Detailed Notes on Valuation of Goodwill
1. Meaning of Goodwill
Goodwill is an intangible asset representing the reputation, brand value, customer loyalty, and
earning capacity of a business. It helps a firm earn excess profits compared to the average profits
of similar businesses. Since it cannot be seen or touched, goodwill is considered a non-physical
asset but holds significant financial value.
2. Need for Valuation of Goodwill
Goodwill is valued during important changes in a firm. Some situations include:
• Admission of a new partner • Retirement or death of a partner • Change in profit-sharing ratio •
Sale/merger/amalgamation of business • Conversion of a firm into a company • When settling
claims between existing partners
3. Factors Affecting Goodwill
• **Location of the business** – A prime location attracts more customers. • **Quality of
products/services** – Better quality increases goodwill. • **Management efficiency** – Skilled
managers improve profitability. • **Market reputation** – Brand loyalty increases long-term
earnings. • **Working style and policies** – Ethical practices add goodwill. • **Government
policies** – Favorable policies increase business value. • **Monopoly/unique advantages** –
Exclusive rights add goodwill.
4. Methods of Valuation of Goodwill
There are mainly three methods used in accounting to calculate goodwill. These methods help
estimate the value based on profits, super profits, or capitalisation approaches.
4A. Average Profit Method
Under this method, goodwill is calculated by taking the average of past profits and multiplying it by
the given number of years’ purchase.
Formula: Goodwill = Average Profit × Years’ Purchase
• Used when profits are stable. • Abnormal gains and losses are adjusted before calculating
average profit.
4B. Weighted Average Profit Method
Here, profits of recent years are given more importance by assigning weights. Useful when profits
show increasing or decreasing trends.
Formula: Goodwill = Weighted Average Profit × Years’ Purchase
Weighted Average Profit = (Sum of Profit × Weight) / Total Weight
4C. Super Profit Method
Super profit is the excess profit a firm earns over the normal profit earned by similar firms. This
method highlights a firm's additional earning capacity.
Steps:
1. Calculate Average Profit 2. Compute Normal Profit = Capital Employed × Normal Rate of Return /
100 3. Super Profit = Average Profit – Normal Profit 4. Goodwill = Super Profit × Years’ Purchase
4D. Capitalisation Method
This method identifies goodwill by comparing capitalised value of profits with actual net assets.
Two types:
1. Capitalisation of Average Profit Method 2. Capitalisation of Super Profit Method
Formulas:
• Capitalised Value = Average Profit × 100 / Normal Rate of Return • Goodwill = Capitalised Value –
Net Assets
OR
• Goodwill = Super Profit × 100 / Normal Rate of Return
5. Adjustments Required While Calculating Profits
• Add abnormal losses • Deduct abnormal gains • Deduct non-operating incomes (e.g., profit on
sale of asset) • Add non-operating expenses • Adjust depreciation, provisions, undervalued or
overvalued stock
6. Important Terms
Normal Rate of Return (NRR)
The expected rate of return earned by similar businesses under normal market conditions.
Capital Employed
Capital invested in business operations. Formula: Total Assets – Outside Liabilities.
Years’ Purchase
The number of years for which the buyer is willing to pay for the expected future profits.
7. Small Illustrative Example
Average profits of a firm for the last 4 years are ■2,00,000. Normal rate of return is 10%. Capital
employed is ■12,00,000. Calculate goodwill using Super Profit Method for 3 years’ purchase.
Solution:
1. Average Profit = ■2,00,000 2. Normal Profit = 12,00,000 × 10% = ■1,20,000 3. Super Profit =
2,00,000 – 1,20,000 = ■80,000 4. Goodwill = 80,000 × 3 = ■2,40,000