Goodwill: How to Calculate Goodwill?

What is Goodwill?

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.

What is Goodwill

Goodwill 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.

For example, if you are selling an outstanding product or providing excellent service consistently, there is a lot of chance that goodwill raises quicker.

Read More: Important Questions for Goodwill

Goodwill Accounting Treatment

There are 3 types related to the accounting treatment of goodwill at the time of admission of anew partner:

  • When the amount of goodwill is paid privately.
  • When the new partner brings his share of goodwill in cash.
  • When the new partner does not bring his share of goodwill in cash.

Goodwill Example

To put it in a simple term, a Company named ABC’s assets minus liabilities is $10, and a company purchases Company ABC for $ 15, the premium value following the acquisition is $ 5. This $5 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.

In a real-life example, consider the PQR-Mobile company and copollo merger announced in early 2019. The deal was valued at $35.85 billion as of March 31, 2019, per an S-4 filing. The fair value of the assets is $78.34 billion, and the fair value of the liabilities is $45.56 billion. Thus, goodwill for the deal would be recognized as $35.85 billion – ($78.34 billion – $45.56 billion).

Factors Affecting Goodwill

  1. Quality Of Product: Better quality of product will increase the sales and profits which will increase the value of goodwill.
  2. Efficiency Of Management: A well-handled interest normally enjoys the merit of more cost efficiency and productivity, which will increase the value of goodwill.
  3. Location: The better location will attract more customers resulting in an increase in sales and profits which in turn, will result in an increase in the value of goodwill.
  4. Market Condition: The monopoly situation or limited competition facilitates the concern to earn more gains which leads to the more value of goodwill
  5. Access To Supplies (Raw Material Etc.): If a firm has better access to supplies or assured supply of inputs then it enjoys a better reputation than others and higher goodwill.
  6. Special Advantages: If a firm enjoys special advantages like patents, trademarks, brand image, or any other exclusive benefit, then the firm enjoys a higher value of goodwill.
  7. External resources: After sales service, Research & Development, Effectiveness of Advertisement, the supply of electricity, import licenses, well-known collaborators, long-term contracts for the supply of materials, trademarks, patents, etc.certainly enjoy more value of goodwill.

Also Read: What is the Accounting Treatment of 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

Additional Reading: TS Grewal Solutions for Goodwill- Nature and Valuation

The above mentioned is the concept that is explained in detail about Goodwill for the class 12 Commerce students. To know more, stay tuned to BYJU’S.

Multiple Choice Questions
Q.1-Goodwill is a ________asset which cannot be seen or touched.
a. Liability. b. Current asset. c. Intangible. d. None of the above.
Q.2- Goodwill is shown in:
a. P & L Appropriation A/c b. Balance sheet. c. Profit and Loss A/c… d. None of the above.
Q.3- In which side, the goodwill is shown in the balance sheet.
a. Asset side under Fixed Assets b. Assets side under current assets. c. Intangible Fixed Assets d. Both (a)&(c)
Answer Key
1-c, 2-b, 3-d.

Frequently Asked Questions on Goodwill

Define Goodwill?

It is the reputation of a firm which enables it to earn higher profits in comparison to the normal profits earned by other firms in the same business.

What Is The Nature Of Goodwill?

It is the intangible asset which does not have a physical existence. It is not a fictitious asset. It can be sold with the sale of the business itself.

Why Is ‘goodwill’ Considered An ‘intangible Asset’ But Not A ‘fictitious Asset’?

It is considered an intangible asset as it cannot be seen or touched. However, it is not a fictitious asset as it can be sold for money or money’s worth.

Mention the Two Characteristics Of Goodwill?

(i) Goodwill is an intangible asset and not a fictitious asset.

(ii) Goodwill enables to earn a super profit.

Name Any Two Factors Affecting Goodwill Of A Partnership Firm?

(i) The favourable location of the Business

(ii) The efficiency of Management

Name Any Two Methods Of Valuation Of Goodwill?

(i) Average Profit Method

(ii) Super Profit Method

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