Goodwill means the present value of future earnings in excess of the earnings normally realized in the industry. Above average earnings may arise not only from favourable customer relations but also from such factors as location, monopoly, manufacturing efficiency, and superior management. The existence of the intangible asset of goodwill is indicated when an entire business is sold for a price in excess of the fair market value of the other assets.
The willingness of the purchaser of a going concern to pay a price greater than the sum of the values of the tangible assets indicated that they are payingfor intangible assets as well. If the business does not include such specific identifiable intangible assts as patents of franchises, the extra amount paid is presumably for goodwill.
Superior earnings in the past years are of significance to prospective purchaser of a going business only to the extent that they believe such earning may continue after they acquire the business. The premium which they pay represents the cost of goodwill and may properly be recorded in the accounting records of thenew owners in a goodwill account.
Goodwill is to be recorded in the accounts only when paid for. This situation usually occurs only when a going business is purchased entirely. When ownership of a business changes hands, any amount paid for goodwill rests on the assumption that earnings in excess of normal will continue under the new ownership.
Methods of estimating a value of goodwill are arbitrary agreement between buyer and seller of the business may be reached on the amount of goodwill. Goodwill may be determined as a multiple of the average net income of past years. Goodwill may be determined as a multiple of the amount by which the average annual earnings exceed normal earnings. Goodwill may be determined as the capitalized value of excess earning power, using a capitalization rate considered normal in the industry.