Almost all aspects of your life require building goodwill among people. It is gratifying to spread goodwill, and the same is true in business as well. Business success is largely determined by the relationships that you build, so creating goodwill is important.
In this post, we shall come across the following talking points:
- What is Goodwill?
- What is goodwill in accounting?
- Essential features of goodwill
- Types of goodwill
- How to calculate goodwill?
- Valuation and Types of Valuation Techniques
- Example of goodwill
- Importance of goodwill in business
- Factors affecting goodwill
What is Goodwill?
An intangible asset that is acquired when one company purchases another is known as goodwill. In other words, goodwill refers to the portion of the purchase price that surpasses the aggregate net fair value of all the assets acquired in the acquisition and all the liabilities assumed.
Among the factors that define goodwill are brand recognition, a solid customer base, good customer relations, good employee relations, and proprietary technology. The items that makeup goodwill are intellectual property and brand recognition, which cannot be easily measured.
What is Goodwill in Accounting?
In accounting, goodwill is an increase in value over the company's assets minus its liabilities. Assets that are non-physical, such as solid customer relationships, brand recognition, or excellence in management, are considered tangible.
The goodwill must be evaluated for impairment each year. The amortization period for goodwill may only be ten years for private companies.
According to US GAAP and IFRS standards, the goodwill of a company has an indefinite life span, so it does not have to be amortized.
Essential Features of Goodwill
Goodwill can be defined through its features as described here:
- Goodwill comes under the category of intangible assets. It does not have a physical form but it is not hypothetical or fictional.
- Since it can't be separated from the business, it can't be sold separately like other identifiable assets.
- Goodwill is a unique asset that is not based on investments or costs.
Types of Goodwill
There are two main types of goodwill:
Purchased goodwill is a result when purchasing a business is done for a higher price than the fair value of the separated acquired assets. Due to this, goodwill is shown as an asset on the balance sheet, whereas other types cannot be recognized.
Non-Purchased or Inherent Goodwill
In contrast to purchased goodwill, inherent goodwill represents the business's value in excess of its separable net assets. Developing inherent goodwill is an internal process that occurs over time as a result of reputation. It could go either ways, positive or negative.
Goodwill takes time to build but it can bring you a lot of benefits. There are certain factors that can greatly impact it.
How to Calculate Goodwill?
For calculating Goodwill, we need the values of the Purchase price of the company, Fair market value of assets, and Fair market value of liabilities.
With these three values, here is how the Goodwill is calculated:
Valuation of Goodwill
We have seen the various aspects related to Goodwill but in this section, we highlight the importance and need for the valuation of Goodwill. Let’s explore this along with the methods of valuation of goodwill.
We need to carry out the valuation of goodwill for the following reasons:
- When there is more number of partners, valuation of goodwill becomes important for the purpose of Profit-sharing and for deriving the Profit Sharing Ratio (PSR).
- The inclusion of a new member or a partner demands the valuation of goodwill.
- It is also carried out in the times when the enterprise dissolves and the sale of the business need to be accomplished.
- Valuation is also done in case of the death of one of the partners.
- Goodwill valuation needs to be done in the case of the retirement of a partner.
Methods of Valuation
There are three methods used for the valuation of goodwill:
- Super Profits Method
- Average Profits Method
- Capitalization Method
Example of Goodwill
All the factors pertaining to goodwill that we have learned so far can be better understood by a simple example here.
Let us assume a company ABC ltd. has (Assets-Liabilities) worth $100,000.
Another company purchases ABC Ltd. for $150,000. The premium value comes out to be $50,000.
Going by the formula of Goodwill:
The acquirer's balance sheet will list the $50,000 as goodwill.
Additionally, it is recorded when the purchase price of the target company exceeds the assumed liabilities of the company.
Importance of Goodwill in Business
Creating goodwill can take a number of forms, from implementing customer appreciation programs to providing extra services. Business owners will reap several benefits in return. Some examples of how goodwill with customers can benefit your business follow.
Boosts Brand Loyalty
When you are satisfied with a company, you do business with them frequently. When you build goodwill with your customers, they'll be more confident about doing business with you and are more likely to be loyal to your brand. As a result, your customers are more likely to contact you the next time they need a product or service you offer. Moreover, they may also recommend your business. This consequently enables you to grow your business.
It Can Help You Stand Out
Your goodwill can enable you to stand out from competitors who offer similar products and prices. This boosts your position in the market, helping you differentiate yourself from your competition. Goodwill can be a result of your hard work to resolve matters or complicated information. If you create this goodwill, your brand will stand out among your competitors and attract more customers.
Imagine what it is like to receive a gift from your neighbor who has upset you in the past. This same neighbor may be less likely to upset you the next time when they park their car incorrectly. Your business is subject to the same principles. Making your customers feel appreciated - by going the extra mile, exceeding their expectations, or providing personal attention - can make the customers overlook your mistakes.
Improves Your Business' Value
Because of its goodwill, a company with a positive reputation grows in value. Customers recognize the value of goodwill of a company. This way you will be able to attract more investors. It can also help you to receive credit more easily if you desire to expand your business. In case you choose to sell your business, it will enable you to make a bigger profit. Building goodwill builds value.
Factors Affecting Goodwill
Let’s cover this topic in the table here:
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We shall wrap up the post by running through the following points again:
- An intangible asset that is acquired when one company purchases another is known as goodwill.
- Among the factors that define goodwill are brand recognition, a solid customer base, good customer relations, good employee relations, and proprietary technology.
- In accounting, goodwill is an increase in value over the company's assets minus its liabilities.
- According to US GAAP and IFRS standards, the goodwill of a company has an indefinite life span, so it does not have to be amortized.
- There are two distinct types of goodwill, namely the purchased goodwill and inherent goodwill.
- There are three methods used for the valuation of goodwill: Super Profits, Average Profits, and Capitalization Method.
- Efficiency, capital, nature of business, risks, and location are some of the essential factors that affect the goodwill of a company.