Purchased goodwill has been defined as “the excess of the price paid for a business over the fair market value of the individual assets and liabilities acquired”.
The accounting treatment of purchased goodwill
Once purchased goodwill appears in the accounts of a business, we must decide what to do with it. Purchased goodwill is basically a premium paid for the acquisition of a business as a going concern: included, it is often referred to as a “premium on acquisition”. When a purchaser agrees to pay such a premium for goodwill, he does so because he believes that the true value of the business is worth more to him than the value of its tangible assets.
One major reason why he might think so is that the business will earn good profits over the next few years and so he will pay a premium now in the expectation of getting his money back later. He pays for the goodwill at the time of purchase, and the value of the goodwill will eventually were off.
Goodwill is a changing thing. A business cannot last forever on its past reputation; it must create new goodwill as time goes on. Even goodwill created by a favorable location might suddenly disappear, for example a newsagent’s shop by a bus stop will lose its location value if the bus route is axed.
Since goodwill erodes it would be inadvisable to keep purchased goodwill indefinitely in the accounts of a business.
The treatment of goodwill is the subject of an accounting standard. The Financial reporting standard requires that goodwill should be capitalized and shown in the balance sheet as an intangible fixed asset. It is than amortized over its expected economic life.
Amortization is the name for depreciation in the case of intangible fixed assets.