Goodwill is an important part of the business and it is one of the intangible assets. It is used for the valuation of the business. Mostly it comes into the picture at the time of selling and purchasing of a business or organization. It also comes into the picture when the business form is changing, when there is a change in the partner’s profit-sharing ratio, in case of entry or exit of any partner, a split of some division or part of the business, etc. The buyer of the business pays certain charges for the goodwill to the seller that he had earned since the business started. No one can calculate the exact value of the goodwill, but they can just predict or assume its value. There are certain formulas to calculate goodwill in monetary terms. Therefore, accounting for goodwill is very important.
In other words, goodwill is the amount that the seller, whether it is a company, sole proprietor, partnership, or any other organization charges for the hard work that they have done to make their business grow not only in terms of profit but also creating a good image of the business among people and maintaining it for so long. In simple words, it is the reputation of the business for which they charge a certain amount.
- Characteristic of Goodwill
- Types of Goodwill
- Accounting Treatment of Goodwill
- Formulas for Evaluating Goodwill
Characteristic of Goodwill
It is an intangible asset that cannot be seen from the naked eyes but are present and play an important role in the valuation of the business
There is no requirement for investments to build goodwill. It is just the hard work and image creation that increase the valuation of business leading it to increased goodwill value over the years of operations.
The amount of goodwill is not fixed and depends on the person judging it. The amount might be more or less than the expectation or what has been agreed to be paid.
As there is not any investment it is difficult to evaluate goodwill. There is no method to evaluate the exact amount of goodwill, but these are predictions that we make using certain formulas.
Types of Goodwill
It is basically the difference that a buyer is paying for all the assets of the firm/company and after deducting the sum of its liabilities. Here, each asset and liability is separately valued, and thereafter the balancing figure or the remaining excess payment is termed as goodwill.
It is the goodwill that is generated internally after a certain time with a lot of hard work. As it is for the business which is new or does not have any old history it can be either positive or negative.
Accounting Treatment of Goodwill
Accounting treatment for goodwill is different for different organizations. The following are the accounting treatment of goodwill:
In Case of Company
The assets and the goodwill is recorded at the debit side of the journal whereas the liabilities and cash is recorded at the credit side of the journal. The accounting for goodwill will be as under:
In Case of Partnership
Partner brings Goodwill, but not Recorded in Books
When a new partner brings goodwill but is not recorded in the books of accounts – Many times to avoid income tax the goodwill brought by the new partner and payment to the old partner is not recorded in the books of accounts rather they show this in some other way so that it appears as a transaction other than goodwill transaction. Or it is directly paid to the existing other partners and nothing comes into the business and thus in the books of account As this leads to the generation of black money it is not considered a good practice.
Partner brings Goodwill and Retained in the Firm
When the new partner brings the goodwill and is retained in the firm/company -The amount of goodwill brought by the new partner is recorded in the books of account. The same is credited and distributed amongst the old partners in the ratio of their sacrificing profit share. However, if it is not known then it is distributed in their old profit-sharing ratio’
For example, there are two partners A & B, with the profit-sharing ratio of 2:1, and C the new partner brings Goodwill Rs.300,000. Now partners will be distributing this amount of Rs.300,000 in the ratio 2:1 i.e., A gets Rs. 200,000 and B get Rs. 100,000.
Partner brings Goodwill and Withdrawn by Old Partner
When the new partner brings goodwill, and the goodwill amount is withdrawn by the old partners- The accounting entry and treatment of goodwill will remain the same as we discussed above. That is The goodwill amount brought by the new partner is credited to the existing partner’s capital account with their respective share of goodwill. Once credited the old partners have an option to either withdraw the full amount or they can even withdraw a partial amount.
For example, there are two partners A & B, with the profit-sharing ratio of 2:1, and C the new partner brings the goodwill Rs. 300,000. Now the partner will credit this goodwill amount in the accounts of both A & B in the ratio 2:1, the partners A & B can now withdraw this amount fully or partially as per their wish and timing.
Partner does not bring Goodwill and Raised its Full Value
When the new partner does not bring the goodwill and it is raised to its full value- when the new partner is not able to bring anything in cash for goodwill. In such a scenario the existing goodwill (proportionate for the new partner) will be raised to its full value. Then the goodwill account is debited by the full value of the goodwill and the old partner’s capital accounts are credited by this full goodwill amount in their old profit sharing ratio. And again if the goodwill amount needs to be written off then the same will be debited to all the partner’s capital account in their new profit sharing ratio.
For example, there are two partners A & B, with the profit-sharing ratio of 3:1, and C the new partner does not bring the Goodwill amount of Rs. 300,000 and the new profit-sharing ratio of the partner is 2:1:1. Here, the accounting for goodwill is as follows:
|To A’s Capital A/c||xxx|
|ToB’s Capital A/c||xxx|
|(for goodwill raised to its full)|
|A’s Capital A/c||Dr.||xxx|
|B’s Capital A/c||Dr.||xxx|
|C’s Capital A/c||Dr.||xxx|
|To Goodwill A/c||xxx|
|(For goodwill written off)|
Goodwill Already Present in Books of Account
When the new partner brings the goodwill and there is already goodwill in the books of accounts-If the goodwill is already appearing in the books of account and the present value is the same then there would be no entry in the books of accounts. But if there is a difference in the goodwill amount, then the old partners’ accounts need to be debited or credited in the old profit-sharing ratios accordingly.
- There are two partners A & B, with the profit-sharing ratio 3:1, and C the new partner brings the Goodwill amount of Rs. 200,000 and the goodwill appearing the books of accounts is Rs. 100,000, then the partners will debit there account by Rs. 100,000 in the ratio 3:1
- There are two partners A & B, with the profit-sharing ratio 3:1, and C the new partner brings the Goodwill amount of Rs. 200,000 and the goodwill appearing the books of accounts is Rs. 300,000, then the partners will be credit there account by Rs. 100,000 in the ratio 3:1
Formulas for Evaluating Goodwill
Average Profit Method
Average profit * No. of year’s purchased
Where average profit = sum of profits of respected years / no. of years
Super Profit Method
Super profit * No of year’s purchase
Where super profit= average profit- normally expected profit for the industry
Super profit * Annuity value
Where annuity value= (1+r)n-1/r(1+r)n
Capitalized Average Profit Method
Super profit / Normal rate of Return