Goodwill: Meaning in Accounting and Methods of Valuation

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Table of Content

• Goodwill Accounting Definition
• How to Calculate Goodwill?
• Factors Affecting the Value of Goodwill
• Goodwill Valuation
• Methods of Valuation of Goodwill

Goodwill Accounting Definition

Goodwill is listed as an intangible asset under the long-term assets category on the acquiring company’s balance sheet. Because it is not a physical asset like machinery or buildings, it is considered an intangible asset (or noncurrent asset).

Goodwill combines qualities and elements that a business pays extra for, such as its good reputation, loyal customer base, brand recognition, and proprietary technology. These are actual assets of a company. It is impossible to calculate their value accurately, nor are they tangible (physical) assets.

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At least once a year, companies must assess Goodwill on their financial statements and report impairments according to generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS).

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Example of Goodwill

"Spice Delights," a well-known restaurant chain in India, was purchased by a multinational food corporation for ₹50 crores. The tangible assets and financials of Spice Delights, like its property and kitchen equipment, are valued at only ₹35 crores. The additional ₹15 crores paid is accounted for as goodwill on the acquiring company's balance sheet. This goodwill represents Spice Delights' brand reputation, loyal customer base, and unique recipes, which, while not physically tangible, add significant value to the business.

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How to Calculate Goodwill

In theory, determining Goodwill is a relatively simple process, but it may be quite tricky. Using a straightforward formula, you may calculate it by starting with the company’s purchase price and deducting the net fair market value of its identifiable assets and liabilities.

Goodwill= P−( A − L )
where:
P=Purchase price of the target company
A=Fair market value of assets
L=Fair market value of liabilities

Example of Goodwill

If a firm buys Company MNO for $15 billion, the fair value of their assets minus liabilities is $10 billion. Hence, the premium paid for the transaction is $5 billion ($15 billion – $10 billion). This $5 billion will be recorded as Goodwill on the acquirer’s balance sheet.

Factors Affecting the Value of Goodwill

The company’s reputation is impacted by any aspect that impacts its ability to turn a profit. Following is a list of some of the variables influencing Goodwill:

1. Location of the Company

 If a business unit is situated in a suitable marketplace, the company will attract more clients, resulting in more revenue. The value of goodwill increases along with an increase in the company’s profit. Its value will decrease if the company operates in a less developed market or a backward area since fewer customers will visit the location.

2. The Firm’s Lifespan

A company with a long history of serving society would have more satisfied clients, a well-known brand, better customer support, etc. As a result, an older business unit will have a more extensive client base and a better reputation in the marketplace than a newly founded unit. Therefore, the Goodwill of a company increases in value with time. 

3. Effective Management

The management of any business unit determines its success. An organization run by effective managers will make more money and enjoy a high level of Goodwill in the market. Ineffective management plan execution hinders the company’s financial position, which ultimately reduces the goodwill value of the company.

4. Risk Factor

Investors, bankers, lenders, customers, and other stakeholders do not trust a business with a high-risk factor. When the risk is significant, a business fails to raise the necessary cash, hindering the execution of a managerial strategy and the company’s capacity to produce a profit.

5. Nature of the Goods

A company is more likely to have a more consistent profit and dependable clients if it deals in necessities or everyday goods, raising its Goodwill value. Similarly, businesses that sell trendy goods experience erratic sales and profits since they struggle to draw in additional clients and, in comparison, have lower goodwill values.

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Goodwill Valuation

A well-established company, as compared to a freshly created one, gains a positive reputation in the marketplace, establishes customer trust, and has more industry connections. Therefore, Goodwill is the monetary value of this benefit that a buyer is willing to pay. The buyer who purchases it anticipates generating exceptional profits compared to the earnings generated by the other businesses. Therefore, Goodwill is only there when a company makes exceptional profits; it is not present when it experiences average earnings or losses.

Goodwill is documented in the books only when a monetary or monetary equivalent consideration is given. Therefore, in a partnership firm, we must value Goodwill at the time of:

• Change in the existing partners’ profit-sharing ratio
• The admission of a new partner
• The partner’s retirement
• The amalgamation of partnership firms
• Death of a partner
• Firm dissolution in which the company is sold is a going concern.

Methods of Valuation of Goodwill

The choice of goodwill valuation methodology is solely up to the partners or the partnership deed if they have created it.  

1. Average Profits Method

i] Simple Average

Using this method, Goodwill is valued at the average profits of the prior years multiplied by the agreed-upon number of years since Goodwill was acquired.

Goodwill = Average Profit x No. Of years of purchase

ii] Weighted Average

Using this method, Goodwill is evaluated at the weighted average profits of the previous years purchased across an agreed-upon period. When profits are upward or downward, we utilize the weighted average, assigning the highest weight to the current year’s profit. 

Goodwill = Weighted Average Profit x No. of years of purchase
Weighted Average Profit = Sum of Profits multiplied by weights/ Sum of weights

2. Super Profits Method

(i) The Number of Years Purchase Method

This method values goodwill based on the number of years the firm has acquired super profits.

Goodwill = Super Profit x No. of years' of purchase
Super Profit = Actual or Average profit – Normal Profit
Normal Profit = Capital Employed x (Normal Rate of Return/100)

(ii) Annuity Method: 

In this method, we consider money’s time value. We consider the super profit’s discounted value here.

Goodwill = Super Profit x Discounting Factor

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3. Capitalization Method

(i) Capitalization of Average Profits

Calculating goodwill value requires deducting capital employed from capitalized profits and calculating an average rate of return.

Goodwill = Normal Capital – Actual Capital Employed

Normal Capital or Capitalized Average profits = Average Profits x (100/Normal Rate of Return)
Actual Capital Employed = Total Assets (excluding Goodwill) – Outside Liabilities

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(ii) Capitalization of Super Profits

 Under this method, the capitalization of super profits directly results in Goodwill calculations.

Goodwill = Super Profits x (100/ Normal Rate of Return)

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