Valuation of Goodwill

Goodwill: Over a period of time, a well-established business develops an advantage of good

name, reputation and wide business connections. This helps the business to earn more profits
as compared to a newly set up business. In accounting, the monetary value of such advantage
is known as “goodwill”.

Goodwill is the value of the reputation of a firm in respect of the profits expected in future over
and above the normal profits..

Factors affecting the value of goodwill:

1. Nature of Business: A firm that produces high value added products or having a stable
demand is able to earn more profits and therefore has more goodwill.
2. Location: If the business is centrally located or is at a place having heavy customer
traffic, the goodwill tends to be high.
3. Efficiency of management: A well-managed concern usually enjoys the advantage of
high productivity and cost efficiency. This leads to higher profits and so the value of
goodwill will also be high.
4. Market situation: The monopoly condition or limited competition enables the concern
to earn high profits which leads to higher value of goodwill.

Need for Valuation of Goodwill:

Normally, the need for valuation of goodwill arises at the time of sale of a business. But, in the
context of a partnership firm it may also arise in the following circumstances:

1. Change in the profit-sharing ratio amongst the existing partners

2. Admission of new partner
3. Retirement of a partner
4. Death of a partner
5. Dissolution of a firm involving sale of business as a going concern
6. Amalgamation of partnership firms
Classification of Goodwill:

Goodwill is of two types:

1. Purchased goodwill: Purchased goodwill is a goodwill which is acquired by the firm for
some monetary value. For example, Facebook acquired Whatsapp for $22 billion out of
which goodwill of the Whatsapp was valued at $15.3 billion; Facebook purchased the
goodwill of the Whatsapp so this is a purchased goodwill. This goodwill is recorded in
the books of accounts; Facebook will record Goodwill of $15.3 billion as intangible
assets in the balance sheet.

2. Self-generated Goodwill: Goodwill which is earned through the business efforts, due to
which the business would be able to earn higher profits. This goodwill is not recorded
in the books of accounts as it cannot be accurately valued

Watch this video for better understanding: [Link]

Methods of Valuation of Goodwill:

Since goodwill is an intangible asset it is very difficult to accurately calculate its value. Various
methods have been advocated for the valuation of goodwill of a partnership firm. Goodwill
calculated by one method may differ from the goodwill calculated by another method. Hence,
the method by which goodwill is to be calculated may be specifically decided between the
existing partners and the incoming partner.

The important methods of valuation of goodwill are as follows:

 Average Profits Method

 Weighted Average profit method
 Super Profits Method
 Capitalisation Method

1) Average Profits Method

Under this method, the goodwill is valued at agreed number of years’ purchase of the average
profits of the past few years. It is based on the assumption that a new business will not be
able to earn any profits during the first few years of its operations. Hence, the person who
purchases a running business must pay in the form of goodwill a sum which is equal to the
profits he is likely to receive for the first few years. The goodwill, therefore, should be
calculated by multiplying the past average profits by the number of years during which the
anticipated profits are expected to accrue in future (called ‘number of years purchase').
Step 1: Calculate the Normal Business profit

Profit/(loss) of the Past year (Given) XXX

Add:
(i) Abnormal losses (loss by fire, theft, etc.) XXX
(ii) Loss on sale of fixed assets XXX
(iii) Overvaluation of opening stock XXX
(iv) Undervaluation of Closing stock XXX
(v) Non-recurring expenses (Expenses not expected in the future) XXX
(vi) Capital expenditure charged as revenue (Fixed assets XXX
purchased wrongly debited in the P&L account)
Less:
(i) Abnormal gains (gain on sale of fixed assets) (XXX)
(ii) Overvaluation of Closing stock (XXX)
(iii) Undervaluation of opening stock (XXX)
(iv) Non-recurring incomes (Incomes not expected in the future) (XXX)
(v) Income from Non-trade investments (XXX)
(vi) Partner’s remuneration (if not deducted) (XXX)
(vii) Any future expenses (like Insurance premium) (XXX)

Adjusted Profit ( Normal Business profit) XXX

Important points:

 In case of the capital expenditure treated as revenue, depreciation on the capital assets
would be deducted from the profits for all the subsequent years, starting from the year
in which it was wrongly treated.
 Similarly, if revenue expenditure is treated as capital expenditure and depreciation has
been charged on it, then revenue expenditure should be deducted from the profits and
depreciation already charged should be added back to the profits.
 Any future expenses given in the question should be deducted from the profit of all the
years or simply deduct it from the average profit.

