Cambrige Notes: Principle of Accounting: The concept of goodwill

It is not unusual for a business to be bought or sold as a going concern i.e.
The entire business (or business unit) and its related assets and liabilities
Often when a business is sold or bought it is at a price that is higher than its net assets
Purchase consideration is the price which is paid by the purchasing company
Net Assets = Assets – Liabilities
Goodwill = Purchase Consideration-Net Assets
Goodwill, often called purchased goodwill, is the excess of the purchase price over the the net assets of the business
Goodwill is considered to be an intangible asset
It only exists if the purchase price i.e the price at which a business was sold is higher than its net assets
Generally this only happens when the purchased business had a good reputation
Goodwill can be therefore seen as representing that general reputation of the business

There are advantages to buying a business which is already a going concern and therefore pay goodwill
These advantages include:
- Existing customers who will continue to deal with the new business
- The reputation which the business had cultivated over time
- Experienced and reliable employees that already work for the business
- The business might be already located on a good/popular/prime location
- It is good contacts/relationship with suppliers
- The business might have valuable brands whose value was difficult to ascertain and therefore not included as part of its assets
None of this things would exist in a completely new business
To cultivate these a new business would have to expend time and money
For this reason most buyers are willing to spend more than a business is actually worth on paper

Where the price paid in buying a business ( purchase consideration) is less than the net assets of the business
The difference is known as negative goodwill
Negative goodwill is treated as a profit in the Income Statement ( Profit and Loss account) in the year in which it is realized
Negative goodwill normally occurs when a business is bought at a bargain normally because:
The business has an inefficient workforce
Has a bad reputation etc

Prudence, measurement concept, historical concept and other accounting regulations forbid the recording of goodwill in accounting records before it is actually realised
Goodwill should only be recorded in partnership changes or when a business is bought or sold
A business cannot estimate goodwill and record it as an asset before this happens
During the actual sale it is up to the buyer and seller how they want to calculate goodwill
Common methods include using profit, sales and opportunity cost
Goodwill can also be recorded when a sole trader acquires another business

Cambrige Notes: Principle of Accounting: The concept of goodwill- Updated 2024