Goodwill is an insubstantial asset that helps a firm earn a higher profit than the average normal profit. In short, to purchase one company from another over its actual net worth is known as goodwill. Treatment of goodwill is the portion of the purchase price that is higher than the total of all assets’ fair value that is purchased in liabilities and acquisition. Goodwill relates to the value of the brand name of a company, the solid customer base of the company, the good relationship of the customers with the employees, employees’ good relationship with the company, and the proprietary technology that states a few reasons for goodwill existence.
Calculating Goodwill
Treatment of goodwill in the cash flow statement is a fair and straightforward principle. It is applied to calculate goodwill, and it is a challenging practice. At first, to determine the value of goodwill, the company’s purchase price should be taken into consideration and then subtract the market value of the net fair of the assets and the liabilities from the same.
Goodwill Calculation is as follows: P- (A-L)
Here,
The purchase price of the target company is P
The value of the fair market value of assets is A, and
The value of the liabilities of the Fair market is L
Nature affecting Goodwill
- Product Quality
A company that produces qualitative products can easily establish a name in the market. If the product quality is good, it will increase sales and profit. The value of goodwill also increases.
- Management Efficiency
The increase in the value of goodwill is proportional to the management’s efficiency. Well-handled management usually enjoys the merit of more productivity and cost-efficiency. Increasing profit also helps increase the value of goodwill through properly planned distribution, production, and services.
- Nature of the Business
Business nature can affect the value of goodwill. When the company enjoys a favourable situation and a secured monopoly that brings assured earnings, the value of goodwill increases. A company having constant sales has a good chance of earning profit and goodwill.
- Location
If the company is located in a popular place, it can easily attract more customers and eventually increase turnover. A better location will attract more customers, and it results in an increase in sales and profit. This eventually results in increasing the value of goodwill.
- Market Condition
Limited competition or the monopoly facilitates the concern to earn more profits, leading to more value for goodwill. When the company has a monopoly right, or the competition is limited, it can earn high profits.
- Supply Access
When the supply access of the company is better, or it has an assured supply of inputs, then the company easily enjoys a better reputation than the other companies and thus can earn higher goodwill.
- More capital, more chances of Goodwill
The more the business capital, the more the chances of goodwill. More buyers may come to purchase a business that requires a comparatively small amount of capital, whereas the rate of earning profit is high. Consequently, raising the value of goodwill.
Treatment of Goodwill
Treatment of goodwill is the portion of the purchase price that is higher than the total of all assets’ fair value that is purchased in liabilities and acquisition. Treatment of goodwill is carried out in the following cases:
- When the partners’ profit-sharing ratio (PSR) is changed, goodwill will rise
- When a new partner is being admitted
- In the time of retirement or the death of a partner
- At that time when the whole business is sold
In all these cases, the adjustment of goodwill is required. And the valuation of goodwill will be done by choosing the below methods:
- Super profit method
- Average profit method
- Capitalisation method
Methods to Treat Goodwill
During the time of admission of a partner, by following the two methods below, goodwill can be treated:
- Premium Method: The premium method is the treatment of goodwill in cash flow statements. In this method, the incoming partner brings his goodwill share in cash in a sacrificing ratio. And the existing partner shares it. Moreover, if the goodwill amount is paid privately by the new partner to the old partner in cash, entries will not pass in the firm’s books.
- Revaluation Method: This method is used when the new partner decides not to bring his share of goodwill in cash. In this case, the goodwill account in the books can be raised by debiting the goodwill account and crediting the old partners’ capital account in the old profit-sharing ratio.
Goodwill in Diverse Scenarios
The accounting treatment of goodwill in diverse scenarios is very significant:
- The deceased or retiring partner is authorised to his part of goodwill in case of retirement or death
- During this time, goodwill is earned by the company with the perseverance and hard work of all the existing partners
- Therefore, during retirement or death, the evaluation of goodwill is based on the agreement
- Among the retiring/ deceased partners that recompensed for his portion of goodwill with the continuing partners
In these two scenarios, the accounting treatment of goodwill will depend on whether goodwill exists in the company’s book.
Conclusion
This article elucidates the concept of the treatment of goodwill, how to count goodwill, and the value and treatment of goodwill. Goodwill is an impalpable asset that helps a firm earn a higher profit than the average normal profit that the other firms earn in the organisation. In short, to purchase one company from another is known as goodwill. Goodwill can be treated by following the premium method and revaluation method.
