In this article we will discuss about:- 1. Definition of Goodwill 2. Nature of Goodwill 3. Features 4. Need for Valuation 5. Accounting Treatment.
Definition of Goodwill:
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.”
“When a man pays for goodwill, he pays for something which places him in the position of being able to earn more money than he would be able to do by his own unaided efforts.”
“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.
Nature of Goodwill:
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.