What is goodwill and how is it calculated?
How does Goodwill work?
An intangible asset associated with the sale of one company to another is goodwill. Goodwill is recorded when the purchase price exceeds the fair value of all visible solid assets and intangible assets acquired and all liabilities assumed as part of the acquisition. A company’s brand name, a solid customer base, good customer relations, and its patents and proprietary technology represent some examples of goodwill.
In accounting, goodwill is defined as
The acquisition of an entire business creates goodwill for a company. Goodwill is calculated as the purchase price minus the fair market value of the tangible assets, the intangible assets that are able to be identified, and the liabilities acquired in the transaction.
Calculating Goodwill
Goodwill can be calculated by subtracting identifiable assets and liabilities from the purchase price of a company.
The Goodwill Formula is as follows:
The goodwill formula is P−(A+L)
In what place?
Target company purchase price = P
An asset’s fair market value is equal to A
The fair market value of liabilities is L
There are different types of goodwill
There are two distinct types:
- Goodwill purchased: Purchased goodwill refers to the difference between the price paid for the enterprise as a going concern and the value of the enterprise’s assets less liabilities.
- This is the excess between the fair value of the business’s separable net assets and the value of the business itself.
- It is referred to as internally generated goodwill, and it arises over a period of time due to the good reputation of a business. It can also be called as self generated or non-purchased goodwill.
When you consistently provide excellent service or sell an excellent product, goodwill is likely to increase.
The treatment of goodwill in accounting
There are five types of accounting treatment of goodwill at the time of admission of a new partner:
- In this case, the amount of goodwill is brought in cash without being recorded in the books.
- New partners bring their share of goodwill in cash and remain in the business.
- Goodwill is not brought into the partnership in cash by the new partner.
- In cases where goodwill is already present on the books.
- Goodwill is raised at its full value when it is raised.
Example of goodwill
In simple terms, if ABC’s assets minus liabilities equal 10 crores, and another company purchases it for 15 crores, the company ABC will be worth 5 crores as a premium value following the acquisition. This amount of goodwill is recorded as goodwill on the acquirer’s balance sheet. If the purchase price of the target company exceeds the assumed debt, it is recorded as goodwill.
The Goodwill Factor
The following factors have an impact on the goodwill, which are:
- Location of the business : If the business is located in a suitable place, its goodwill will be higher than if it is located in a remote location.
- Quality of goods and services: Companies offering superior products and services are more likely to earn goodwill than those providing inferior products.
- Efficiency of management : When the business is managed efficiently, profits increase and goodwill increases.
- Business Risk : Low risk businesses have a better chance of creating goodwill than high risk businesses.
- Nature of business: This refers to the type of products that a business deals with, the level of competition in the market and the demand for the products.
- Favorable Contracts: A firm will enjoy a higher goodwill if it has access to favorable contracts for sale of products.
- Possession of trade mark and patents : Patented and trademarked companies have monopolies on their markets, which contributes to the firm’s goodwill.
- Capital : Buyers will consider a firm that has a higher return on investment combined with a lower capital investment to be more profitable and trustworthy.
Goodwill Valuation Needed
- Profit-sharing ratios (PSR) among existing partners
- A new partner is admitted
- Partner retires
- In the event of the death of a partner
- Sale of the business as a trading concern during the dissolution of an enterprise
- The consolidation of partnership firms
Valuation of goodwill methods
The significant methodologies of valuation are mentioned :
- The average profit method
- How to make super profits
- The capitalisation method
Class 12 Commerce students have completed the topic of Goodwill. As a result, a more clear understanding of the concept of goodwill will be gained. Visit Nemani Classes to read more about such interesting concepts.
| Multiple Choice Questions |
| Q. ________assets cannot be touched or seen, such as goodwill. |
| a. Intangible asset. b. Assets of current value. c. Non-tangible. d. None of the above apply. |
| Q.2- Goodwill can be demonstrated in the following ways: |
| a. P & L Appropriation Account b. Statement of balances. c. Earnings and Losses Account…Earnings and Losses Account… d. None of the above. |
| Q.3- Where is goodwill shown on the balance sheet? |
| a. In the Fixed Assets section, find the asset side b. Under current assets, there is an asset side. c. Fixed assets with intangible components d. Both (a)&(c) |
| Answer Key |
| 1-c, 2-b, 3-d. |
Frequently Asked Questions on Goodwill
What is goodwill?
