Corporate Accounting

Treatment of Goodwill in a Business Purchase

Business Purchase

When a limited company purchases another business, the amount that it pays is known as the purchase consideration.

The purchase consideration is often different from the net value of the business that is being purchased, so the difference is recorded in the books of account. If the purchase consideration is more than the net assets, the difference is known as positive goodwill. 

What is Goodwill?

Goodwill is an intangible asset that arises when a company has a good reputation. Goodwill is found on the company’s balance sheet, and it is listed as an asset. The higher the value of goodwill, the more that business has to pay for acquisitions or success in improving its market share.

Goodwill is the name given to the reputation and goodwill of a business. It represents the business’s ability to continue generating money after the sale. It includes such intangibles as the business location, the image of the business, the brand name of the business, the reputation of the employees, and the ability of the business to continue to generate business and keep the same customers. Without goodwill, a business that is losing money would find it difficult to sell.

The following are some reasons for positive goodwill:

  • The business has a good reputation.
  • It has a loyal customer base that will continue to purchase from the new owner.
  • It has a high-quality workforce that is efficient and reliable.
  • It is situated in a strategic location where it attracts a lot of customers.
  • It maintains a strong, long-term relationship with its suppliers.

Positive goodwill can be calculated using the following formula:

(Purchase consideration) – (Net assets of the business)

Keep in mind that you should consider the net assets at their revalued amount rather than their original amount.

It may be recorded as a non-current asset in the balance sheet of the limited company that is purchasing the business. According to the Generally Accepted Accounting Principles (GAAP), goodwill can be recorded in a company’s financial statements only when an entire business or a portion of a business is being purchased.

On the other hand, negative goodwill arises when the purchase consideration is less than the business’s net assets. This might happen when the business has an inefficient workforce or is seen as unreliable by its suppliers. Negative goodwill is usually recorded as a capital reserve.

What is the importance of goodwill?

Goodwill is important because if we buy a business at a discount, i.e. if we buy it at a lower price than what it is worth, there will be a loss. If you purchase a business that has goodwill, you will have to pay it’s future earning which were not present when it was bought. The good will of the business is calculated in business purchases; for this reason, it is always important to assess the value of a business and purchase it only if it is worth buying.

Conclusion

Goodwill is the additional value of a business asset in exchange of the business. In simple terms, if a business seller and buyer have negotiated the selling price of a business, goodwill is calculated. Goodwill value represents the premium value of the business to the buyer.

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