For long we have heard that term “Goodwill” into usage for different purposes. It is widely seen to be used in all of business studies categories like-marketing, finance, accounting and several other fields. What is needed to be seen though the difference amongst the usages in different fields. Let’s check them out below:
A company which has a good name in the market either for its product or services, which is helpful in boosting the sales of its other (maybe future) products or services, the good name then will be known as goodwill.
Take for example, UNILEVER. The giant in health and beauty industry produces a variety of goods. Now, if they market a new brand then it will thrive on the other product names, like- LUX, FAIR & LOVELY, POND’S etc. And on the other hand if they produce a new type of Already existing product, then the product will be running in the Market smoothly with the already existent market for the aforesaid Product, like- FAIR & LOVELY and FAIR & LOVELY FACEWASH.
When a business is acquired by another business then the outstanding amount which comes out from subtraction of the amount paid and the amount derived from subtraction of liabilities from assets is called goodwill. This definition is hard to understand so check the example below:
ABC Co. has this structure for its assets and liabilities:
Doing a simple subtraction anybody can tell that the amount is 27000.
But, now if XYZ Co. comes to acquire ABC Co. and the later charges 30000 then you can see they are charging 3000 more. This is called goodwill in accounting.
The amount which exceeds the amount of profit(all the profits generated unto a future period based on their ROR) for one institution from other institutions in the same industry, provided that the amount extracted from the funds invested in the same category or same type of categories, then the amount exceed gained by the aforesaid company is called that company’s goodwill.
The technique here is a bit complex as it includes several financial methods, like- discounting and compound value charts. More importantly the ROR (Rate Of Return) should be discussed elaborately to be familiar and to get a hold of the idea of goodwill and goodwill valuation properly. So, please read the chapter on it.
As far as accounting is concerned we have seen what goodwill is, what we haven’t seen is that how goodwill is treated. Now we are aiming for that. As when a business is acquired then there is a separate kind of account created named PURCHASE CONSIDERATION (In fact, the excess amount is called the purchase consideration). The purchase consideration shows the excess amount calculated perfectly as it considers everything at marketable value. Now, the journal entries will look like this (We have excluded partnership goodwill valuation over here which is assessed separately) :
1. When goodwill arises :
To, Cash/Share Capital/Debentures A/C
2. Depletion of goodwill :
To, Goodwill A/C
3. Depletion of goodwill using share premium a/c or, retained earnings a/c :
Share Premium A/C or, Retained Earnings A/C
To, Goodwill A/C
Now, the question arises for many, what is depletion? The answer is, it is the form of depreciation for intangible assets or, fictitious assets. That means, with time the value of the excess amount paid comes down. It may not seem right to many, but, to say the least it is the way to follow according to the guidelines. And it is the more sensible way also as the acquired business no longer exists and so any account related to that should perish with time. The account should be depleted slowly over several periods as doing that in one accounting period will derive abnormal loss and huge abnormal profit in others (For details please read GOODWILL DEPLETION : WHAT’S THE DEAL).
The purpose of keeping goodwill a/c for a fixed period (For most of the companies it is 20-25 accounting periods) is to eliminate the chance for businesses to do as per their wish. It is important to know, without a proper guideline in place it would have been tough not only to record goodwill but, also to measure it. Keep in mind another important point that, any expense rising from that goodwill after its purchase been complete should be recognized as an expense and not as an asset unlike other tangible assets (It is the same for all fixed life intangible assets).