What is Goodwill?How is it treated under the Purchase method?

Expert Solution

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.

Purchase method:

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

Therefore,

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.

Thus,

Normal profit = $500,000 × 8% = $40,000

Super profit = 56,000 – 40,000 = $16,000

Goodwill = 16,000 × 4 = $64,000

jeff jeffy answered 1 year ago

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