Goodwill in accounting is an intangible asset that arises when a buyer

acquires an existing business. Goodwill represents assets that are not

separately identifiable. Goodwill does not include identifiable assets that
are capable of being separated or divided from the entity and sold,
transferred, licensed, rented, or exchanged, either individually or
together with a related contract, identifiable asset, or liability regardless
of whether the entity intends to do so. Goodwill also does not include
contractual or other legal rights regardless of whether those are
transferable or separable from the entity or other rights and obligations.
Goodwill is also only acquired through an acquisition; it cannot be self-
created. Examples of identifiable assets that are not goodwill include a
company’s brand name, customer relationships, artistic intangible
assets, and any patents or proprietary technology. The goodwill amounts
to the excess of the "purchase consideration" (the money paid to
purchase the asset or business) over the net value of the assets minus
liabilities. It is classified as an intangible asset on the balance sheet,
since it can neither be seen nor touched. Under US GAAP and IFRS,
goodwill is never amortized, because it is considered to have an
indefinite useful life. Instead, management is responsible for valuing
goodwill every year and to determine if an impairment is required. If the
fair market value goes below historical cost (what goodwill was
purchased for), an impairment must be recorded to bring it down to its
fair market value. However, an increase in the fair market value would
not be accounted for in the financial statements. Private companies in
the United States, however, may elect to amortize goodwill over a period
of ten years or less under an accounting alternative from the Private
Company Council of the FASB.

Goodwill is a thing easy to describe, but very difficult to define. It is the

benefit and advantage of good name, reputation and connection of a
business. It is the attractive force which brings in more customers. It is
one thing which distinguishes an old established business from a new
business at its first start. Goodwill is composed of a variety of elements.
It differs in its composition in different trades and different businesses in
the same trade.”

“Goodwill is a nebulous term for that part of the value of an asset or

business arising from factors and directly associated with the assets or
business as such. For instance, goodwill may arise from the good
reputation of the business or the fact that it is making profits above the
average due to some particular advantages.”

“From the accountants’ point of view, goodwill in the sense of attracting

customers has little significance unless it has a saleable value. To the
accountants, therefore, goodwill may be said to be that element arising
from the reputation, connection or other advantages possessed by a
business which enables it to earn greater profit than the return normally
to be expected on the capital represented by the net tangible assets
employed in the business.”

Goodwill is an intangible and invisible asset. In the statutory form of

Balance Sheet of a Company, goodwill is shown as the first item amongst
fixed assets. Being a fixed asset, it is attached to the business. It is an
attractive force that distinguishes and old business-firm from a new one,
and brings in more customers.

Thus goodwill may be understood as the reputation of a firm and enables

to earn profits. Goodwill and profits go together. It is a valuable asset if
the concern is profitable, on the other hand, it is valueless if the concern
is a losing one. It represents the value of a firm’s reputation. It can be
sold, though a sale will be possible only along-with the sale of business
itself. It is not an independent asset, like cash or stock, which can be sold
or transferred.

The Statement of Standard Accounting Practices (SSAP-22) defines

goodwill as “the difference between the value of a business as a whole
and the aggregate of the fair values of the separable net assets.”
According to this definition, the value of a business as a whole differs
from the value of its net separable assets. This difference is called
goodwill.

Accordingly, goodwill cannot be realised separately from the business as

a whole. This is the fundamental difference between goodwill and all
other assets, which are separable and can be sold without the necessity of
sale of the business as whole.
From the legal point of view, goodwill may be defined as “the advantage
or benefit which is acquired by a business, beyond the more value of the
capital, stock and funds properly employed therein, in consequence of
the general public patronage and encouragement which is received from
constant or habitual customers.” Goodwill is thus the extra saleable value
attached to a prosperous business beyond the intrinsic value of net
assets. Since it is invisible, the goodwill is called an intangible asset, but
since its existence can be felt through extra earning power, it is a real
asset.

Since it is attached to a business, it is impossible to think of selling only

its goodwill while continuing the business.

Goodwill has been said to be the attractive force which brings in

customers. Hence to determine the nature of the Goodwill in any one
given case, it is necessary to consider the type of business and the type of
customers.

The following are the principal classes of Goodwill:

(a) CAT Goodwill:
Special feature of a cat is that it remains at one place and does not
change its living place from time to time. It is said that cat loves place
more than person. Goodwill of some business is like cat because it
depends on the place of business and it does not change due to change in
ownership.

The cat stays in the old home although the person who has kept the
home leaves, and so it represents the customer who goes to the old shop
whoever keeps it, and provides local goodwill. This type of goodwill has
stability and therefore its value is always maximum.

(b) Dog Goodwill:

Dogs are attached to the persons. Dog has more affection for its owner
than the place. The faithful dog is attached to the person rather than to
the place, he will follow the outgoing owner if he does not go too far.

