Goodwill : Nature and Valuation

Goodwill refers to reputation of a

business which enables it to earn relatively more
profits as satisfied customers will come again
and again in future.
Thus Goodwill of a firm enables it to earn
higher profits in comparison to normal profits
earned by a similar firms in the same trade.
 CHARACTERISTICS OR FEATURES OF GOODWILL

❖ It is an intangible asset: can’t be seen

❖ It does not have separate existence: it is sold with business
❖ It helps in earning profits : super profit
❖ Goodwill is subject to constant fluctuation : it increases and
decreases with profit
❖ Exact valuation of goodwill is not possible : depends on
factors which keeps changing
❖ Subjective valuation : it depends on valuer
❖ Goodwill is amortised over its estimated useful life
 GOODWILL

Self-gener Purchased
ated Goodwill
Goodwill

As per AS-26 self-generated goodwill is not recorded in the books

NEED FOR VALUATION OF GOODWILL:
Change in the profit-sharing ratio
Admission of a partner
Retirement of a partner
Death of a partner
Sale of business
Amalgamation of firms
Conversion of firm into company
FACTORS AFFECTING THE VALUE OF GOODWILL:

o Efficient Management
o Favourable Location
o Favourable Contacts
o Longer Establishment of business
o Advantage of Patents
o Access to suppliers
o Quality
o Market Situation
o Risks Associated with business
o Nature of Business
o Past Performance
o Other factors : After sale service, Good customer relations, Good labour
relations
 METHODS OF VALUATION OF
GOODWILL

AVERAGE SUPER PROFIT CAPITALISATION

PROFIT METHOD METHOD METHOD

SIMPLE WEIGHTED CAPITALISATION

CAPITALISATION
AVERAGE AVERAGE OF AVERAGE
OF SUPER PROFIT
PROFIT METHOD PROFIT METHOD PROFIT
 SIMPLE AVERAGE PROFIT METHOD

Value of goodwill = Average profit X No. of Years’ Purchase

Total Profit
Average Profit
No. of Years

* Total Profit = Profits + Abnormal losses of a particular year – Income from

investment ( Non-Operating ) – Normal expenses if not deducted from the
past profit
Q1. Ajay purchases the business of Vijay on 1st January, 2017. The profit of past 3 years earned by Vijay are
as under:
2014 – Rs. 45,000 (including Rs. 7,000 profit from sale of plant)
2015 – Rs. 50,000 (including theft of goods worth Rs. 8,000 during the year)
2016 – Rs. 53,000 (does not include Rs. 5,000 as insurance premium)
Calculate the value of goodwill of the firm based on 2 years’ purchase of the average profit of last 3 years

Ans: Profit of 2014 (45,000 - 7,000) = 38,000

Profit of 2015 (50,000 + 8,000) = 58,000
Profit of 2016 (53,000 - 5,000) = 48,000
TOTAL PROFIT 1,44,000

Average Profit = Total Profit / No. of years

= 1,44,000 / 3
Value of Goodwill = Average Profit X No. of Years’ Purchase
= 48,000 X 2
= 96,000
 WEIGHTED AVERAGE PROFIT METHOD

Value of goodwill = Weighted Average profit X No. of Years’ Purchase

Total of Product of Profits

Weighted Average Profit
Total of Weights

Total of Product of Profit = {Profits + Abnormal losses of a particular year

– Income from investment ( Non-Operating ) – Normal expenses if not
deducted from the past profit} x Weights
Q2. Anil proposes to purchase the business carried on by Bimal. Goodwill is agreed to be valued at 3 years’
purchase of the weighted average profit of the past 4 years. The appropriate weights are – 1,2,3 and 4
respectively.
The profits of 4 years are:
2013 – Rs. 24,000 ; 2014 – Rs. 29,000 ; 2015 – Rs. 23,000 ; 2016 – Rs. 35,000
On Scrutiny of accounts, we find that :
(i) On 1st October, 2015, a major repair was made in plant incurring Rs. 8,000 which amount was charged to
revenue. The said sum is agreed to be capitalised for computation of goodwill subject to depreciation @ 10%
p.a. on diminishing balance method.
(ii) The closing stock of 2014 were over valued by Rs. 2,000.
(iii) It is also agreed that Rs. 3,000 be charged on annual basis as management expenses which have not been
charged earlier. Calculate the value of goodwill of the firm of Bimal.
Year Particulars Normal weights Product
Profit
2013 24,000 -3,000 ( Management Expenses ) 21,000 1 21,000
2014 29,000 – 2,000 (Stock) – 3,000 ( Management Expenses ) 24,000 2 48,000
2015 23,000 + 2,000 (Stock) + 8,000 ( Repair) -200* ( Depreciation) 29,800 3 89,400
- 3,000 ( Management Expenses )
2016 35,000 – 780**( Depreciation ) – 3,000( Management Expenses ) 31,220 4 1,24,880
10 2,83,280
* 8,000 X 10/100 X 3/12 = 200 ; ** ( 8,000 – 200) X 10/100 = 780
Ans:

