Valuation of Goodwill
Introduction
Number of years of purchase means for how many years the firm will earn
the same amount of profits in future.
Assignment
What do you mean by Goodwill? Describe the factors affecting the value of
goodwill.
State whether the following statements are True or False:
1. Business with efficient and experienced management will generate more
goodwill.
2. The business with higher longevity will have more goodwill
3. The business which deals in the daily use products will have less goodwill.
4. If the risk involved in the business is less than it will have less goodwill
Features of Goodwill
1. It is an intangible asset: Goodwill cannot be seen or touched, it does not
have any physical existence, thus it belongs to the category of intangible
assets such as patents, trademarks, copyrights, etc.
2. It is a valuable asset
3. It is helpful in earning excess profits.
4. Its value is liable to constant fluctuations: While goodwill does not
depreciate, its value is liable to constant fluctuation, its value is liable to
constant [Link] is always present as a silent asset in a business where
there are super profits ([Link] than the normal) but declines in value with
the decline in earnings
5. It is valuable only when entire business is sold: Goodwill cannot be sold in
part. It can be sold with the entire business only. The only exception is at the time
of admission or retirement of the partner.
6. It is difficult to place an exact value on goodwill: This is because its value
may fluctuate from time to time due to changing circumstances which are internal
and external to business. Goodwill is divided into two categories.
Categories of Goodwill
1. Purchased Goodwill: Purchased goodwill means goodwill for which a
consideration has been paid e.g. 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.
Characteristics of Purchased Goodwill
(i) It arises on purchase of a business or brand.
(ii) Consideration is paid for it so it is recorded in books.
(iii) Shown in balance sheet as on asset.
(iv) It is amortised (depreciated).
(v) Value is a subjective judgment & ascertained by agreement of seller &
purchaser. It is approximate value and cannot be sold separately in the market or
in parts.
2. 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
Need for Valuing Goodwill: Whenever the mutual rights of the partners 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.
Things to consider before calculating the average profits :-
1. Any abnormal profit/gain should be deducted from the net profits of that year.
2. Any abnormal loss should be added back to the net profits of that year.
3. Any normal loss should be deducted from the net profit of that year.
4. Any normal profit/gain should be added from the net profit of that year.
5. Non-operating incomes e.g. income from investments should be deducted from
the net profits of that year.
6. Unrecorded Expenses should be deducted from the profit of that year.
1. Method under which calculation of goodwill is done on the basis of extra profit
earned above the normal profit.
2. Capital employed × NRR /100 =
Super profit method:
Super profit method: In super profit method, the average/actual profits of the
business are compared with the normal profit which would have earned with the
same capital in the same type of business.
If the average profit of the company exceeds the normal profit the difference is
known as super profit. Under this method value of goodwill is calculated on the
basis of super profit and the following steps are followed for this:
Step 1: Calculate Capital Employed by the following Formula
Capital employed = Fixed Assets + Working Capital
OR
Capital Employed = Fixed Assets + Current Assets – Outside Liabilities
OR
Capital Employed = Capital + Reserve/Accumulated Profits – Fictitious Assets
Step 2: Calculation of Current Year profits after tax = [Current year’s Profits –
Abnormal Gain + Abnormal Loss – Normal Loss + Normal Gain] – Tax
Step 3: Calculation of Average Capital Employed
Average Capital Employed = Capital Employed – ½ of Current Year’s Profit after tax
Step 4: Calculate Normal Profits by the following formula
Step 5: Calculate the Average Profit after tax as per the Average Profit
Method
Step 6: Super Profit = Average Profit after Tax – Normal Profit
Step 7: Goodwill = Super Profit × Number of years of Purchase
Calculation of Capital Employed
The capital employed helps in calculating the normal profits of the business. The
following points are considered while calculating the capital employed:
(i) Both current and fixed assets should be included in the capital employed.
These assets should be valued at the current market prices. Following assets
should not be included: Fictitious assets like discount on issue of
share/debentures, preliminary expenses, etc. Outside investments should not be
included in the assets. Goodwill appearing in the balance sheet should also not be
included.
Provision for taxation can be treated as a current liability and it will decrease the working capital in
the schedule of changes in working capital.
(ii) From the total assets the outside liabilities should be deducted. The outside
liabilities will include: debentures, creditors, provision for tax, outstanding
expenses, bills payable, loans, etc.
So, Net Capital Employed = Fixed Assets + Current Assets – Outside Liabilities
1. Which of the following variables has no impact on a company’s goodwill?
A. The managerial effectiveness of a corporation.
B. Nature of business
C. Customers’ locations are determined by a company’s customers.
D. None of the above
2. Goodwill is paid for procuring
A. Present benefit
B. Past benefit
C. Future benefit
D. None of the above
The term normal profit relates to ___________
A. Average profit earned
B. Excess of average profit over super profit
C. Profit earned in abnormal circumstance
D. Profit earned by similar companies in the same industry
The excess amount which the firm can get on selling its assets over and above the saleable value of its assets is called
A) Surplus
B) Super Profit
C) Reserve
D) Goodwill
A firm’s goodwill is not affected by
A) Location of the firm
B) The reputation of the Firm
C) Better Customer Service
D) None of the Above
Weighted average method of calculating goodwill is used when
A) Profits are not equal
B) Profits show an increasing or decreasing trend
C) Profits are Fluctuating
D) None of the Above
Ex:
The average net profit of a business as adjusted for valuation of goodwill
amounted to Rs. 2,35,000. The net tangible assets employed were of the value of
Rs. 14,50,000. But upon valuation, they amounted to Rs. 15,00,000. Assuming
that 10% represented a fair commercial return, calculate the amount of goodwill by
capitalising super profits.
Ex:
Sam & Co. is contemplating to acquire a business for ₹ 1,60,000. Profits for the last five years
from 2013 to 2017 are given as follows:
2013: ₹10,000
2014: ₹12,000
2015: ₹14,000
2016: ₹9,000
2017: ₹11,000
The business was taken care of by the management. Remuneration from the alternative
employment, if not engaged in the business, for the management comes to `4,500 per annum.
Ascertain the Amount of Goodwill, if it is valued on the basis of three years’ purchase of the
Average Net Profit for the last five years.
Capitalization of Super Profit Method
Capitalisation of Average Method