ACCOUNTING TREATMENT of GOODWILL
- Determine the fair value of the company's assets. As mentioned earlier, the carrying value of a business does not always equal the fair value (or the estimated value that someone in the market would pay for the business). The first step is to take the carrying value of the business (or the assets minus the liabilities), and figure out what the fair value of those net assets are.[4]
- For example, the carrying value of the business being purchased may be $1 million. However, due to recent strong market conditions, the fair value may be slightly higher, at $1.5 million. This means people would pay $1.5 million for those $1 million in assets.
- Calculating fair value is usually fairly complex and requires plenty of background knowledge, and as a result, the fair value of a business is usually calculated by a certified professional, such an accountant or financial analyst.
- Typically, figuring out fair value will involve looking at what other similar assets or businesses are selling for. One approach is to average the value of similar businesses being sold, and then price the value of the business being purchased above or below the average depending on the quality of the business.
- Add together the values of all acquired assets. Once the fair value of assets has been determined, you can add them together. For example, assume the business being purchased has $200,000 in property, plant, and equipment, $500,000 in cash, and $800,000 in inventory.
- The fair value of the business's assets would therefore be $1.5 million.
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Subtract the business's liabilities from the assets. If the business has liabilities of $500,000, subtracting this from the business's assets of $1.5 million means the fair value of the company's carrying value is $1 million.
- This simply means that if you subtract the business's assets from their liabilities to get a carrying value, and you determine what the market would pay in theory for those assets, the result in this case would be $1 million.
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Subtract the fair value from the purchase price to calculate Goodwill.Goodwill is defined as the price paid in excess of the fair value of the firm's carrying value. To calculate it, simply subtract the total asset amount from the purchase price; this amount is nearly always a positive number.
- For example, consider a firm that acquires another firm for $1,000,000. If the fair value of the acquired firm totals $800,000, then the amount of goodwill realized is (1,000,000 - 800,000) or $200,000.
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Record the journal entry to recognize the acquisition. Once the amount of Goodwill is determined, open whatever accounting software you use to enter the appropriate general entries.
- Continuing with the above example, the firm would debit Goodwill for $200,000, debit the acquired asset account for $800,000, and credit Cash for $1,000,000. Goodwill is an intangible asset account on the balance sheet.
- This series of entries adds the $800,000 in assets to the books, adds the $200,000 in Goodwill, and subtracts $1 million in cash from the books to reflect cash leaving to fund the purchase.
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Test the goodwill account for impairment each year. Each year, Goodwill needs to be tested for something known as impairment. Impairment occurs when something bad happens to a business, which causes the fair value of it's assets to decline below the carrying value. When this happens, Goodwill needs to be reduced by the amount the fair value falls below the carrying value. [5]
- For example, assume you made a purchase for $1.5 million, where $500,000 is Goodwill, and the carrying value of the assets are $1 million. If sales drop dramatically, those $1 million of assets will not have a fair value of $1 million anymore. If the fair value drops to $800,000, would would need to reduce Goodwill by $200,000 to reflect the drop in the value of the assets.
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Record the journal entry to recognize any goodwill impairment. If the goodwill account needs to be impaired, an entry is needed in the general journal. To record the entry, debit Loss on Impairment and credit Goodwill for the necessary amount.
Accounting Treatment of Purchased Goodwill
After having acquired purchased goodwill the first question that arises in your mind is – How to treat this acquired Goodwill in your books of accounts? Wheather to show it as an asset along with other possessions of the business and to slowly amortize it over its useful life or to retain it in the business or to immediately write it off against capital reserve. If you decide to amortize this goodwill you again have to decide how to write it off i.e. against your profits or against reserves. Here we are giving you some options to treat Purchased Goodwill in your books.
1) To show it as an asset in the Balance sheet of the company like other assets. Its estimated useful life is determined. It is then written off (amortized) over its estimated useful life through Profit and Loss account or Income statement.
2) To show it as an asset in the Balance sheet and amortize it over its estimated useful life against general reserve or capital reserve or both.
3) To eliminate it completely against capital reserves immediately on its acquisition.
4) To write it off just like any other expense through Profit and Loss account in the accounting period in which it was acquired.
5) To retain it in your business, unless a permanent reduction occurs in it due to circumstances.
Goodwill and Accounting Standard (AS) – 10 : Accounting For Fixed Assets:
AS-10 Accounting for Fixed asset requires you to treat Goodwill in your books as follow:
1) Goodwill can be recored in the books only when it has been acquired after paying some consideration in money;
2) On acquisition of a business entity by some another one for a price, If the price exceeds the value of net assets taken over, the difference in the price paid and the value of net assets is termed as Purchased Goodwill and it is shown in the Balance sheet of the acquiring concern.
