35 Goodwill: Nature and Accounting Treatment

Deepika Gautam

LEARNING OBJECTIVES:

This module helps to understand the concept of Goodwill (reputation of the firm). After studying this module the students may able to understand the nature of goodwill that is how it is an intangible asset of the firm? What are the distinguish characteristics of the goodwill and so on. There are various factors which affect the value of goodwill so this aspect also be clear to students after going through this module. An attempt has been made to classify the goodwill from general point of view i.e. different categories of goodwill are briefly explained.

INTRODUCTION:

Goodwill of a business means good reputation, popularity or image of the firm in the market. Goodwill works as a magnet for a business to attract more customers towards it. Goodwill helps the bushiness to earn excess profits over the normally earned profits on the same capital employed by the other concerns engaged in the same business. Goodwill is treated as an intangible asset (the asset which cannot be touched and seen but can be felt). It is created through various activities such as; quality production, good relationship with employees, integrity, sincerity etc. Goodwill is cemented with business as it cannot be sold separately from business unlike building, plants, machinery, furniture etc.

DIFFERENT AUTHORS VIEW:

1. “Just as the cement binds together the bricks and other building material into walls, similarly goodwill binds together or unites the other assets and aspects of the business into cohesive whole”.

-A.V. Adamson

2. “Goodwill is the present value of expected future income in excess of a normal return on the investment in tangible assets”.

–Eric L, Kohler

3. “The capacity of a business to earn profits in future is basically what is meant by the term goodwill”.

– J.O. Magee

4. “Goodwill is a thing very easy to describe, but very difficult to define. It is the benefit and advantage of name, reputation and connections of a business. It is the one thing which distinguishes an old established business from new business as it first starts. Goodwill is composed of variety of elements. It differs in its composition in different traders and in different businesses in the same trade”.

-Lord Machnaughton

SPECIAL FEATURES OF GOODWILL:

Goodwill of a business has some special features, and is therefore distinct from other assets. These features are as follows:

1. Goodwill is an intangible asset.

2. Goodwill of a business cannot be sold in a part or in isolation as it‟s the value of the firm in terms of reputation.

3. There is no relation between the value of goodwill and the amount spent to build the same.

4. The valuation of goodwill is subjective and not objective, because its valuation will differ from estimator to estimator.

5. Value of goodwill changes from time to time with changes in factors of goodwill as there are various factors determining the value of goodwill.

FACTORS DETERMINING THE VALUE OF GOODWILL:

Following are the various factors which affect the value of goodwill in any firm:

1. Business Nature: It means the type of goodwill dealt. Some goods are of daily use (eg, necessities of life). Demand for such goods is constant and the profit fluctuation is minimum. On the other hand, if business is influenced by fashion and public taste, the demand for such goods is temporary which leads to unstable profits. Thus, more stable or constant is the profit, the more is goodwill and vice versa. In simple words there is a direct relationship between demand for the product and goodwill.

2. Risk factor: When the risk is less in the business it creates more goodwill but if the risk is more, it creates less goodwill.

3. Monopolized Business: Monopoly in the business gives jump to earnings. If the buyer of business feels that monopolistic situation will continue to exist in future he would be ready to pay more for goodwill because he is assured of future profits. However, if there is a possibility of rivals setting up same line of trade, the advantages of monopoly may not continue to be derived.

4. Trade Name: Worldwide recognition by a trade name or trade mark will favorably influence the value of goodwill.

5. Government Support: Where the business enjoys the support of government, people are willing to buy the product of such a company. Thus, goodwill increases.

6. Management efficiency: Efficiency of the management plays an important role in earnings of profits and valuation of goodwill. A good and dynamic management will certainly make optimum use of resources.

7. Location Factor: A manufacturing concern which have easy access to quality raw material, availability of labor and is near the big markets will have advantages over other concerns. It enhances the value of goodwill.

8. Exceptional Contracts: If the exceptionally favorable contracts for the supply of goods or services to the customers are not likely to continue, the profits from such contracts will not be considered while determine the amount of goodwill.

9. Future Competition: The possibility of future competition either be the previous owner or be new rival will adversely affect the value of goodwill.

10. Pending Contract: If there are pending contract or order which are likely to fetch substantial profits, these will certainly increase the value of goodwill.

11. Capital Requirement in future: When the profit of a business is more in relation to the investment of capital the value of goodwill is higher than the business earnings less profits with proportionately large investment of capital.

12. Profits Trends: When there is a upward trend in profits, it increase the value of goodwill. In contrary, if the profits are gradually declining the value of goodwill will also diminish.

13. Money and Market Conditions: Where money market condition is easy, more buyers will be available in the market and the value of goodwill may go up. On the other hand if money is scarce the value of goodwill may come down.

