Introduction to Goodwill
Goodwill is defined as a type of intangible asset which mainly comes into use when one company is getting acquired by another and is also that part of the purchase cost which is generally incrementally more than the total of the net fair value of all the other assets which is bought during the acquisition phase and the liabilities which was assumed in the process.
Explanation of Goodwill
Goodwill comprises of the intangible assets of the company which are as brand name, healthy customer base, sound customer relationship, good employee relationship, and technology strength. It generally comprises of the assets which cannot be quantified easily such as recognition of a brand. It is generally calculated by taking the price at which the company is purchased and then subtracting the difference of the fair market value of the liabilities and the assets. It is generally mandatory for the companies to take a review of their goodwill and record it in their financial statement at-least once a year and in a similar manner, it also must record any impairments which has happened. The calculation of this is rather simple in the process but can get quite complex when it is implemented into practice. It is something which is very closely observed during phases of acquisition and the acquirer company will be very keen to acquire such target companies which has a good level of the goodwill attached to it.
How to Calculate Goodwill?
There are three methods which can be applied to calculate which are described below:
Calculation using the average profit method:
- Here the concept of average profit is applied which is like goodwill equals to average profit multiplied by the number of years.
- Certain adjustment needs to be made to the numbers before we make the calculations like we should not consider any abnormal profit and any abnormal losses should be added back to the net profit. Also, any kind of non-operating income should not be considered.
- Then we need to do the math where the average profit for the numbers of years considered is added and divided by the number of years.
- As goodwill equals to the average profit over the number of years multiplied by the number of years, the average obtained in the last step is multiplied by the number of years to obtain at the figure.
Calculation using a super profit method:
- In this method, the average profits for the number of years to be considered is calculated.
- Now each year will have an actual profit where for each year the average calculated is deducted from the actual profit.
- Thus, if the number of years considered is five, we will have 5 different values for each year.
- Each year’s value is known as the super profit and overall when all the year’s value is calculated, and the sum is multiplied by the number of years it gives us the goodwill value.
Example of Goodwill?
Few examples can be as follows:
- Brand name of the business which is popular among the customers.
- Technology know-how and competency which is the core competency for the company and is unique.
- A strong customer base which makes the company very popular and has a good word of mouth communication among the target customers.
- A good employee relationship and benefiting employee policies can also be considered as goodwill for a company as employees stay motivated and focused towards their job.
Types of Goodwill?
There are generally two types which are as follows:
- Purchased: Purchased goodwill is defined as the difference of the sum paid for a business as a going concern and the total value of the assets less the total value of its liabilities where each item is identified and valued separately.
- Inherent: This is defined as the value of the firm in excess of the fair price of each individual net asset. This is more of an internally generated goodwill and it mainly comes into place on account of the good reputation of the company over a period.
Factors Affecting Goodwill?
The factors affecting are as follows:
- Managerial skills depending on the ability of the managers and their skills affect the goodwill value.
- The nature of the business also impact the goodwill value which means the type pf products, the demand for the products, and competition in the market.
- The trend in the profit or the earning capacity of the business also impacts the goodwill value.
- The existence of many profitable contracts for the supply of services or the goods will impact the goodwill.
- The capital and profit relation have a major relation to the goodwill especially the case when the profit is larger than the capital employed, the value of it increases.
Accounting for Goodwill?
There are two scenarios when it can be accounted for during an acquisition phase.
- When the company bought the goodwill and paid for it:
Goodwill A/C Debit
Cash A/C Credit
This goodwill will be shown as an intangible asset in the balance sheet.
- When a company is selling the goodwill and getting the amount for goodwill.
Cash A/C Debit
Profit on sale of goodwill A/C Credit
Goodwill A/C Credit.
Now it means the goodwill value has decreased from the balance sheet and thus we transfer this as a write off to the profit and loss account debit side.
Need for Valuation of Goodwill?
Valuation is required for several purposes:
- It is an important aspect during the phase of acquisition as both the companies want to be in a win-win situation where goodwill makes a difference in the valuation.
- When different partnership firms amalgamate, or any firm converts into a company.
- When stock exchange quotation of the value of shares is not available to calculate the gift tax or wealth tax.
- When there is a requirement of implementing a change in the profit-sharing ratio of the firm.
- When there is a requirement of conversion of shares of one class into another.
Some of the disadvantages are:
- The cost of acquiring a company with goodwill may be very high.
- It is more of intangible in nature and just based on calculation.
- It does not consider abnormal profits or losses during its calculation.
- It can at times make the firm over valued without any real and constructive reason behind it.
- It is easy to calculate in papers but while in practice the concept is complex.
As discussed, we found that goodwill plays a major role in the acquisition phase for both companies. It all together impacts the valuation of a company. Gathering goodwill takes a considerable span of time and it can’t happen overnight. Thus, a company to gather goodwill has to stand apart in this competitive world and also fulfill the expectation of its customers.
This is a guide to Goodwill. Here we also discuss the introduction to Goodwill and how to calculate goodwill along with factors affecting. You may also have a look at the following articles to learn more –