3) Goodwill should be written off as early as possible.
Goodwill and Accounting Standard (AS) – 14: Accounting for Amalgamation:
It provides for the following treatment of Goodwill in the case of amalgamation in the nature of purchase:
1) Goodwill arising on amalgamation represents a payment made in the anticipation of future profits and it is appropriate to show it as asset in the books of accounts.
2)This Goodwill should be amortized to income over its useful life on a systematic basis.
3) It is appropriate to amortize Goodwill over a period not exceeding 5 years unless a longer period can be justified.
4) While estimating the useful life of Goodwill, the following factors should be considered:
i) The foreseeable life of the business or industry;
ii) The effect of product obsolescence, change in demand and other economic factors;
iii) The service life expectancies of the key individuals involved or group of employees;
iv) Expected actions by competitors or potential competitors; and
v) Legal, regulatory or contractual provisions affecting the useful life.
Accounting Entries for Goodwill in Partnership
We have researched for latest 2013 accounting entries for goodwill in partnership at the time of admission of a new partner in the partnership firm. As per Accounting standard 10 of Indian GAAP, we will treat the goodwill in the book of firm if a new partner will bring the goodwill in cash or cash's worth. Otherwise, there will not be any treatment.
1. When A New Partner Gives the Goodwill in Cash Privately
If a new partner came and got his profit share from old partner and gave the goodwill in the pocket of old partner privately without any information or proof to public. Its accounting entry will not be in the books of account.
2. When A New Partner Gives Goodwill in Cash and Mentioned to Public
A new partner came. Goodwill gave to old partner in cash and he mentioned this in public. Same goodwill will be kept in the business as Asset . Following entries will be passed.
1st Entry
Cash / Bank Account Debit
Goodwill / Premium Account Credit
2nd Entry
Goodwill / Premium Account Debit
Old Partner's Capital Account Credit
( In sacrifice ratio, old partner will divide the goodwill)
3. When A New Partner Gives Goodwill in Cash and Old Partners Withdraw
A new partner came. Goodwill gave to old partner in cash and he mentioned this in public. Same goodwill will be kept in the business as Asset . But after this, same day or other day, old partner withdraw the goodwill. Following entries will be passed.
1st Entry
Cash / Bank Account Debit
Goodwill / Premium Account Credit
2nd Entry
Goodwill / Premium Account Debit
Old Partner's Capital Account Credit
( In sacrifice ratio, old partner will divide the goodwill)
3rd Entry
Old Partner's Capital Account Debit
Cash/ Bank
( In sacrifice ratio, old partner will withdraw the goodwill amount)
4. When A New Partner will not Pay Goodwill in Cash But Adjustment through His Capital Account
At that time, we will pass following journal entry
New Partner's Capital Account Debit
Old Partner's Capital Account Credit
( In sacrifice ratio, old partner will divide the goodwill proportion through new partner's capital adjustment. New partner's capital will decrease and new partner's capital will increase. )
5. When A New Partner will not Pay whole in Cash Goodwill
If a new partner has decided that he will some proportion of goodwill in cash and other in his capital adjustment. At that time, following entry will be pass.
1st Entry
Cash / Bank Account Debit
Goodwill / Premium Account Credit ( suppose, it is the 60% of total payable goodwill by a new partner)
2nd Entry
Goodwill / Premium Account Debit ( 60% of total goodwill)
New Partner's Capital Account Debit (40% of total goodwill)
Old Partner's Capital Account Credit ( 100%)
( In sacrifice ratio, old partner will divide the goodwill)
6. When A New Partner will Give Goodwill in Kind of Any Asset
when a new partner has decided to give the goodwill to old partner in the form of any asset. At that time, following entry will be passed.
1st Entry
Assets which is Given by New Partner Account Debit
New Partner's Capital Account Credit
Goodwill/ Premium Account Credit ( Difference between asset and capital)
2nd Entry
Goodwill/Premium Account Debit
Old Partner's Capital Account Credit
( In sacrifice ratio, old partner will divide the goodwill)
7. When there is Goodwill in Balance Sheet or Books
We do the action for written off all these goodwill by transferring in old partners' capital account and then all other above treatment will do.
For Written off the goodwill in old balance sheet
Old Partners' Capital Account Debit
Goodwill/ Premium Account Credit
( this goodwill will be written off in old sharing ratio between the old partners. )
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