Amortization & Goodwill in Accounting
The term Amortization is used to describe the write-off
to expense of the cost of an intangible
over its useful life. The usual accounting
entry for amortization consists of a debit to Amortization Expense and a credit
intangible asset account.
Amortization general journal entry in accounting
intangible asset account
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There is no theoretical objection to crediting
an accumulated amortization account rather than the intangible asset account, but
this method is seldom encountered in practice.
Although it is difficult to estimate the useful life of
an intangible such as a trademark, it is highly probable that such an asset will
not contribute to future earnings on a permanent basis. The cost of the
intangible asset should, therefore, be deducted from revenue during the years in which it may
be expected to aid in producing revenue. Under the current rules of the Financial
Accounting Standards Board, the maximum period for amortization of an intangible
asset cannot exceed more than 40 years. The straight-line method normally is used for amortizing
Business executives used the term Goodwill
in a variety
of meanings before it became part of accounting terminology. One of the most common
meanings of goodwill in a non accounting sense concerns the benefits derived from
a favorable reputation among customers. To accountants, however,
goodwill has a
very specific meaning not necessarily limited to customer relations. It means the
present value of future earnings in excess of the normal return on net identifiable
assets. Above-average earnings may arise not only from favorable customer relations
but also from such factors as superior management, manufacturing efficiency, and
The phrase normal return on net identifiable assets requires
explanation. 'Net assets' means the owners' equity in a business, or assets minus
liabilities. Goodwill, however, is not an identifiable asset. The existence of
is implied by the ability of a business to earn an above-average return; however,
the cause and precise dollar value of goodwill are largely matters of personal opinion.
Therefore, net identifiable assets mean all assets except goodwill, minus liabilities.
A normal return on net identifiable assets is the rate of return which investors
demand in a particular industry to justify their buying a business at the fair market
value of its net identifiable assets. A business has goodwill when investors will
pay a higher price because the business earns more than the normal rate of return.
Recording Goodwill in the Accounting Records
Goodwill is recorded in the accounting records only when
it is purchased; this situation usually occurs only' when a going business is purchased
in its entirety. After the fair market values of all identifiable assets have been
recorded in the accounting records of the new owners, any additional amount paid
for the business may properly be debited to an asset account entitled Goodwill.
This intangible asset must then be amortized over a period not to exceed 40 years,
although a much shorter amortization period is usually appropriate.
Many businesses have never purchased goodwill but have
generated it internally through developing good customer relations, superior management,
or other factors which result in above-average earnings. Because there is no objective
means of determining the dollar value of goodwill unless the business is sold, internally
developed goodwill is nol recorded in the accounting records. Thus, goodwill may
be a very important asset of a successful business but may not even appear in the
company's balance sheet.
Goodwill is perhaps the most misunderstood asset in financial
accounting and reporting. A primary reason for this misunderstanding is that most
discussions of goodwill fail to distinguish clearly between the definition and the
measurement of goodwill. Goodwill consists of the favorable characteristics of a
business enterprise that are intangible and that cannot be separately identified
and valued. Examples of favorable characteristics that often comprise goodwill include
- 1. Superior management team.
- 2. Outstanding sales manager or organization.
- 3. Weakness in the management of a competitor.
- 4. Effective advertising.
- 5. Secret manufacturing process.
6. Good labor relations.
- 7. Outstanding credit rating.
8. Top-flight training program for employees.
9. High standing in the community.
10. Unfavorable developments in operations of a competitor.
11. Favorable association with another company.
12. Strategic location.
13. Discovery of talents or resources.
14. Favorable tax conditions.
15. Favorable government regulation.
Unlike inventory, property, and even specifically identifiable
intangibles, such as patents and copyrights, the components of goodwill cannot be
sold separately because they cannot exist apart from the company to which they belong.
By increasing earning power, these components increase the value of the entity;
they are, then, assets. We record goodwill as an asset, however, only when we can
identify part of a company's acquisition cost with goodwill, A company may generate
goodwill in its normal business operations, such as when it develops resources or
gains a favorable image in the community. But to value this goodwill without a market
transaction is so difficult, and the results are so subjective, that the company
generating the goodwill cannot record it as an asset. Only by acquiring another
entity may a company record goodwill as an asset.
Amortization of Goodwill
There are two schools of thought with respect to the amortization
(1) Since it has an indefinite life, it should not be written off unless
there is Clear evidence that it no longer exists, In this case,
a large amount could be deducted as a lump-sum write-off.
(2) Because goodwill is essentially the purchase of excess
earnings for a limited time period, it should be amortized over that period.
While both arguments concur that goodwill should be written
off or down at some point in time, the one for periodic amortization is more realistic
since it prevents the distortion of asset and capital balances and presents excess
earnings as a return on capital rather than income;"
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For tax purposes, goodwill
is' considered a permanent asset, and no deduction for
is permitted. However, if the operations of a business are terminated or sold, a
deduction equal to the unrealized portion of the asset (or investment) may be taken