ZIMSEC O Level Principles of Accounting: Accounting for Partnerships: 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

Reasons for payment of goodwill

  • 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

Negative Goodwill

  • 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

Determining the value of goodwill

  • 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

To access more topics go to the Principles of Accounts Notes.