STOP Quick Revision

While Purchasing a running business will you give weight age to goodwill? If yes, why?

It is always advantageous to acquire a running business which is yielding profits. This means that such a business has reputation. The buyer f such a running business will have the privilege to continue his business relationship with the old customers, thus profits are assured in future for a reasonable period of time.

NATURE OF GOODWILL:

Goodwill is an intangible asset, which cannot be seen, touched, melted, broken, etc. It is a fixed asset of the business. However, like other fixed assets of the business such as; buildings, furniture, plant and machinery it cannot be sold independently during the life period of the business. For example, the building, plant, furniture, etc., can be sold and purchased individually at any time during the regular course of the business but goodwill cannot be sold. While doing the business, goodwill is undetectable from the business. It can be sold/ realized only when the business is sold. In other words goodwill is transferable only in the events of sale of business unit (like amalgamation or reconstruction).

Goodwill is related with the profits of the business. If profits of the business are increasing, the goodwill will also increase as there is a direct relation between profits and goodwill). In contrary to this, if the profits are decreasing, the amount of goodwill will also decrease.

Goodwill can be classified into two categories:

(i) Purchased Goodwill

(ii) Self-Generated Goodwill

(i) Purchased Goodwill: Purchase goodwill arises on the purchase of a business. It is shown on the balance sheet under the head Non-Current assets.

(ii) Self Generated Goodwill: It is generated by the firm internally, generally over the years. It is not recorded in the books of accounts. Accounting Standard 26 issued by ICAI. Goodwill is an attractive force which brings in customers. In white Man Smith Motor Company V. Cahplin; (Reference: Advance Accounting Vol.2 by Yorston Brown & Smyth Page 484) the variety of customers were classified zoologically i.e. cats, dogs, rats and rabbits. These are explained as follows:

(a) Cat Goodwill: The cat prefers the old home of the person who keeps it, and stays in the old home although the person who has kept the home leaves and so it represents the persons who goes to the old shop whoever keeps it.

(b) Dog Goodwill: The faithful dog is attracted to the person rather than to the place. He will follow the outgoing owner, if he does go too far. It is sort of personal goodwill and is generally found in professions.

(c) Rat Goodwill: The rat has no attachment either with the owner of the house or with the place. Rat is interested only in filling its stomach no matter from where things come. So as certain customers who are neither attached to any owner of the business nor to any shop. Such type of goodwill has a small value or no value.

(d) Rabbit Goodwill: Rabbit has the habit of living close and is afraid of going too far. There are customers who neither attract value to the owner nor shop but to the nearness of the shop. Such type of goodwill ha s a low market value.

Recommendations of Accounting Standard 26 (AS 26) issued by Institute of Chartered Accountants of India regarding treatment of Goodwill

As per the AS-26 it is mandatory that goodwill is recorded in the books only when some consideration (means something in return) in money or money‟s worth has been paid for it. This implies that goodwill account can be opened in the books only when goodwill has been acquired by paying some price. The accounting standard makes it clear that goodwill account cannot be opened in the books of admission, retirement, and death of a partner or in case of change in profit ratio of partners. Sometime, at the time of change in the constitution of the firm goodwill of the firm is evaluated. In that situation the value of the goodwill is not brought to the books since it is interest goodwill. In such situation goodwill is adjusted through partner‟s capital/current accounts.

A. TREATMENT OF GOODWILL ON ADMISSION Of A Partner:

There are different situations which require accounting treatment on admission of a partner some of them are as follows:

Case 1: Private payment of goodwill by the old partner to new partners:

Whenever new partner admit in the firm, it may happen that new partner pays goodwill to old partner off the record of the firm i.e. privately. The amount paid privately will not be recorded in the books of the accounts.

Case 2: Cash payment of goodwill:

Whenever new partner bring his share of goodwill in cash there are two possibilities in the business which are describe as follows:

(a) Retained the share in the business

(b) Withdrawn by the old Partners

Case 2(a) When Goodwill is retained in the business:

On the admission of the new partner it is obligatory that new partner has to compensate the old partner by paying amount of his share of goodwill. The amount so paid by new partner to old partner through the firm is debited to cash account and credited to premium account. Then premium account is closed by transferring it to old partner capital account in sacrifice ratio. Thus, premium account is closed and it will not appear in balance sheet.

Journal entries to be passed in the books of accounts:

(a) When premium is brought in cash

Cash A/c……………………….Dr

To Premium A/c……………………………………

(Being premium brought in cash)

(b) When premium is credited to old partners in sacrifice ratio:

Premium A/c……………………..Dr

To Old Partners Capital A/c………………………..

