Definition Goodwill is an intangible asset that places an enterprise in an advantageous position due to which the enterprise is able to earn higher profits without extra effort. For example, if the enterprise has rendered good services to its customers, it will be satisfied with the quality of its sRead more
Definition
Goodwill is an intangible asset that places an enterprise in an advantageous position due to which the enterprise is able to earn higher profits without extra effort.
For example, if the enterprise has rendered good services to its customers, it will be satisfied with the quality of its services, which will bring them back to the enterprise.
Features
The value of goodwill is a subjective assessment of the valuer.
• It helps in earning higher profits.
• It is an intangible asset.
• It is an attractive force that brings in customers to the business.
• It has realizable value when the business is sold out.
Need for goodwill valuation
The need for the valuation of goodwill arises in the following circumstances :
• When there is a change in profit sharing ratio.
• When a new partner is admitted.
• When partner retires or dies.
• When a partnership firm is sold as a going concern.
• When two or more firms amalgamate.
Classification of goodwill
Goodwill is classified into two categories:
• Purchased goodwill
• Self-generated goodwill
Purchased goodwill :
Is that goodwill acquired by the firm for consideration whether paid or kind?
For example: when a business is purchased and purchase consideration is more than the value of net assets the difference amount is the value of purchase goodwill.
Self-generated goodwill
It is that goodwill that is not purchased for consideration but is earned by the management’s efforts.
It is an internally generated goodwill that arises from a number of factors ( such as favorable location, efficient management, good quality of products, etc ) that a running business possesses due to which it is able to earn higher profits.
Methods of valuation
1. Average profit method
2. Super profit method
3. Capitalization method
Average profit method: goodwill under the average profit method can be calculated either by :
• Simple average profit method or
• Weighted average profit method
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Prepaid expense means a service to be rendered in the future period for which the business has already paid the remuneration. Prepaid expenses are classified as assets. The benefits of this payment will accrue to the business at a later period. For example, insurance is often paid for annually on tRead more
Prepaid expense means a service to be rendered in the future period for which the business has already paid the remuneration. Prepaid expenses are classified as assets. The benefits of this payment will accrue to the business at a later period.
For example, insurance is often paid for annually on the basis of the calendar year. A business may pay insurance every year on 1st January for that entire year. While preparing the financial statements on 31st March, it will recognize the insurance premium for the period 1st April to 31st December of the next financial year as a prepaid insurance expense.
Why are prepaid expenses classified as assets?
First of all, let us understand what an asset is. An asset is anything over which the business has ownership rights and which it can sell for money. The benefits of this asset should accrue to the business.
In light of this definition, let us analyze prepaid expenses as an asset. As the business has already paid for these goods or services, it becomes a legal right of the business to receive the relevant goods or services at a later date. As the benefit of this expense would accrue to the business only at a later date, the prepaid expenses are classified as an asset.
Some examples of prepaid expenses are prepaid insurance, prepaid rent etc
Treatment of Prepaid Expenses
Prepaid expenses are recorded in the balance sheet under the heading “Current Assets” and sub-heading “Other Current Assets”
As per the Generally Accepted Accounting Principles or GAAP, expenses must be recognized in the accounting period to which they relate or in which the benefit due to them is likely to arise. Thus, we cannot recognize the prepaid expenses in the accounting period in which they are incurred.
Prepaid assets are classified as assets and carried forward in the balance sheet to be debited in the income statement of the accounting period to which they relate.
Adjusting Entries
Adjusting entries are those entries that are used to recognize prepaid expenses in the income statement of the period to which they relate. These entries are not used to record new transactions. They ensure compliance with GAAP by recognizing the expenses in the period to which they relate.
Conclusion
The GAAP and basic definition of an asset govern the treatment of prepaid expenses as an asset. The business incurs them in an accounting period different from the accounting period in which their benefit would accrue to the business. The business has a legal right to receive those goods or services.
The business carries them as a current asset on the balance sheet. In the relevant accounting period, they are recognized in the income statement.
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