What Is Goodwill in Accounting – Its Working, Examples, Types and Features
When the purchase price of an organisation is more than the calculated value due to intangible assets, it is referred to as goodwill in accounting. A few examples of goodwill in accounting include reputation, permits and licenses, copyrights, patents, brand identity, etc. Note that goodwill does not have a definite lifespan. A company might not consider amortising it as per accounting standards.
This blog provides a detailed overview of goodwill in accounting – its types, features, how to calculate it, examples, limitations and more. Read on!
Essential Features of Goodwill
To know the meaning of goodwill in accounting, it is crucial for you to know the various features it possesses. Some of them have been mentioned below:
- By definition, goodwill is an intangible asset, which means that you can measure or estimate it.
- It is the additional amount that a purchasing company pays while acquiring a business. However, you can buy or sell it as a separate asset.
- You have to build goodwill for your business over time. However, you cannot specifically invest in it.
- Goodwill varies substantially, as it is not constant and does not feature a definite lifespan.
- Positive goodwill will attract more customers, build sales and drive a business towards growth.
What Are the Types of Goodwill?
Businesses that undertake goodwill accounting treatment usually have the following types of goodwill:
- Inherent Goodwill: This showcases the company’s value over and above the fair value of identifiable assets. Typically, a business generates this type of goodwill through reputation, which could be negative or positive.
- Business Goodwill: This refers to all intangible assets owned by a company. These include market share, customer base, good reputation and more.
- Purchased Goodwill: This goodwill occurs when a company buys a subsidiary at a value more than the fair value of identifiable assets.
How to Calculate Goodwill in Accounting?
Calculating goodwill is not daunting if you are well aware of the goodwill accounting formula. You can simply follow these steps:
- Step 1: Find the book value of the assets of a company. You can find this information on a company’s balance sheet.
- Step 2: Upon that, determine the fair value of assets with the help of an accounting firm.
- Step 3: The next step entails the calculation of fair value adjustments. You can calculate it by applying this formula: Fair value of assets – book value of assets.
- Step 4: In the next step, assess the excess purchase price by applying this formula: Actual price paid – Company’s net book value.
- Step 5: Finally, calculate goodwill through this formula: Excess purchase price – fair value adjustments.
Example of Goodwill
Suppose company A acquires company B by paying Rs.5 lakh. The book value of assets, as per the balance sheet of company B, is Rs.50,000, and the fair value of assets is Rs.80,000.
Fair value adjustments = Rs.80,000 – Rs.50,000 = Rs.30,000.
Now, let us consider that the net book value of company B is Rs.40,000.
Excess purchase price = Rs.5,00,000 – Rs.40,000 = Rs.4,60,000.
Thus, goodwill = Rs.4,60,000 – Rs.30,000 = Rs.4,30,000.
What Are the Methods of Goodwill Valuation?
The method of goodwill valuation can differ as per one’s preferences. The different methods have been discussed below:
1. Purchase of Average Profit
This method considers the average profits of a company for a specific period before the date of acquisition. To arrive at a result, you have to multiply it by a certain number of years by which the parent company expects to reach this average. The calculation of goodwill formula through this method is:
Average profit x years of acquisition
Here, average profit = Total profit of a subsidiary for a certain time frame.
Years of acquisition = Number of years the parent company owns the acquired company.
2. Purchase of Weighted Average Profit
This method takes into account the weighted average profit of a company instead of just the average profit. To calculate goodwill with this method, you need to use this formula:
Weighted average x years of acquisition
Here, Weighted average = The weight of all average profits for a specific time frame.
Years of acquisition = Number of years of subsidiary ownership
3. Capitalisation Method
This is yet another method to calculate goodwill. It considers the acquired business’s normal return rate and net tangible assets. To base your calculation on this method, apply the following goodwill formula in accounting:
Capitalised average net profit – net tangible assets
Here, Capitalised average net profit = Capitalised profit, which can be calculated by dividing the average profit 100 times by the NRR (normal rate of return).
Net tangible assets = Tangible assets – liabilities.
What Factors Affect the Goodwill of a Company?
Here are a few most common factors that can affect the goodwill of a company:
- When a company offers quality products and services, it helps generate goodwill.
- A company whose services extend commendable value for money get more goodwill.
- Companies that are stable and feature low risk are more likely to experience an increase in goodwill.
- A company’s customer base also affects its goodwill. In simple terms, a loyal customer base generates more goodwill.
- Typically, the type of business also affects goodwill. Some companies have certain characteristics that tend to generate more goodwill than others.
- Companies possessing valuable trademarks and patents hold more value; thus, they will generate more goodwill.
- Higher returns and lower investments indicate that a company is financially good. Such a situation, if occurring on a continuous basis, helps drive goodwill.
What Are the Drawbacks of Goodwill Accounting?
As goodwill evaluation is tricky, it would be difficult for you to know goodwill treatment in balance sheet if you do not have the needed data. Moreover, a business can also face negative goodwill. This can occur when a target company does not want to negotiate a fair purchase price. Negative goodwill is a common occurrence in distressed sales. It then becomes income on the income statement of the acquirer.
It is also possible for an already operating business to go bankrupt. In such a situation, the target company subtracts goodwill from residual equity calculations. This is because the company’s goodwill features no market value.
How to Calculate Goodwill Through Weighted Average Profit Method?
You can easily calculate a company’s goodwill through the weighted average profit method. Simply go through the following steps:
- Step 1: Find the weighted average of net profits for every year for a company prior to the year of acquisition.
- Step 2: Know the number of years of acquisition.
- Step 3: Applying this formula: Weighted average profit x years of acquisition to calculate goodwill.
Final Word
Evidently, goodwill in accounting is an intangible asset that a company accumulates through years of work. In essence, this accounting term plays a huge role in the acquisition phase of a business. Although it can be difficult to price, the concept of goodwill is useful to value a business beyond just numbers.
FAQs
Ans: Goodwill falls under the fixed assets category in a company’s balance sheet. Viewing from a fiscal or accounting point of view, goodwill does not require amortisation. However, accounting rules require businesses to calculate goodwill at regular intervals for impairment.
Ans: One of the most significant differences between goodwill and other intangible assets is that goodwill arises mostly during times of acquisition. Moreover, goodwill cannot be bought or sold, unlike other intangible assets like copyright, trademarks, patents, and more.
Ans: Before calculating goodwill, you need to consider various things, such as:
• Consideration payment, which comes from the overall purchase price of a merger.
• Non-controlling interest, which refers to a shareholder’s ownership of not more than 50% of a company’s outstanding shares.
• Net identifiable assets, which denotes the total assets a parent company generates after the merger.
Ans: Internally generated goodwill is not an asset, as they are not a part of identifiable assets. That said, subsequent expenditures about other intangible assets, such as brands and items of the same nature, form a part of expenses, which helps avoid internally generated goodwill.
Ans: Creating goodwill boosts the brand loyalty of a company. It can also help your business stand out in the market amongst competitors. Finally, building positive goodwill over a period of time increases the business’ value, which can result in bigger profits.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
