[AMY INSTITUTE OF MANAGEMENT STUDIES] ACCOUNTANCY

2. GOODWILL: NATURE AND VALUATION

Meaning of Goodwill: Goodwill is an intangible asset that places the firm at an advantageous
position due to which the firm is able to earns higher profits than normal. Goodwill cannot be
seen but felt. Therefore, goodwill is called an Intangible asset.

Characteristics of goodwill
1. It is an intangible Assets and it has a value, thus it is not fictitious assets.
2. It does not have an existence separate from that of an enterprise.
3. Its value depends upon the subjective judgment of the valuer.
4. It helps in earning higher profits without any extra efforts.
5. It is an attractive force that brings old customer more frequently to the place of business.

Factors affecting the value of Goodwill:

1. Efficient management: Special ability and skill of the persons engaged in the management
adds to the value of goodwill. When the management is able, efficient and competent in the
business, in turn, profit increases, which is a symptom of creating goodwill.
2. Quality of products: If the firm enjoys good reputation for its product quality, there will be
higher sales and the value of its goodwill will increase.
3. Location of business: If the business is located at favorable place, resulting in increased
customer walk in and therefore, increased sale and profits.
4. Nature of Business: If the business of a firm is of the nature where the product dealt in are
in high demand along with secured monopoly which brings more earnings which are
assured, value of goodwill increases.
5. Risk in Business: When the risk is less in the business, it creates more goodwill but if the
risk is more, it will create less goodwill.
6. Advantage of Patents: The patents prevent and distinguishes rival products. The object is
to acquire monopolistic rights, which create goodwill. A firm which possesses the necessary
patents will have a better value for its goodwill.
7. Favorable contracts: Possession of large number of profitable contracts for supply of
goods or services enhances the value of goodwill.
8. Past performance: The firm earning higher profits year after year, will have higher value
of goodwill as compared to the firms earning lesser profits or incurring losses.

Need for valuation of goodwill: Whenever the mutual rights of the partners change then
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 there is change in profit sharing ratio.

2) On admission of a new partner
3) On Retirement or death of a partner
4) When two or more firms amalgamate
5) When partnership firm is sold as a going concern.
6) when partnership firm is converted into company.

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[AMY INSTITUTE OF MANAGEMENT STUDIES] ACCOUNTANCY

Classification of goodwill: goodwill can be classified into categories

1. Purchased goodwill: Purchase goodwill is that goodwill for which the firm has paid certain
amount in cash or kind. It arises when a business unit is purchased by another business. It is
recorded in the balance sheet because the payment is made.

2. Self-generated goodwill: Self-generated goodwill is an internally generated goodwill which

arises from a Numbers of factors (such as location, quality and management) that a running
business possesses due to which it is able to earn higher profit.
It is not recorded in the balance sheet.

Methods of valuation of goodwill:

1. Average profit method 2. Super profit method 3. Capitalization method

1. Average Profit Method:

(A). Simple average profit method:
The profit earned by a Firm during previous accounting periods on an average basis is called
average profit. Here profit means normal business profit of the firm thus abnormal income and
expenses are not considered.
Goodwill is calculated on the basis of average profit

Normal profit = profit during the year – Abnormal gain + Abnormal loss

𝐓𝐨𝐭𝐚𝐥 𝐍𝐨𝐫𝐦𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭𝐬

Average Profit =
𝐍𝐨.𝐨𝐟 𝐘𝐞𝐚𝐫𝐬

Goodwill = Average Profit (after remuneration if any) X Number of years purchase.

Illustration 1. (Average Profit Method)

Calculate the value of goodwill if the goodwill is to be valued at 2 times the average annual
profits of the previous four years. The average profits for the past four years were:
Year Rs.
2020 96,000
2021 60,600
2022 62,400
2023 84,400

Solution: Average Profit = Total Profit/No. of Years

Average profit = 3,03,400/4=75,850

Goodwill = Average Profit x Number of Years of Purchase

Goodwill = 75,850x2=1,51,700

Number of year purchase means the year for which the firm is likely to earn similar profits
because of efforts made in the past

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[AMY INSTITUTE OF MANAGEMENT STUDIES] ACCOUNTANCY

(B). Weighted average profit method:

Under this method weight is assigned to each year and we have to find weighted average profit
by multiplying each year profit to assigned weights.