Step 2: Find Average profit:

Average Profit = Total of Normal Business profits
Number of years

Step 3: Goodwill = Average profit X No. of years of purchase

Watch this video for better understanding: [Link]

2) Weighted Average profit method:

The above calculation of goodwill is based on the assumption that no change in the overall
situation of profits is expected in the future. Sometimes, if there exists an increasing or
decreasing trend, it is considered to be better to give a higher weightage to the profits of the
recent years than those of the earlier years because the recent profit is likely to be maintained
in the future by the firm. Hence, it is a advisable to work out weighted average based on
specified weights for respective year’s profit.

Step 1: Calculate the Normal business profit as calculated in the above method.

Step 2: Multiply the weights (given in the question) with the normal business profit to calculate
the weighted average profit for every year.

Step 3: Calculate the weighted average normal profit:

Weighted average profit = Total of the weighted profit
Total of weights
Step 4: Goodwill =Weighted average profit X No. of years of purchase

3) Super Profit:

The basic assumption in the average profits (simple or weighted) method of calculating
goodwill is that if a new business is set up, it will not be able to earn any profits during the first
few years of its operations. Hence, the person who purchases an existing business has to pay in
the form of goodwill a sum equal to the actual profits he is likely to receive for the first few
years. But it is contended that the buyer’s real benefit does not lie in total profits; it is limited
to such amounts of profits which are in excess of the normal return on capital employed in
similar business. Therefore, it is desirable to value goodwill on the basis of the excess profits
and not the actual profits. The excess of actual profits over the normal profits is termed as ‘super
profits’.

The steps involved in calculation of goodwill by super profits method are:

Step 1: Calculate the average profits (as calculated in the average profit method) based on the past
few years of performance.

Step 2: Calculate average capital employed. It can be calculated by two approached:

I. Liabilities side approach:

Capital employed= Capital + Reserves –Fictitious assets (Advertisement suspense) – Non-
trade investments – Goodwill (already appearing in the books)
II. Assets side approach
Capital employed= All Assets – Outside liabilities –Fictitious assets (Advertisement
suspense) – Non-trade investments – Goodwill (already appearing in the books)

Average capital employed =Opening capital employed + Closing capital employed

2
Step 3: Calculate the normal profit on the capital employed on the basis of the normal rate of
return:
Normal Profit = Average Capital Employed x Normal Rate of Return (NRR)/100
Step 4: Calculate the Super profits by deducting normal profit from the average profits.
Super Profits = Actual Average Profits - Normal Profits
Step 5: Goodwill =Super profit X No. of years of purchase
Watch this video for better understanding: [Link]
4) Capitalisation Methods:

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

 by Capitalising the Average profits, or
 by Capitalising the Super profits.

Capitalisation of Average profits: Under this method, the value of goodwill is ascertained by
deducting the actual capital employed (net tangible assets) in the business from the capitalised
value of the average profits on the basis of normal rate of return. This involves the following
steps:

Step 1: Ascertain the average profits based on the past few years’ performance

Step 2: Ascertain the capitalised value of average profits/capitalised value of the firm on the
basis of the normal rate of return

Capitalised value of the firm = Average Profits x 100/Normal Rate of Return

Step 3: Ascertain the Net assets (capital employed) by deducting outside liabilities from the
total assets (excluding goodwill, fictitious asset and non-trade investments).

Step 4: Compute the value of goodwill by deducting net assets from capitalised value of the
firm.

Goodwill = Capitalised value of the firm - Net Assets

 Number of years purchase is not considered in the Capitalisation method
Capitalisation of Super profits:

Goodwill can also be ascertained by capitalising the super profit directly. Under this method,
there is no need to work out the capitalised value of average profits. It involves the following
steps:

Step 1: Calculate actual capital employed of the firm, which is equal to total assets (excluding
goodwill, fictitious asset and non-trade investments) minus outside liabilities
Capital Employed = Total Assets (excluding goodwill) — Outside Liabilities

Step 2: Calculate normal profits on capital employed

Normal Profit = Capital Employed x Normal Rate of Return (NRR)/100

Step 3: Calculate average profit (Normal business profits) for past years.

Step 4: Calculate super profits by deducting normal profits from average profits.
Super Profits = Actual (average) Profits - Normal Profits

Step 5: Multiply the super profits by the required rate of return to get the value of goodwill of
the firm.

Goodwill = Super Profits x 100/Normal Rate of Return

-The amount of goodwill worked out by capitalising the super profits will be exactly the same as
calculated by capitalising the average profits.

Watch this video for better understanding: [Link]

Important Questions: [Link]

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