Treatment of Goodwill

Concept of Goodwill

When partners carry on business with their firm for a long time, they earn a reputation for it. This reputation translates in monetary terms into expected future profits above normal profits. We commonly refer to this excess profit as the firm’s goodwill. Let’s understand the concept of goodwill in detail.

Concept of Goodwill

Goodwill is nothing but the reputation of a partnership firm. It is computed on the basis of expected profits in excess of normal profits. It denotes the firm’s capacity to earn a greater profit in the future based on its track record.

All firms functioning in a geographical area and working in the same business can expect to earn similar profits. If one firm earns excess profits than it expects, this is due to its goodwill. This can happen because of various factors. For example, it offers better customer service or its partners have a greater market reputation.

Concept of Goodwill

For example, two partners have owned a popular bakery since 2000. The bakery’s total worth (assets-liabilities) is Rs. 30 lakhs. The partners decided to sell their bakery in 2015. A prospective buyer offers Rs. 32 lakhs for their entire business. The excess of Rs. 2 lakhs is the goodwill they earned over 15 years.

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Nature of Goodwill

We have to treat goodwill in accounting terms as an asset. It is not a physical asset because we cannot see or touch it. Despite this, we treat it as an intangible asset because we derive some value from it.

According to Accounting Standards, an intangible asset must contain the following features. Since goodwill contains all these characteristics, we can conclude that it is an intangible asset.

  1. It must have characteristics of assets. This means that it must have some clearly identifiable value.
  2. The asset must have future economic benefits. The firm must be able to expect and predict what value they will get from it.
  3. Its value must be measurable. It is not an asset if we cannot measure its value in monetary terms.

Calculation of Goodwill

According to Accounting Standards, partners have to compute their firm’s goodwill for the following purposes:

  1. A new partner joins a firm
  2. An existing partner retires or dies
  3. Partners want to dissolve the firm
  4. Partners change their profit sharing ratio

In all these cases, partners have to first calculate and distribute existing goodwill before taking further steps.

Factors Affecting Goodwill

There is no exhaustive list of factors affecting goodwill. The following factors, however, commonly affect a firm’s goodwill:

  • Partners’ ability to attract customers due to their reputation
  • Quality of goods or services
  • Customer satisfaction
  • Location of business
  • Possession of intellectual property rights like trademarks
  • Monopoly rights like exclusive license to sell the product
  • Possession of special contracts to make goods available easily
  • Good managerial skills
  • How much the company has spent on R&D

Principles of Treatment of Goodwill

Now that we understand the concept of goodwill, let’s take a look at the treatment of goodwill. According to Accounting Standards, we have to follow these basic principles while treating goodwill.

Firstly, goodwill can be recorded only when some consideration is paid in money or money’s worth. Hence, we can record only purchased goodwill.

Secondly, Accounting Standards prohibit internal goodwill. In other words, this means that we cannot record goodwill for which money has not been paid. For example, partners may decide to record goodwill without any purpose necessary. They cannot do this.

Finally, partners must write off goodwill over a period of time. In the case of reconstitution of the firm, they must first write off goodwill immediately and then proceed ahead.

Solved Example for You

Question: Which of the following factors does not affect a firm’s goodwill?

  1. Quality of management
  2. Income of partners
  3. Location of the business
  4. Quality of customer services

Answer: Option (b), i.e. personal income of partners does not affect goodwill.

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