What is Goodwill?How is it treated under the Purchase method?
A firm may acquire reputation in market by doing business year after year with good conducts. Such market reputation indicates goodwill of that firm. This is an intangible (can’t be touched) but real asset (it exists) and appears in the asset side of firm’s balance sheet.
Under this method goodwill is the product of super profit and the number of years’ of purchase.
Super profit = Average profit – Normal profit
Normal profit = Capital employed or net worth × Normal rate of return
Goodwill = Super profit × Number of years’ of purchase
Example: Suppose ABC firm purchases DEF firm with a goodwill treatment for 4 years under purchase method. Average profit of DEF is $56,000. Capital employed of DEF and normal rate of return are $500,000 and 8% respectively.
Normal profit = $500,000 × 8% = $40,000
Super profit = 56,000 – 40,000 = $16,000
Goodwill = 16,000 × 4 = $64,000