Goodwill is a term widely used in accounting. When a buyer acquires an already existing business, goodwill tends to arise. It is an intangible asset that cannot be self-created and can only be acquired through accession. It tends to represent assets that are not identified separately.
Goodwill is computed on the basis of the profits that are expected in excess of normal profits. In other words, it indicates the firm’s capacity to earn a higher profit in the future on the basis of its track record.
Methods of Treating Goodwill
In a situation or case of admission of a new partner, the accounting treatment of goodwill is as follows:
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Premium method:
According to this method, when the new partner brings their share of goodwill (in cash), the already existing members or partners tend to share it in the sacrificing ratio. But, if the new partner privately pays the amount of goodwill (in cash) to the old partner, then no kind of entry is passed in the books of the firm or organisation. In this case, the share of goodwill that the new partner brings in can be credited to their capital account and then adjust the capital accounts of the existing partners in their sacrificing ratio.And when goodwill already exists in the books of the firm, then:
(a). Either it does not appear in the books of the organisation in the future.
(b). Or it continues to show up in the books of the firm in the future. In this case, the new partner is supposed to bring in his share of goodwill, but only with respect to the difference between the book value and the new value.
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Revaluation method:
If the new partner makes a decision not to bring in his/her share of the goodwill, then the revaluation method is utilised. In such a situation, the goodwill account in the books of the firm or organisation is raised. This is done by debiting the goodwill account and crediting the capital accounts of the old partners or members in the old profit sharing ratio.
Factors that Affect the Value of Goodwill
The factors that affect goodwill are as follows:
1. Location of the business: While ascertaining goodwill, this factor should always be taken into account. This is mainly because if the firm is located somewhere centrally, then it would be able to attract more and more customers, thereby leading to an increase in turnover.
2. Nature of the business: This tends to include various aspects like the nature of goods, the risk involved, the benefits of trademarks and patents, raw material that is easily accessed, and the monopolistic nature of the business.
3. Time: The amount of time since a firm has catered to its customers also tends to make a difference and influences the value of goodwill. Between an old firm and a new one, the former would be better known by its customers, as a result of which, it may earn a relatively more commercial reputation.
4. Efficiency of management: If the management is efficient and effective, then it can be of great help to increase the value of goodwill.
5. The trend of profit: the basis of the rate of return or fluctuations in the amount of profit also affect the value of goodwill; if the trend of profit rises, then the value of goodwill is likely to increase and vice versa.
6. Other factors like capital required, the government policies, the condition of the money market, the possibility of competition, etc., also tend to influence the value of goodwill.
How is Goodwill Calculated?
Based on the Accounting Standards, the following are the purposes based on which goodwill of a firm is to be computed:
In each case, goodwill is first calculated by the partners, the existing goodwill is distributed, and then further steps are taken.