What is 'Goodwill'

Goodwill
Goodwill's meaning is simple and straightforward. The probability that an old customer will continue to return to the company and the ability to attract new customers to the company's products plays a major role in determining the company's profitability.

Companies in an industry always obtain a certain average return rate in similar conditions. However, there are chances that a company would generate additional revenue due to its geographical advantages, better customer service, ownership of its own patent rights, the personal reputation of the partner, or other similar reasons. The ability to generate such additional revenue is goodwill.

What is Goodwill?
Goodwill is a company's reputation for expected future profits that exceed the normal rate of profits in the industry.

In simple words, goodwill is the ability of a company to generate super-profits in the future.

Goodwill is an intangible asset. Though it cannot be seen or touched, it is very realistic. For accounting, goodwill needs to be of monetary or retail value.

Types of Goodwill
There are two types of goodwill.
Purchased Goodwill Definition:
The difference between the price paid to a company as a continuing concern (going concern) and net worth can be individually identified and evaluated. Such difference is the goodwill you get.

Inherent Goodwill Definition:
It is the firm's worth that is greater than the fair value of its separable net assets. It develops over time due to a company's strong reputation. It's also known as "non-purchased" or "self-generated" goodwill.

Factors influencing goodwill
Business Location:
A business in a good location has a better chance of gaining goodwill than one in an unsuitable one.

Quality of Goods and Services:
Companies that offer higher quality goods and services are more likely to have goodwill than companies that offer mediocre or inferior goods and services.

Management Efficiency:
Effective management leads to an increase in business profit, which boosts the company's reputation.

Business Risk:
A low-risk company has a higher chance of building goodwill than a high-risk company.

Business Type:
The type of product the business trades in, the level of competition in the market, the demand for the product, and the regulations that affect the business affect the profitability and reputation of a company. Companies with positive scores in all these areas will gain tremendous credit.

Favourable Contracts:
Companies enjoy more significant goodwill if they have access to profitable contracts to sell their products.

Trademarks and Trademark Ownership:
Patents and companies that own them tend to enjoy a monopoly in the market. This helps in increasing their corporate value.

Capital:
Companies that generate a high return on investment and low capital spending are considered profitable by buyers and have a lot of goodwill.

Need for Valuation:
When a partner's existing relationship changes, some partners will have to sacrifice their future interests in the entity. Those who offer to sacrifice future profits should be compensated by others who benefit from such a sacrifice.

Adjustments to the rights of this entity may result from new shareholder approvals, changes in profit sharing ratios, shareholder turnover or death, and the entity's dissolution.

The partner who gains the profit-sharing percentage must pay the profit in proportion to the value of goodwill. Affiliates who lose in terms of profit-sharing receive sacrificial payments in proportion to the value of goodwill.

For these purposes, the goodwill's value is required to be determined.

Valuation of Goodwill
There are three methods for the valuation of goodwill.

Average Profit Basis:
In this case, the average profit over the past few years is adjusted for expected future changes. The number of years is determined based on judgment and trial.

Depending on the situation, you can use either a simple average or a weighted average to past average revenues. If your profits are on ups or downs, it's better to focus on recent earnings than the previous years. However, if you don't have a clear winning trend, it's better to go with a simple average.

Super Profit Basis:
The super-profit method evaluates goodwill based on the super-profits generated by the company.

Super Profit = Actual Profit - Normal Profit

Here, the actual profit is the maintainable average profit.

Normal Profit = Normal Profit Rate (NRR) x Capital Employed.

Capitalization Basis:
In this method, the entire company's value is determined using normal rates of return. If this value (achieved by applying a normal rate of return) is higher than the capital used by the company, the difference is goodwill.

Goodwill = Normal Capital - Actual Capital

Normal Capital = Average Income / NRR

Is goodwill a fictitious asset?
Fictitious assets do not exist in the real world and have no monetary value. However, they represent actual financial outlays that are deducted from profits.

On the other hand, goodwill is not an expense. It takes time to build goodwill. It is intangible in nature because it cannot be touched or felt, but goodwill has a measurable worth.

As a result, goodwill isn't regarded as a fictional asset.

Can goodwill be sold separately like other intangible assets?
During the purchase of a firm, the premium paid over the fair worth of the assets is goodwill. As a result, it is associated with a company or business and so cannot be sold or purchased alone.

Licenses, patents, and other intangible assets, on the other hand, can be sold and purchased independently.

Can there be negative goodwill?
Negative goodwill is an accounting concept that happens when the price paid for an item is less than its market worth, resulting in a "discount" to the buyer.

Thus, it is possible to have negative goodwill.

However, it is important to note that only purchased goodwill can be negative. There cannot be a negative inherent goodwill.

Is goodwill a current asset or a non-current asset?
Goodwill is an intangible asset, which means it is not linked to a physical asset such as a building or piece of machinery.

No matter how long they generate economic value, intangible assets are never considered current assets.

Goodwill is thought to have an infinite lifespan. Thus, it is a non-current asset.

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