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 and mostly comes into the picture at the time of selling and purchasing 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/methods 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 business’s reputation 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 a 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 after that, 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 a business that 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 are recorded on the journal’s debit side, whereas the liabilities and cash are recorded on the journal’s credit side. 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. Instead, they show this in some other way so that it appears as a transaction other than a 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 a 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 of 2:1, i.e., A gets Rs. 200,000, and B gets 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 a profit-sharing ratio of 2:1, and C, the new partner, brings the goodwill of Rs. 300,000. Now the partner will credit this goodwill amount in the accounts of both A & B in the ratio of 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 accounts in their new profit sharing ratio.
For example, there are two partners, A & B, with a 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 accounts 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 to the old profit-sharing ratios accordingly.
- There are two partners, A & B, with a profit-sharing ratio of 3:1, and C, the new partner, brings the Goodwill amount of Rs. 200,000 and the goodwill appearing in the books of accounts is Rs. 100,000, then the partners will debit their account by Rs. 100,000 in the ratio of 3:1
- There are two partners, A & B, with a profit-sharing ratio of 3:1, and C, the new partner, brings the Goodwill amount of Rs. 200,000, and the goodwill appearing in the books of accounts is Rs. 300,000, then the partners will be credited their account by Rs. 100,000 in the ratio of 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