Goodwill Nature and Valuation

Goodwill is the value of the reputation of a firm which enables it to earn higher profits in
comparison to the normal profits earned by other firms in the same trade.

Goodwill is divided into two categories.

Purchased Goodwill: Purchased goodwill means goodwill for which a consideration has been
paid.When business is purchased the excess of purchase consideration of its net assets i.e.
(Assets – Liabilities) is the Purchased Goodwill. It is separately recorded in the books
because as it is purchased by paying in form of cash or kind.
It is amortized (depreciated).
Self-generated Goodwill also called as inherent goodwill. It is an internally generated
goodwill which arises from a number of factors that a running business possesses due to
which it is able to earn more profits in the future.

As per Accounting Standard 26 ( Intangible Asset), it is not recorded in the books of accounts
because consideration in money or money's worth has not be paid for it.

Need for Valuing Goodwill: Whenever the mutual rights of the partner’s changes the party
which makes a sacrifice must be compensated. This basis of compensation is goodwill so we
need to calculate goodwill.

Mutual rights change under following circumstances

1. When profit sharing ratio changes

2. On admission of a partner

3. On Retirement or death of a partner

4. When amalgamation of two firms taken place

5. When partnership firm is sold.

Method of valuation of goodwill:

It is very difficult to assess the value of goodwill, as it is an intangible asset. In case of sale of
a business, its value depends on the mutual agreement between the seller and the purchaser
of the business. Usually, there are three methods of valuing goodwill:

1. average profit method

2. Super profit method
3. Capitalization method
Average Profit Method

In this method, goodwill is calculated on the basis of the number of past years years.
Average of such profits is multiplied by the agreed number of years (such as two or three)
to find out the value of goodwill.

Formula for calculation of goodwill

Goodwill = Average Profits X Number of years of purchase

Number of years of purchase means for how many years the firm will earn the same amount
of profits in future.

Average Profits = Total Profits/Number of years

A buyer always wants to estimate the future profits of a business. Future profits depend
upon the average performance of the business in the past. Past profits indicate as to what
profitsare likely to accrue in the future. Therefore the past profits are averaged. But before
calculating the average profits, the profits earned in the past must be adjusted in the light of
future expectations and the following factors should be taken into account while calculating
the average profits:

(i) Abnormal income of a year should be deducted out of the net profit of that year.
(ii) Abnormal loss of a year should be added back to the net profit of that year.
(iii) Income from investments should be deducted out of the net profits of that year, because
this income is received from outside the business.

Weighted Average Profit Method:

This method is a modified version of average profit method. In this Method each year’s profit
is assigned a weight. The highest weight is attached to profit of most recent year.

Eg: 2011-1, 2012-2, 2013-3, 2014-4.

Each year profits are multiplied by assigned weights. Products are added & divided by total
number of weights. Weighted average is multiplied by agreed Number of years of Purchase.

Weighted Average Profit: =

Goodwill = Weighted Average Profit X No. of years of purchase.

Weighted average profit method is considered better than the simple average profit method
because it assigns more weightage to the profits of the latest year which is more likely to be
earned in future. This method is preferred when profits over the past years have been
continuously rising or falling.

Super profit Method:

In this method goodwill is calculated on the basis of surplus (excess) profits earned by a firm
in comparison to average profits earned by other firms. If a business has no anticipated
excess earnings, it will have no goodwill. Super Profit is the excess of actual profit over
normal profits. Where Normal profits are profits earned by similar business.

If a firm earns higher profit in comparison to normal profit (generally earned by other firms
of same industry) then the difference is called Super Profit. Goodwill is calculated on the
basis of Super profit due to future expectations of earning capacity of the firm.

Goodwill is calculated by the formula

Goodwill = Super Profit X Number of years of purchase

Super Profit = Average profit - Normal profits

Normal Profit = Investment (Capital Employed)X

Capital Employed = {Capital + Free Reserves – fictitious Assets (if any)}

or
{All Assets – (Goodwill, fictitious assets and non-trade Investment) – Outsider’s Liabilities}

Capitalised Method

Under this method, goodwill can be calculated in two ways:

(A) Capitalisation of Average Profit Method: Under this method first of all we calculate the
average profits and then we assess the capital needed for eanring such average profits on the
basis of normal rate of return. Such capital is also called capitalised value of average profits.
It is calculated as under.

Capitalised value of the firm =

Goodwill is calculated by deducting the actual capital employed in business from the
capitalised value of average profits. There will be no goodwill if the actual capital employed
in the business exceeds or equals the capitalized value of the average profits.
Net Assets or Capital employed = Total assets – Outside liabilities

Goodwill = Capitalized value of average profits – Capital Employed

(B) Capitalization of Super Profit Method: Under this method first of all we calculate the
super profits and then we assess the capital needed for earning such super profits on the
basis of normal rate of return. Such capital is actually the amount of goodwill. Super profits
are calculated in the same manner as calculated in super profits method.

Goodwill of the firm = Super Profits * 100 / Normal rate of return.

Note: Treatment of Goodwill is Discussed in later chapter.