(Being premium credited in sacrifice ratio)

Case2(b) : When goodwill is withdrawn by the old partners

In this case the cash introduced by the new partner as goodwill is given to the old partners in sacrifice ratio and subsequently the old partner withdraw the amount from business. The following entries are passed in this case:

(a) For cash paid by new partner as goodwill:

Bank A/c…………………….Dr

To Premium A/c…………………..

(Being cash received from new partner)

(b) Goodwill is credited to old partner in sacrifice ratio:

Premium A/c…………………………..

To Old partner capital A/c………………………

(Being premium credited to old partner in sacrifice ratio)

Old partner capital A/c………………………………… To Bank A/c……………………………….

(Being goodwill withdrawn by old partner)

STOP

QUICK REVISION

v Goodwill brought by the old partner in cash by new partner is always credited to old partner in sacrifice ratio (can be calculate as old ratio – new ratio).

v When one of the old partner gains his capital account is also debited with reference to his proportionate share in total goodwill in order to compensate sacrificing partner.

v Goodwill is withdrawn by old partner will reduce their capital and cash.

Case 3: Goodwill is not brought in cash by new Partner

Sometime new partner is unable to bring his share of goodwill in cash. Under such circumstances the goodwill account is not raised as per the guidelines of Accounting Standard 26. When capital accounts are fluctuating the capital account of new partner is debited with the share of his goodwill and the capital account of old partners are credited with sacrifice ratio. However, when capital accounts are fixed, then instead of capital accounts current accounts are used. Journal Entry:

New Partner Current A/c……………………Dr

To Old Partner Capital A/c…………………

(Being the share of new partner transfer to old partners).

STOP

QUICK REVISION

v New Partner is required to compensate the old partners for his proportionate share in goodwill.

v But when new partner does not bring his share of goodwill in cash, he will compensate the old partners through his current account.

Case5: When Goodwill already existing in books on admission

Sometimes, at the time of admission of a new partner, there may appear goodwill in the books of firm. The reason for goodwill being appearing in the books could be: (i) that it was brought by old partners in the past or (ii) the goodwill might have been raised in past before the issuance of Accounting Standard

26. It must be remembered that goodwill which existing in the books must be written off between old partners in old ratio.

Journal Entries:

Old partners capital A/c…………………………

To Goodwill A/c……………………………………

(Being Goodwill written off in old ratio)

Note: The above mentioned entry to write off existing goodwill is always passed whether the goodwill is brought in cash or not. After passing the above entry goodwill will not appear in new balance sheet.

Cash 6: Goodwill is partly brought in cash by new partner:

Sometimes, the new partner may not be in a position to bring full amount of his share of goodwill in cash. In other words he brings a part of his share of goodwill in cash. Under such circumstances the following steps need to be followed:

Step1: The cash brought in as goodwill will be credited to old partners in sacrifice ratio.

Step 2: New partner current account is debited with the amount of goodwill not brought in cash and the old partners‟ current account are credited with sacrifice ratio.

Journal Entries:

(a) Cash A/c………………….Dr

(b) Premium A/c………………………………….. New Partner Current A/c……………………..

To Old partner Capital A/c…………………….

Cash 7: Goodwill is brought in kind by New Partner:

In case goodwill is brought in consideration other than cash or in Kind i.e. in the form of assets, then the assets so brought in by the new partner shall be credited. After this the premium will be transferred to old partner‟s capital account in sacrifice ratio.

Journal Entries:

(a) Assets A/c…………………….Dr

(b) Premium A/c…………………Dr

To Old Partners Capital A/c

STOP

QUICK REVISION

v In the treatment of Goodwill sacrifice ratio is used.

v When goodwill is brought in cash, the same is credited to old partners in sacrifice ratio.

v When goodwill is not brought in cash, new partner capital account is debited.

v When goodwill is brought in kind, old partners are credited in sacrifice ratio.

Case 8: Old Partners do not have goodwill but new partner has goodwill

A situation may arise where old partners are running their business in losses, hence do not have any

goodwill. So in this case instead of paying for goodwill to the old partners, the new partner will be

paid by the old partners, accordingly the old partners will compensate the new partner with their

share in total goodwill of new partner.

Journal Entries:

Old partner Capital A/c……………………

To New partner Capital A/c………………………..

(With the share of old Partner)

Case 9: Hidden or Inferred Goodwill

It may happen sometime that goodwill is silent about the existence of goodwill in the business. Under such circumstances the amount of goodwill which though exists but not apparently will have to be calculated:

Step 1: Find out the total capital of a new firm on the basis of new partner‟s share and his capital.

Step 2: Find out the difference between the capitals calculated as per step 1 and the total capital of old partners and new partner. This difference is the amount of goodwill.

Goodwill = Total Capital as per Step 1 less Combined Capital of Old and New Partners.