Year Profits after adjustments Weights Product (A×B)

𝐓𝐨𝐭𝐚𝐥 𝐩𝐫𝐨𝐝𝐮𝐜𝐭
Weighted average profit =
𝐓𝐨𝐭𝐚𝐥 𝐰𝐞𝐢𝐠𝐡𝐭𝐬

Goodwill = Weighted average profit X Number of year purchase

Illustration 2. A & B are the partner in a firm with a ratio of 3:2. Calculate the value
of goodwill under the suitable method where no. Of purchased year is estimated as three years
of profits, Profits for the last five years were Rs. 40,000 , 60,000 , 80,000 , (10,000) , 90,000
And their weights were 1,2,3,4,5 respectively & partner is getting a remuneration of Rs. 500 pm
each.
Solution:
Year Profit Adjustments Final profit Weight Product
I 40000 (12000) 28000 1 28000
II 60000 (12000) 48000 2 96000
III 80000 (12000) 68000 3 204000
IV (10000) (12000) (22000) 4 (88000)
V 90000 (12000) 78000 5 390000
15 630000

Total product
Weighted average profit =
Total weights

630000
= = 42000
15
Goodwill = Weighted average profit X Number of year purchase
= 42000 X 3 = Rs. 1,26,000.

2. Super Profit Method:

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 learning capacity of the firm.

Super profit = Average profit – Normal profit

Goodwill = Super profit X No. of year purchase

𝐍𝐨𝐫𝐦𝐚𝐥 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧

Where Normal Profit = Capital Employed X
𝟏𝟎𝟎

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[AMY INSTITUTE OF MANAGEMENT STUDIES] ACCOUNTANCY

Capital employed = All Assets (except Non trade investment, goodwill & fictitious Assets)
– Outsider liability
Or
= Capital + Reserve + Cr. Balance of current A/c – Dr. Balance of current
Account – fictitious Assets – Non trade investment – goodwill

Illustration 3. (Super Profit Method)

A firm earned net profits during the last three years as:
Year Profit (Rs)
2019 36,000
2020 40,000
2021 44,000
The capital investment of the firm is Rs.1,20,000. A fair return on the capital having regard to
the risk involved is 10%. Calculate the value of goodwill on the basis of three years purchase of
the average profit for the last three years.
Solution:
36000+40000+44000
Average profit = = 40000
3

Normal rate of return

Normal Profit = Capital Employed X
100
120000 x 10
Normal Profit = = 12,000
100

Super profit = Average profit – Normal profit

= 40,000 – 12,000 = 28,000

Goodwill = Super profit X number of years purchased

So the goodwill is = 28,000 x 3 = 84,000

3. Capitalization Method:
Under the capitalization method, goodwill can be valued in two ways:
(a). capitalization of average profit (b). Capitalization of super profit

(A). Capitalization of Average profit

Under this method, the value of the entire business is determined on the basis of Normal
Average profit. Goodwill is taken as the difference between the Values of the Business minus
Net Tangible Assets.
Here Goodwill = Total capitalized value of firm – Capital employed

𝟏𝟎𝟎
Capitalized value of the firm = Average profit X
𝐍𝐨𝐫𝐦𝐚𝐥 𝐫𝐚𝐭𝐞 𝐨𝐟 𝐫𝐞𝐭𝐮𝐫𝐧

Capital employed = Total Assets – liabilities

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[AMY INSTITUTE OF MANAGEMENT STUDIES] ACCOUNTANCY

Illustration 4. A earns Rs. 1,20,000 as its annual profits, the rates of normal profit being 10%
The assets of the firm amounted to Rs.14,40,000 and liabilities to Rs. 4,80,000. Find out the
value of goodwill by capitalization method.
Average profit x 100
Solution: Capitalized value of the firm =
Rate of normal profit

1,20,000x100
= = 12,00,000
10
Capital employed = Total assets – liabilities = 14,40,000 – 4,80,000
= 9,60,000
Goodwill = capitalized value of firm – capital employed
= 12,00,000 – 9,60,000 = 2,40,000
(a). Capitalization of Super profit
Under this method, goodwill is calculated by capitalization of super profit on the basis of
normal rate of return.
𝟏𝟎𝟎
Here Goodwill = Super profit X
𝐍𝐨𝐫𝐦𝐚𝐥 𝐫𝐚𝐭𝐞 𝐨𝐟 𝐫𝐞𝐭𝐮𝐫𝐧

Where Super profit = Average profit – Normal profit

𝐍𝐨𝐫𝐦𝐚𝐥 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧

Normal Profit = Capital Employed X
𝟏𝟎𝟎
And Capital employed = Assets – liabilities

Goodwill with past Adjustment

1. Abnormal Expenses or Losses Added in profit

2. Abnormal Gains or Profits Deduct from profit
3. Any Expense that is not yet Recorded Deduct from profit
4. If Capital Expense recorded as Revenue Expenses Added in profit
5. If Revenue Expense recorded as Capital Expense Deduct from profit
6. Under valuation of closing stock (it decrease the profit) Added in profit
7. Over valuation of closing stock (it Increase the profit) Deduct from profit
8. Over valuation of opening stock (it decrease the profit) Added in profit
9. Under valuation of opening stock (it Increase the profit) Deduct from profit

Closing stock of current year will become opening stock Next year

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