There are some businesses whose goodwill depends on the owner. Such
goodwill is called Dog Goodwill and its value is less. Certain customers
are attached to the owner of the business due to his exceptional skill,
personality, honesty etc. This applies specifically to professionals like
Chartered Accountants, Doctors, Lawyers, and Sweet-stall Owners etc.
Dog goodwill is difficult to transfer and is correspondingly less valuable.

(c) Rat Goodwill:

The characteristic of a rat is that it moves from place to place. The rat has
no attachments and is purely casual. If the Goodwill of a business often
changes, it is known as Rat Goodwill. Such goodwill is valueless.

(d) Rabbit Goodwill:

The rabbit is attracted by mere propinquity. He comes because he
happens to live close by and it would be more troublesome to go
elsewhere.

Features of Goodwill:
Following are the important features of goodwill:
1. Goodwill has no existence separate from business, i.e. goodwill cannot
exist independently of business. It is attached to the business.

2. Goodwill can be sold or purchased with entire business. It is valuable

only when entire business is sold or purchased.

3. The value of goodwill and the assessment of its existence is based

upon subjective judgement of the valuer, inspite of different methods of
its valuation.

4. It is difficult to place an exact value to goodwill since its value

fluctuates from time due to changing circumstances of business.

5. It represents a non-physical value, intangible in nature, goodwill does

not depreciate by wear and tear. However, the goodwill becomes a
fictitious asset if it appears in the books of a losing concern.

Need for Valuation of Goodwill:

Circumstances necessitating ascertainment of goodwill are:
In the case of a Company:
1. When amalgamation and absorption take place.

2. When sales or purchase take place.

3. When shares are to be acquired by a holding Company.

4. When value of share is not quoted in Stock Exchange and shares are to
be valued for taxation purposes.

In the case of Partnership Firm:

1. When there is a change in profit sharing ratio.

2. When a partner is admitted.

3. When a partner has died or retired.

4. When two partnership firms are amalgamated.

5. When a firm is sold to a Company.

Accounting Treatment of Goodwill:

Goodwill is always paid for the future. Record of Goodwill in accounting
is made only when it has a value. When a business is purchased and an
additional amount is paid more than the amount of asset, then the
additional amount is called goodwill. It is treated as an asset and the
payment made for it is a capital expenditure.

It is treated as an intangible asset and thus depreciation is not charged.

The value of goodwill decreases and increases but the fluctuations are
not recorded in the books. Presence of goodwill in the books is not
necessarily a sign of prosperity. A prospective purchaser would agree to
make any payment for the goodwill only when he is convinced that the
profit likely to accrue to him from the acquired business would be in
excess of the normal return expected in a business of similar nature.

This means that any such payment refers to the future differential
earnings and is a premium to the vendor for relinquishing his right
thereto in favour of the vendee. The goodwill of a business is the
intangible value to it, independent of its visible assets, by reason of the
business being a well established one having a good reputation.

But at the same time, it is obvious that goodwill is inseparable from the
business to which it adds value. The value of the goodwill of a business
will therefore be the value which a reasonable and prudent buyer would
give for the business as a going concern minus the value of the tangible
assets.

Types of Goodwill:

It is generally of two types:

 Purchased, and.
 Non-Purchased or Inherent.

Purchased Goodwill:

Purchased goodwills arise when a business concern is purchased and the

purchase consideration paid exceeds the fair value of the separable net assets
acquired. The purchased goodwills show on the assets side of the Balance sheet.
Para 36 of AS-10 ‘Accounting for fixed assets’ states that only purchased
goodwill should recognize in the books of accounts.

Non-Purchased Goodwill/Inherent Goodwill:

Inherent goodwills the value of the business in excess of the fair value of its
separable net assets. It is referred to as internally generated them and it arises
over a period of time due to the good reputation of a business. The value of
goodwill may be positive or negative. Positive goodwill arises when the value
of the business as a whole is more than the fair value of its net assets. It is
negative when the value of the business is less than the value of its net assets.

For Accounting:

Methods of Valuing Goodwill of a Company

1. Years’ Purchase of Average Profit Method:
Under this method, average profit of the last few years is multiplied by

one or more number of years in order to ascertain the value of goodwill

of the firm. How many years’ profit should be taken for calculating

average and the said average should be multiplied by how many number

of years — both depend on the opinions of the parties concerned. The

average profit which is multiplied by the number of years for

ascertaining the value of goodwill is known as Years Purchase. It is also

called Purchase of Past Profit Method or Average Profit Basis Method.

Profit Basis Method:

Value of Goodwill = Average Profit x Years’ Purchase

2. Years’ Purchase of Weighted Average Method:

This method is the modified version of Years’ Purchase of Average Profit

Method. Under this method, each and every year’s profit should be

multiplied by the respective number of weights, e.g. 1, 2, 3 etc., in order

to find out the value of product which is again to be divided by the total

number of weights for ascertaining the weighted average profit.

