WHAT IS GOODWILL?
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WHAT IS GOODWILL?
Why do people pay money, and in many cases, substantial amounts for goodwill? Many definitions of goodwill exist and are recorded in the literature with most based on legal or accounting concepts. Accounting concept From an accounting viewpoint, goodwill is simply the difference between the purchase price and the “hard” assets of the business. This is best illustrated in the following example: Price Less Plant Less Stock Goodwill 100,000 30,000 30,000 40,000
The accounting and legal concepts of goodwill are important, but don’t fully explain why people are prepared to pay money for this ‘invisible’ asset. Purchasers are prepared to pay goodwill for one basic reason – THE EXPECTATION OF MAKING FUTURE PROFITS. If the buyer doesn’t believe the business will make future and / or sufficient profits, he won’t pay any goodwill. Why should he? Goodwill is essentially the price a person pays for an established business instead of starting the same business from scratch. When you start a business you have no guarantee of its future success and, thus, making profits. Even if the business does become profitable, it takes time (eg. 1 – 2 years). However, buying a business and paying goodwill enables you to achieve profits from the day you take over. Statistics show that the failure rate of businesses are extremely high in the first 1 – 2 years. Some studies indicate a 65% failure rate in this period. Buying a business that has survived this period enhances the purchaser’s chances of remaining in business. This is why people pay goodwill.
Under the accounting definition, goodwill is given a dollar figure. However, this does not adequately explain what is “goodwill”. Legal Concept The courts, over time, have defined goodwill in different ways. However, the basic legal concept of “goodwill” is: “the benefits that belong to a business resulting from intangible factors like location, reputation, customer base, internal knowledge and skills of staff, production methods, plus anything that will retain old customers and gain new ones”. The legal concept doesn’t put a dollar figure on goodwill but goes closer to what people consider goodwill to be. However, it is still not the full answer.
Practical Definition