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Goodwill

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Goodwill is an extremely interesting business phenomenon. It enables a firm to derive competitive advantage because of issues like reputation, stability, technical excellence, perceived quality and other intangibles, and thereby allows it to earn higher profits, than it would otherwise have, by selling its products or assets. While the need for valuation or accounting of goodwill does not arise in the normal course of a business or in its growth on a periodic basis, (because of the absence of physical assets to back it up), it becomes an extremely important aspect when a running business goes up for sale, or changes ownership, through mechanisms like mergers, or acquisitions.

Goodwill can be considered from two different points of view: an economic and an accounting approach. The economic approach regards goodwill as the present value of the additional profits the acquiring company is expecting to gain in the future resulting from the acquisition. These additional profits arise from a “favourable attitude towards the firm” and from synergies. From an accounting perspective, goodwill is the difference in valuation between the purchase price and the book value of the acquired firm. (Lycklama, 2006)

The dilemma faced by accountants in valuing goodwill is best illustrated by the sign Albert Einstein had in his Princeton office that stated, “Not everything that counts can be counted, and not everything that can be counted counts.” (Bullen and Cafini, 2006) Businesses with strong goodwill are valued at prices much higher than the value of their net assets, the differentials being asked and paid because of the intrinsic ability of these businesses to earn profits higher than what their assets would warrant. The accounting of goodwill thus arises at the time of change of ownership of a business, pursuant to its sale, merger or acquisition, and on a regular basis

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