Limitations of Goodwill

Good Will

Meaning

Goodwill is an intangible asset associated with the purchase of one company by another. Specifically, goodwill is recorded in a situation in which the purchase price is higher than the sum of the fair value of all visible solid assets and intangible assets purchased in the acquisition and the liabilities assumed in the process. The value of a company’s brand name, solid customer base, good customer relations, good employee relations, and any patents or proprietary technology represent some examples of goodwill.

Good will Meaning in Accounting

Goodwill arises when a company acquires another entire business. The amount of goodwill is the cost to purchase the business minus the fair market value of the tangible assets, the intangible assets that can be identified, and the liabilities obtained in the purchase.

How to Calculate Goodwill

To calculate goodwill, we should take the purchase price of a company and subtract the fair market value of identifiable assets and liabilities.

Goodwill Formula:

Goodwill = P−(A+L)

where,

P = Purchase price of the target company

A = Fair market value of assets

L = Fair market value of liabilities

Types of Goodwill

There are two distinct types:

Purchased: Purchased goodwill is the difference between the value paid for an enterprise as a going concern and the sum of its assets less the sum of its liabilities, each item of which has been separately identified and valued.
Inherent: It is the value of the business in excess of the fair value of its separable net assets. 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.

For example, suppose you are selling an outstanding product or providing excellent service consistently. In that case, there is a high chance of an increase in goodwill.

Goodwill Accounting Treatment

There are five types of accounting treatment of goodwill at the time of admission of a new partner:

When the amount of goodwill is brought in cash and not recorded in books.
When the new partner brings his share of goodwill in cash and is retained in business.
When the new partner does not bring his share of goodwill in cash.
When goodwill already exists in the books.
When goodwill is raised at its full value.

Goodwill Example

To put it in a simple term, a Company named ABC’s assets minus liabilities is ₹10 crores, and another company purchases the company ABC for ₹15 crores, the premium value following the acquisition is ₹5 crores. This ₹5 crores will be included on the acquirer’s balance sheet as goodwill. It is also recorded when the purchase price of the target company is higher than the debt that is assumed.

Factors Affecting Goodwill

The following factors have an impact on the goodwill, which are:

Location of the business : A business which is located in a suitable location will have a more favourable chance of higher goodwill than a business located in a remote location.
Quality of goods and services: A business which is providing a higher quality of goods and services stands a great chance of earning more goodwill than competitors who provide inferior goods and services.
Efficiency of management : An efficient management results in increase in profit of the business which enhances the goodwill of the business.
Business Risk : A business having lesser risk has a better chance of creating goodwill than a high risk business.
Nature of business: It means the type of products that business deals with, the level of competition in the market, demand for the products and the regulations impacting the business. A business having a favourable outcome in all these areas will have a greater goodwill.
Favourable Contracts: A firm will enjoy a higher goodwill if it has access to favourable contracts for sale of products.
Possession of trade mark and patents : Firms that have patents and trademarks will enjoy monopoly in the market, which will contribute to the increase in the goodwill of the firm.
Capital : A firm with a higher return on investment along with lesser capital investment will be considered by buyers as more profitable and having more goodwill.

Need for Valuation of Goodwill

The difference in the profit-sharing ratio (PSR) amongst the existing partners
Admission of a new partner
Retirement of a partner
Death of a partner
Dissolution of an enterprise involving the sale of the business as a trading concern
Consolidation of partnership firms

Methods of Valuation of Goodwill

The significant methodologies of valuation are mentioned :

Average Profits Method
Super Profits Method
Capitalisation Method

How Is Goodwill Used in Investing?

Evaluating goodwill is a challenging but critical skill for many investors. After all, when reading a company’s balance sheet, it can be very difficult to tell whether the goodwill it claims to hold is in fact justified. For example, a company might claim that its goodwill is based on the brand recognition and customer loyalty of the company it acquired.

When analyzing a company’s balance sheet, investors will therefore scrutinize what is behind its stated goodwill in order to determine whether that goodwill may need to be written off in the future. In some cases, the opposite can also occur, with investors believing that the true value of a company’s goodwill is greater than that stated on its balance sheet.

How Is Goodwill Different From Other Assets?

Shown on the balance sheet, goodwill is an intangible asset that is created when one company acquires another company for a price greater than its net asset value. Unlike other assets that have a discernible useful life, goodwill is not amortized or depreciated but is instead periodically tested for goodwill impairment. If the goodwill is thought to be impaired, the value of goodwill must be written off, reducing the company’s earnings.