A firm’s reputation enables it to earn higher profits than its competitors in the same business due to its reputation.
How Does Goodwill Work?
Intangible assets lack a physical existence. Unlike fictitious assets, it does not exist. With the sale of the business, it can be sold as well.
What is the difference between ‘goodwill’ and a fictitious asset?
Because it cannot be seen or touched, it is considered an intangible asset. Despite this, it is a real asset since it can be sold for money or its equivalent.
How would you define goodwill?
(i) Goodwill is not a fictitious asset but an intangible asset.
(ii) Profits can be earned greatly through goodwill.
The goodwill of a partnership firm differs from that of its competitors, how?
(a) The favorable location of the business
(ii) Effectiveness of management
How are goodwill values determined?
(i) Method of Average Profit
(ii) Profit Maximization Method
The nature and valuation of goodwill – Important Questions
Important Questions with Answers for CBSE Class 12 Accountancy Chapter 3- Goodwill- Nature and Valuation which is outlined by expert Accountancy teachers from the latest version of CBSE (NCERT) books.
3 Important Questions for CBSE Class 12 Accountancy
QUESTION 1
Goodwill is defined as.
Answer: Goodwill is an intangible asset that helps an organization earn higher profits without putting in extra effort.
QUESTION 2
Give two features of goodwill.
Answer: Goodwill consists of two features
- An intangible asset. A physical existence is not possible for it
- Profits can be increased through it
QUESTION 3
Why does goodwill need to be valued?
Answer: Goodwill must be valued.
- In the event of a change in profit-sharing ratios
- Admitting a new partner
- The death or retirement of a partner
- Partnership firms that are sold as going concerns
- An amalgamation of two or more firms/partnerships
- Company formation occurs when a partnership becomes a corporation
QUESTION 4
How is goodwill evaluated?
Answer: Goodwill can be evaluated in the following ways:
- The average profit method can be divided into two types: (a) Simple average profit method and (b) Weighted average profit method
- How to make super profits
- Capitalisation Method –i) Capitalisation of an average profit, (ii) Capitalisation of a superprofit.
QUESTION 5
Goodwill purchased is what?
Answer: A firm purchases goodwill for a consideration, whether in cash or kind.
QUESTION 6
Self-generated goodwill: what is it?
Answer: Self-generated goodwill is goodwill earned by the management or partners without being purchased for consideration.
QUESTION 7
How does the super profit method work?
The buyer has an advantage when the return capital employed is greater than the normal return capital employed. It is known as the super profit method when the actual or average profit is greater than the normal profit.
QUESTION 8
How does goodwill value change with time?
Answer: Goodwill’s value is affected by the following factors.
- Management with efficiency
- The location is ideal
- A favorable contract
- A patent’s advantages
- The market situation
- Business type
QUESTION 9
Goodwill that has been purchased has two features.
Answer: Purchased goodwill consists of two characteristics:
- A business purchase triggers it
- Assets are shown on the Balance Sheet
QUESTION 10
A self-generated goodwill has two characteristics.
Answer: The two features of self-generated goodwill are:
- Generally, it develops over time, internally
- In the books of accounts, self-generated goodwill is not recorded
QUESTION 11
What is the formula for super profit?
Answer: Superprofit method formula is as follows:
A super profit is equal to the average maintainable profit minus the normal profit
QUESTION 12
Explain how goodwill is calculated using the super profit method.
Answer: Superprofit method formula is as follows:
An average maintainable profit minus a normal profit is called a super profit
The following formula can now be used to calculate goodwill:
A company’s goodwill is equal to its super profit multiplied by its purchase age.