Therefore, the weighted average profit is multiplied by the years’

purchase in order to ascertain the value of goodwill. This method is

particularly applicable where the trend of profit is rising.

Value of Goodwill = Weighted Average Profit x Years Purchase

3. Capitalisation Method:

Under this method, the value of the entire business is determined on the

basis of normal profit. Goodwill is taken as the difference between the

Value of the Business minus Net Tangible Assets.

Under this method, the following steps should be taken into

consideration for ascertaining the amount of goodwill:

(i) Expected Average Net Profit should be ascertained;

ADVERTISEMENTS:

(ii) Capitalised value of profit is to be calculated on the basis of normal

rate of return;

(iii) Net Tangible Assets (i.e. Total Tangible Assets – Current Liabilities)

should also be calculated;

(iv) To deduct (iii) from (ii) in order to ascertain the value of Goodwill.
Capitalised Value of Profit = Profit (Adjusted)/Normal Rate of Return x

100

4. Annuity Method:

Under this method, Super-profit (excess of actual profit over normal

profit) is being considered as the value of annuity over a certain number

of years and, for this purpose, compound interest is calculated at a

certain respective percentage. The present value of the said annuity will

be the value of goodwill.

Value of Goodwill,

V=

Where

V = Present value of Annuity

a = Annual Super Profit

n = Number of Years

I = Rate of Interest

5. Super-Profit Method:
Super-profit represents the difference between the average profit earned

by the business and the normal profit (on the basis of normal rate of

return for representative firms in the industry) i.e., the firm’s anticipated

excess earnings. As such, if there is no anticipated excess earning over

normal earnings, there will be no goodwill.

This method for calculating goodwill depends on:

(i) Normal rate of return of the representative firms;

(ii) Value of capital employed/Average capital employed; and

(iii) Estimated future profit, i.e. the average profit of the last few years.

Super-Profit = Average Profit (Adjusted) – Normal Profit

Value of Goodwill = Super-Profit x Years’ Purchase

The students should remember that the number of years’ purchase of

goodwill differs from firm to firm and industry to industry. One or two

years’ purchase should be taken into consideration if the retiring partner

of a business was the main source of success. It should also be

remembered that three to five years’ purchase is usually taken. Of

course, a large number of years’ purchase may be considered if the

super-profit itself is found to be large. If there is a declining trend in

super-profit, one or two years’ purchase may be considered.

The following steps should carefully be followed for

calculating the value of Goodwill under Super- Profit Method:

(a) Ascertain the amount of Capital Employed/Average Capital

Employed;

(b) Ascertain the amount of Normal Profit (i.e. Percentage of Normal

Rate of Return on Capital/Average Capital Employed);

(c) Ascertain the Actual Maintainable Profit;

(d) Ascertain the difference between Actual Maintainable Profit minus

Normal Profit. If Actual Maintainable Profit is more than the Normal

Profit, the excess is called Super-Profit and, in the opposite case, this is

no Super-Profit;

(e) Value of Goodwill = Super-Profit x Year’s Purchase.

5. Super-Profit Method:

Super-profit represents the difference between the average profit earned

by the business and the normal profit (on the basis of normal rate of

return for representative firms in the industry) i.e., the firm’s anticipated
excess earnings. As such, if there is no anticipated excess earning over

normal earnings, there will be no goodwill.

This method for calculating goodwill depends on:

(i) Normal rate of return of the representative firms;

(ii) Value of capital employed/Average capital employed; and

(iii) Estimated future profit, i.e. the average profit of the last few years.

Super-Profit = Average Profit (Adjusted) – Normal Profit

Value of Goodwill = Super-Profit x Years’ Purchase

The students should remember that the number of years’ purchase of

goodwill differs from firm to firm and industry to industry. One or two

years’ purchase should be taken into consideration if the retiring partner

of a business was the main source of success. It should also be

remembered that three to five years’ purchase is usually taken. Of

course, a large number of years’ purchase may be considered if the

super-profit itself is found to be large. If there is a declining trend in

super-profit, one or two years’ purchase may be considered.

The following steps should carefully be followed for

calculating the value of Goodwill under Super- Profit Method:

(a) Ascertain the amount of Capital Employed/Average Capital

Employed;

(b) Ascertain the amount of Normal Profit (i.e. Percentage of Normal

Rate of Return on Capital/Average Capital Employed);

(c) Ascertain the Actual Maintainable Profit;

(d) Ascertain the difference between Actual Maintainable Profit minus

Normal Profit. If Actual Maintainable Profit is more than the Normal

Profit, the excess is called Super-Profit and, in the opposite case, this is

no Super-Profit;

(e) Value of Goodwill = Super-Profit x Year’s Purchase.

7. Sliding Scale Valuation Method:

Under this method, the distribution of profit which is related to super-

profit may vary from year to year. In other words, in order to find out the

value of goodwill, sliding scale valuation may be considered relating to

super-pr8fits of an enterprise.