If you browse through the balance sheet of a form or a company, you will often see an asset listed with the heading “goodwill”. Exactly what is goodwill? And how is this asset calculated in monetary terms? Let us understand the concept of goodwill of a partnership firm.
What is Goodwill?
Goodwill itself means the good reputation or status of something or someone in society. Essentially the goodwill of a firm is its standing in the economy, its good repute.
One can even call it its brand value. But what is goodwill in terms of a balance sheet? It is simply the quantification of this brand value or good reputation.
So goodwill is actually a long-term intangible asset of the firm. Intangible means it cannot be touched or felt, but yet exists.
It is a partnership asset that arises from the benefits of the firms business connections, good reputation, brand value, employee morale, competitive advantage etc. Now that we know what is goodwill, let us see in brief how it is calculated.
Calculation of Goodwill
We know that goodwill is an intangible asset of the firm. But how can we quantify this asset? Goodwill is actually the excess price a firm can get during the sale of the business, over and above the identifiable net assets of the firm.
So if the fair market price is more than the net assets (assets minus liabilities) during the sale of the firm, then this difference is the goodwill of the firm. There are other methods of valuation of goodwill for a partnership firm. Let us take a look.
- Average Profit Method: Here the average profits of the last few years is multiplied by a decided number of years, know as years of purchase. Here the goodwill represents the future advantage of earning profits for the following years. It is a fairly simple method
- Super Profit Method: Here we calculate the goodwill on the basis of super profit. This is the excess profit the firm earns than the other firms in the same industry. So the goodwill will represent the competitive advantage the firm has over its competitors.
- Annuity Method: Here we use a complex formula to calculate the present value of the super profits of the next few years.
- Capitalization Method: In this method, we will determine goodwill by calculating the average profits and then calculating the actual capital that has been employed in the business.
Sale of Goodwill
Just like any other asset, even goodwill can be sold. It can be sold to a partner, for example, an incoming partner or even to an outsider.
The sale amount of such sale is divisible among the partners in their profit sharing ratio unless decided otherwise. When such sale of goodwill occurs, both buyers and sellers acquire certain rights. Let us take a look at this.
On the sale of goodwill, the buyer will acquire some rights as per the Act. If there are no provisions to the contrary, the buyer has the following rights
- can use the firm name
- can represent himself as a part of the continuing business
- solicit the previous customers of the business. He can even restrain the seller of the goodwill from being in contact with these customers.
The seller of the goodwill also continues to have certain rights, such as the right to enter into a competing business. But if retrain of trade is decided amongst the parties during the sale, then he has no such rights.
Solved Question on Goodwill
Q: Goodwill cannot be sold to an outsider. True or False?
Ans: This statement is False. The goodwill can be sold to both a partner and an outsider. During the sale of the firm, it is sold to an outsider and he will obtain all the rights of a buyer stated above.