B. TREATMENT OF GOODWILL ON RETIREMENT:

Retiring partner has a right to get his share of goodwill. When a partner retires or dies he leaves behind the reputation of the business which was earned by his efforts also. After the retirement or death, the benefits of the goodwill are enjoyed by the continuing partners. Therefore, it becomes the legitimate right of the outgoing partner to receive compensation from the firm on his retirement. This compensation or share in the reputation calls for the treatment of goodwill on retirement or death.

Guidelines as per Section 26:

Goodwill in general is recorded in the books only when some consideration in money or money‟s worth has been paid for it. In other words Goodwill account can be opened in the books only when goodwill has been acquired by paying some price for it.

Journal Entries:

Case 1:

Step 1: Write off the goodwill if any appearing in the balance sheet on retirement All Partners capital A/c…………………..Dr

To Goodwill A/c…………………………

(Being goodwill written off in old ratio)

Step 2: Find out the share of outgoing partner in goodwill. Continuing partner capital A/c………………………………

To retiring partner capital A/c…………………………..

Note: Retiring partner share in goodwill = Value of total goodwill * Profit ratio of retiring partner

Case 2: Hidden Goodwill

It is possible that the retiring/deceased partner may be given lump sum amount which is greater than the amount actually due to him. The excess paid to him, over and above his claim is called „Hidden Goodwill‟

Hidden Goodwill = Lump sum paid on retirement/death – Amount actually due to him

TREATMENT OF GOODWILL ON DISSOLUTION OF THE FIRM:

On dissolution of the firm, goodwill may be treated in the following manner:

Case1: Where goodwill appears in the balance sheet: If goodwill account appears in the balance sheet, it will be transferred to the realization account and if goodwill is realized for any value, then cash/bank account is debited and realization account is credited with the actual amount realized.

Case 2: When goodwill does not appear in the balance sheet: when goodwill does not appear in the balance sheet, there need not be any transfer entry but if it is sold for any price, then cash account is debited.

SUMMARY

Goodwill is treated as an intangible asset and is created through various activities and it is cemented with the business as it cannot be sold separately from business. It is either acquired by paying some cost or it is generated by the partners themselves collectively with their hard work, sincerity towards the organization and work, dedication, devotion etc. There are certain circumstances where it may be necessary to value goodwill like at the time of admission of a new partner (because when a new partner joins the firm, the old partners sacrifice apart of their share of profit in favor of new partner and therefore it is important to record his compensation in the books of accounts), on the death of a partner, on a retirement (because retiring partner has a right to get his share of goodwill as he leaves behind the reputation of the business which was earned by his efforts also), when a partnership dissolve or even when two or more partnership firms amalgamated

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SUGGESTED READINGS TO LEARN MORE:

Gupta R.L & Gupta K.V (2005) “Principles and Practice of Accountancy” Sultan Chand & Sons 23, Daryaganj, New Delhi- 110002.
Jain P.K (2006) “Corporate Accounting” Kalyani Publishers, Old Maujpur, Shahdara, Delhi-53.
Juneja Mohan .C & Singh Baljindar (2008) “Accountancy- I” Kalyani Publishers, B-15, Sector 8 Noida
Mukherjee A & Hanif M (2003) “Financial Accounting”. Tata Mc Graw Hill Education Private Limited NewDelhi.
Singla. S. R (2105) “ Corporate Accounting” VK Global Publications Pvt Ltd. New Delhi-110002
Siddiqui A.S”(2002) “Comprehensive Financial Accounting” Laxmi Publications Ltd, 22, Golden House, Daryaganj, New Delhi.
Tulsian . P.C (2014) “Financial Accounting”. Dorling Kindersley Pvt Ltd., licenses of Pearson Education in South Asia.

Points to Ponder

1. Goodwill is an intangible asset, which cannot be seen or melted.

2. Goodwill is related with the profits of the business.

3. Goodwill is the present value of expected future income in excess of a normal return on the investment.

4. Purchase goodwill arises on the purchase of a business.

5. Goodwill is considered as an attractive force which brings in customers.

6. On admission of a partner, the adjustment of the goodwill is required.

New partner is entitled to get the share of profit in the business so he compensates the old partners for the reputation build by them in the past.
Goodwill account can be opened in the books only when goodwill has been acquired by paying some price.
If new partner does not bring goodwill in cash in that case new partner compensate the old partners through his current account.
In case goodwill is brought in kind by the new partner then new partner shall be debited and premium shall be credited.
Sacrifice ratio is used in the treatment of goodwill.
The compensation or share at the time of death or retirement calls for the treatment of goodwill.
On dissolution of the firm, goodwill is to be treated in different ways depend upon the situation.