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Goodwill – Need & Factors Affecting Valuation

Introduction

Goodwill is an intangible asset that represents the good name and reputation of a business. It enables a firm to earn Super Profits (profits higher than normal rate of return).

1. Features of Goodwill

  1. Intangible: It has no physical existence (cannot be seen or touched).
  2. Valuable: It has a realizable value.
  3. Variable: Its value fluctuates with business performance.
  4. Not Fictitious: It is NOT a fictitious asset (like Preliminary Expenses) because it can be sold.

2. Need for Valuation

When is Goodwill valued?

  1. Change in Profit Sharing Ratio among partners.
  2. Admission of a new partner.
  3. Retirement/Death of a partner.
  4. Sale of Business.
  5. Amalgamation of companies.
  6. Conversion of partnership into a company.

3. Factors Affecting Goodwill

Why does Apple have high goodwill?

  1. Location: A shop in a prime market has higher goodwill than one in a remote area.
  2. Quality: Consistent quality builds trust.
  3. Management: Efficient management leads to higher profits.
  4. Longevity: Older businesses usually have established customer bases.
  5. Nature of Business: Stable demand goods (FMCG) have stable goodwill. Risky business has low goodwill.
  6. Monopoly Power: If the firm has no competitors, goodwill is high.

4. Types of Goodwill (AS-26)

Accounting Standard 26 (Intangible Assets) classifies goodwill into two:

A. Purchased Goodwill

  • Acquired by paying money (e.g., purchasing a business for ₹10L when net assets are ₹8L. The extra ₹2L is Goodwill).
  • Recorded in Books: Yes.

B. Self-Generated Goodwill

  • Built internally over years.
  • Recorded in Books: NO. (AS-26 prohibits recording self-generated goodwill because no cost can be reliably attributed to it).

Exam Notes: Writing the Answer

Question: "Under what circumstances is goodwill valued?" (5 Marks)

Answer: List the 6 points (Admission, Retirement, Sale, Amalgamation, etc.).

Question: "Can self-generated goodwill be shown in the Balance Sheet?"

Answer: No. As per AS-26, only Purchased Goodwill is recorded in the books of accounts. Self-generated goodwill is not recorded.

Summary

  • Definition: Capacity to earn super profits.
  • AS-26: Only record Purchased Goodwill.
  • Key Factors: Location, Management, Quality.

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