Weighted Average Profit = Total of Product of Profit / Total of Weights

= 2,83,280 / 10

Value of Goodwill = Weighted Average Profit X No. of Years’ Purchase

= 28,328 X 3
= 84,984
 SUPER PROFIT METHOD

Value of goodwill = Super profit X No. of Years’ Purchase

Super Profit Actual Profit or Average Profit Normal Profit

Normal Rate
Normal Profit Capital Employed
100

• Capital Employed = Fixed Assets + Current Assets – Outside Liabilities

• Capital Employed = Total Assets – Goodwill and other fictitious assets – Outside Liabilities
• Capital Employed = Capital + Reserve & Surplus
Q3. A firm earned profits of Rs. 80,000 Rs. 1,00,000, Rs. 1,20,000 and Rs. 1,80,000
during 2010-11, 2011-12, 2012-13 and 2-013-14 respectively. The firm has capital
investment of Rs. 5,00,000. A fair rate of return on investment is 15% p.a. Calculate
goodwill of the firm based on three years’ purchase of average super profits of
last four years.

Ans: Total Profit = 80,000 + 1,00,000 + 1,20,000 + 1,80,000 = 4,80,000

Average Profit = Total Profit / No. of years
= 4,80,000 / 4 = 1,20,000

Normal Profit = 5,00,000 X 15/100 = 75,000

Super Profit = Average Profit – Normal Profit = 1,20,000- 75,000 = 45,000

Value of Goodwill = Super Profit X No. of Years’ Purchase

= 45,000 X 3
= 1,35,000
 CAPITALISATION OF SUPER PROFIT

Value of goodwill = Super profit X 100 / Normal Rate of Return

Super Profit Actual Profit or Average Profit Normal Profit

Normal Rate
Normal Profit Capital Employed
100

• Capital Employed = Fixed Assets + Current Assets – Outside Liabilities

• Capital Employed = Total Assets – Goodwill and other fictitious assets – Outside Liabilities
• Capital Employed = Capital + Reserve & Surplus
Q3. A firm earns Rs.60,000 profit for the year 2016. The normal rate of return is 10%.
The firm has assets worth Rs 7,00,000 and Liabilities Rs. 2,10,000. Determine
Goodwill by Capitalisation of Super Profit Method.

Ans: Profit during 2016 = 60,000 ; Rate of Return is = 10%

Capital Employed / Net Tangible Assets = Tangible Assets – Outside Liabilities
= 7,00,000 - 2,10,000
= 4,90,000

Normal Profit = 4,90,000 X 10/100 = 49,000

Super Profit = Average Profit – Normal Profit = 60,000 - 49,000 = 11,000

Value of Goodwill = Super Profit X 100/Normal Rate of Return

= 11,000 X 100/ 10
= 1,10,000
 CAPITALISATION OF AVERAGE PROFIT

Value of goodwill = Capitalised value of Average Profit - Capital Employed

100

Capitalised value of Average profit Average Profit

Normal Rate

• Capital Employed = Fixed Assets + Current Assets – Outside Liabilities

• Capital Employed = Total Assets – Goodwill and other fictitious assets – Outside Liabilities
• Capital Employed = Capital + Reserve & Surplus
Q3. A firm earns Rs.60,000 profit for the year 2016. The normal rate of return is 10%.
The firm has assets worth Rs 7,00,000 and Liabilities Rs. 2,10,000. Determine
Goodwill by Capitalisation of Super Profit Method.

Ans: Profit during 2016 = 60,000 ; Rate of Return is = 10%

Capital Employed / Net Tangible Assets = Tangible Assets – Outside Liabilities

= 7,00,000 - 2,10,000 = 4,90,000

Capitalised Value of Average Profit = Average Profit X 100

Normal Rate of Return

= 60,000 X 100/10 = 6,00,000

Value of Goodwill = Capitalised Value of Average Profit – Capital Employed

= 6,00,000 – 4,90,000
= 1,10,000
THANK YOU
Prepared by:
Deepali Gupta