. Nature of Business
Nature of Business refers to the kind of items that the company deals with, the level of competition in the market, demand for the products, and the regulations that affect the firm. A business with a positive outcome in all of these categories will have more goodwill.
2. Location of Business
A business in a suitable location has a better possibility of generating more goodwill than one in a remote place.
3.Quality of Goods and Services
Quality of goods and services: A company that provides higher-quality goods and services has a better chance of garnering more goodwill than competitors who supply inferior products and services.
4. Efficient Management
Management efficiency results in an increase in profit for the business, which improves the company’s Goodwill.
5. Capital
A business with a higher return on investment and less capital investment will be considered to be more profitable and have more goodwill.
Goodwill Accounting Treatment
There are five methods of accounting treatment of goodwill when a new partner is added.
- When the amount of goodwill is paid in cash rather than recorded in a book.
- When goodwill is raised to its greatest potential.
- When a new partner brings his portion of goodwill in cash and remains in the business.
- When the new partner fails to bring his fair share of goodwill in cash.
- When benevolence is already recorded in the books.
Frequently Asked questions
Meaning of Goodwill in Accounting.
When a company acquires another entire business, it creates goodwill. The amount of goodwill is calculated as the cost of purchasing the business minus the fair market value of the tangible assets, identifiable intangible assets, and liabilities acquired in the transaction.
What is the nature of Goodwill?
It is an intangible asset that does not have a physical counterpart. It is not a fictional asset. It might be sold alongside the sale of the firm.
Why Goodwill classified an intangible asset ?
It is classified as an intangible asset because it cannot be seen or touched. However, it is not a fake asset because it may be sold for cash or its equivalent.