As the term suggests, goodwill reflects the reputation, recognition, connection, and several other non-quantifiable factors garnered by the business.
Several judgements by the Indian judiciary clarify the concept of goodwill and reflect the importance of goodwill in the industry.
Goodwill is garnered by every aspect concerning the firm, including the persona of owners, reputation, location, nature of business, and impact on present-day market situations.
Before the evolution of the term ‘goodwill’, approbation was considered to be a marketable commodity of a business. However, with advancements in the commercial sector, goodwill has come to be associated as a matter of sale. Goodwill defines the probability of clients rendering services from the same business again.
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What is Goodwill?
Goodwill is an intangible asset associated with a business or company during acquisition by another business or company. Generally, goodwill results in a higher sum paid than the fair value of the assets and liabilities procured during the acquisition process.
Goodwill is typically concerned with the acquisition process and assists the acquiring company in gaining an indefinite value associated with the acquired business.
In contrast to other tangible and intangible assets, the time of existence of goodwill cannot be determined because it does not exist from the initial stage of the business. However, its presence impacts the value of the business considerably.
The following three crucial factors boost the creation of goodwill:
- If the company’s existing working capital is sufficient for the effective functioning of a business and produces requisite income.
- If an additional income is generated because of the existence of goodwill
- If the company attracts several other economic opportunities for the creation of wealth
Types of Goodwill
As per available practices and declarations, goodwill is of the following types:
1: Purchased Goodwill
At the time of acquisition, the purchasing company must pay a specific consideration concerning a particular intangible advantage. Goodwill has a higher value than all available assets, even after deducting liabilities. Furthermore, goodwill is the premium paid to the acquired enterprise for the goodwill purchased, and the acquiring organisation must recognise goodwill as an asset in their accounting statements.
2: Inherent Goodwill
Known as self-generated goodwill, unlike purchased goodwill, inherent goodwill does not go through the accounting process by recording in the company’s accounts book. This form of asset is not acquired by paying any premium. It is an excess of value for a business compared to the fair value of separable net assets and can be determined as negative or positive.
Importance of Goodwill
Business functions on tangible assets accumulated and intangible assets contributing to profitability. Every business is impacted to a certain extent with frequent changes in the market, and businesses with well-established goodwill survive and thrive despite challenges.
Typically, businesses having a good social standing in the market succeed. Therefore, goodwill impacts a business in the following ways:
- Increases customer retention for future business translations and fosters new client relationships.
- Attracts potential investors and assists in earning investments easily.
- Strengthens the foundation of businesses and ushers new opportunities for further business expansion.
- Impacts the accounting and equity value of the business
- Goodwill is the most priced asset among all tangible and intangible assets.
Factors Affecting Goodwill
The following four factors affect goodwill:
Location is critical to the flow of business because ease of access to the goods and services lowers the cost and encourages customers to transact frequently. If transactions increase, so do profits.
2: Standing Time
The reputation of a firm increases with constant effort for customer satisfaction over the years.
3: Classification of Business
When a particular firm is dealing with goods and services that are critical for a particular time, the business attracts investments from potential investors and increases goodwill.
The history of a business and its trends and practices affects goodwill.
A set procedure does not exist for goodwill accounting. Every organisation or accountant follows a distinct approach by determining future cash flows and several other considerations. Goodwill accounting reflects the importance of recording and recognising goodwill in accounts if an amount has been paid.
Another important terminology is accounting impairment, which defines a drastic decline in goodwill and considerably affects goodwill accounting.
Furthermore, the following goodwill accounting practices are common:
- To be written off against the percentage of profit and cumulative assets.
- To retain it as an asset until a decline in value.
- To deduct the value of goodwill from the funds of shareholders.
- To retain it as an asset for an extended period and use accounting write-offs per the profits and loss.
Calculation of Goodwill Treatment
Assigning a particular value or amount to goodwill may become burdensome as an intangible asset. However, per the International Financial Reporting Standards (IFRS), goodwill can be calculated by the difference between the consideration amount transferred by the acquirer and assets acquired by the acquirer.
The general formula for calculating goodwill is as follows:
Goodwill = (C + NCI + FV) − NA
C = Consideration given by the acquirer
NCI = Non-controlling interest amount received
FV = Fair value of earlier equity interests
NA = Net identifiable assets
Numerous factors are significant in the accounting of goodwill:
- The deceased or retiring partner of the enterprise is authorised for a portion in goodwill. The agreement impacts the calculation of goodwill.
- In the scenario in which the complete business has been sold off.
- When the profit-sharing ratio among partners has changed
In all the scenarios, the goodwill will increase, and the portion of the purchase price increases after adding the fair net value of the assets and deducting procured liabilities.
Valuation of Goodwill
The value of goodwill is a specific financial worth assumed for the business. Factors such as reputation, client rapport, and stakeholder relations are considered for valuation.
Valuation of goodwill can be performed using the following methods:
1: Average Profits Method: This method is bifurcated into two other methods—simple and weighted average
- Simple Average: As per this method, goodwill is equivalent to the multiplication result of average profit by the number of years the business has existed from the date of purchase.
- Weighted Average: As per this method, goodwill is equivalent to the multiplication result of weighted average profit by the number of years from the date of purchase. Weighted average profit equals the total accumulated profit multiplied by weights accustomed with a profit of various years and divided by the sum of those weights.
2: Super Profits Method: This method is further classified into two methods.
- Purchase Method: Through the purchase method, super profits are calculated by subtracting the average profit from the normal profit of the business.
- Annuity Method: In this method, goodwill is calculated by multiplying super profits by the discounting factor, which includes the discounted super profit at a particular interest rate.
3: The Capitalisation Method is the most prominent method for calculating goodwill.
- The average profits method involves multiplying the average profit of the business by an average rate of return divided by 100.
- The super profits method involves multiplying super profit by the normal rate of return divided by 100.
Goodwill is a reflection of the business in terms of brand value or the reputation among stakeholders, employees, and customers, and bestows a competitive advantage over other business units.
Goodwill is the foundation stone of a successful business because of its vitality in the success and valuation of the business.
Goodwill is an upward ladder that only intends to enhance reputation, performance, and minimise risk associated with challenges. Therefore, goodwill is a firm’s most valuable asset that necessitates maintenance of the same level of business for long-term achievements and growth.
FAQs on Goodwill
Can the goodwill of a business be acquired separately from other assets of the business?
Goodwill alone can be sold off or acquired depending upon the component involved. These transactions are business specific and require proper legal arrangements by lawyers.
What is the duration of goodwill?
Goodwill is not associated with a fixed duration because it is determined by several business-related factors. However, in general terms, goodwill exists until the business complies with the market requirements and industry standards while maintaining a positive impact.
What is the role of taxation concerning goodwill?
In most cases, when purchasing goodwill, taxes are applicable to long-term capital gains made by the business.
What is the importance of self-generated goodwill?
Self-generated goodwill is similar to purchased goodwill in terms of reputation, customer centricity, and several other factors. However, self-generated goodwill is not considered an asset for the company.