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N E E D F O R TH E VAL U ATIO N O F G OO D W I LL

The valuation of the Goodwill of a sole proprietorship is done when the business is being sold, but in
case of a partnership firm and a joint stock company goodwill can be sold to some another business
entity without selling the whole business. Hence when you are going to sell the goodwill of your
business, you should be assured of the value of your goodwill at that particular time.

In case of a Partnership firm, there is a need for the valuation of Goodwill of the Firm in the
following cases:

1) In the case of a change in the profit sharing ratio of the firm;

2) In case of admission of a new partner;

3) In case of retirement or death of an old partner;

4) In case of Sale / amalgamation of the firm.

In case of a Joint Stock Company, Goodwill is valued in the following circumstances:

1) In case of amalgamation of two or more companies;

2) In case of taking over of business of a company by another company;

3) In case of taking over the business of the company by Government;

4) In case of conversion of shares of one class into another;

5) If a company wants to acquire conrol of another company;

6) In case of valuation of shares of the company for taxation purposes, if stock exchange quotations
are not available.

MET H O D S OF VAL U ATIO N O F G OO D W I LL

There are three methods of valuation of goodwill of the firm;

1. Average Profits Method

2. Super Profits Method

3. Capitalisation Method

1. Average Profits Method:


Under this metod goodwill is calculated on the basis of the average of some agreed number of past
years. The average is then multiplied by the agreed number of years. This is the simplest and the
most commonly used method of the valuation of goodwill.

Goodwill = Average Profits X Number of years of Puchase

Before calculating the average profits the following adjustments should be made in the profits of the
firm:

a. Any abnormal profits shoulld be deducted from the net profits of that year.

b. Any abnormal loss should be added back to the nat profits of that year.

c. Non operating incomes eg. income from investments etc should be deducted from the net profits
of that year.

Now we will explain this method with the help of a simple example.

A Ltd agreed to buy the business of B Ltd. For that purpose Goodwill is to be valued at three years
purchase of Average Profits of last five years. The profits of B Ltd. for the last five years are:

Year Profit/Loss ($)


2005 10,000,000
2006 12,250,000
2007 7,450,000
2008 2,450,000 (Loss)
2009 12,400,000
Following additional information is available:

1. In the year 2008 the company suffered a loss of $1,000,500 due to fire in the factory.

2. In the year 2009 the company earned an income from investments outside the business $
4,500,250.

Solution:

Total profits earned in the past five years= 10,000,000 + 12,250,000 + 7,450,000 2,450,000 +
12,400,000 = $ 39,650,000

Total Profits after adjustments = $ 39,650,000 + $ 1,000,500 $ 4,500,250=$ 36,150,250

Average Profits= $ 36,150,2505=$ 7,230,050

Goodwill = $ 7,230,0503=$ 21,690,150

Thus A Ltd would pay $21,690,150 as the price of Goodwill earned by B Ltd.
2. Super profits method:

Super Profits are the profits earned above the normal profits. Under this method Goodwill is
calculated on the basis of Super Profits i.e. the excess of actual profits over the average profits. For
examplle if the normal rate of return in a particular type of business is 20% and your investment in
the business is $1,000,000 then your normal profits should be $ 200,000. But if you earned a net
profit of $ 230,000 then this excess of profits earned over the normal profits i.e. $ 230,000 $
200,000= Rs.30,000 are your super profits. For calculating Goodwill, Super Profits are multiplied by
the agreed number of years of purchase.

Steps for calculating Goodwill under this method are given below:

i) Normal Profits = Capital Invested X Normal rate of return/100

ii) Super Profits = Actual Profits Normal Profits

iii) Goodwill = Super Profits x No. of years purchased

For example, the capital employed as shown by the books of ABC Ltd is $ 50,000,000. And the
normal rate of return is 10 %. Goodwill is to be calculated on the basis of 3 years puchase of super
profits of the last four years. Profits for the last four years are:

Year Profit/Loss ($)


2005 10,000,000
2006 12,250,000
2007 7,450,000
2008 5,400,000
Total profits for the last four years = 10,000,000 + 12,250,000 + 7,450,000 + 5,400,000 =
$35,100,000

Average Profits = 35,100,000 / 4 = $ 8,775,000

Normal Profits = 50,000,000 X 10/100 = $ 5,000,000

Super Profits = Average/ Actual Profits Normal Profits = 8,775,000 5,000,000 = $ 3,775,000

Goodwill = 3,775,000 3 = $ 11,325,000

3. Capitalisation Method:

There are two ways of calculating Goodwill under this method:

(i) Capitalisation of Average Profits Method

(ii) Capitalisation of Super Profits Method

(i) Capitalisation of Average Profits Method:


Under this method we calculate the average profits and then assess the capital needed for earning
such average profits on the basis of normal rate of return. Such capital is called capitalised value of
average profits. The formula is:-

Capitalised Value of Average Profits = Average Profits X (100 / Normal Rate of Return)

Capital Employed = Assets Liabilities

Goodwill = Capitalised Value of Average Profits Capital Employed

For example a firm earns $40,000 as its average profits. The normal rate of rteturn is 10%. Total
assets of the firm are $1,000,000 and its total external liabilities are $ 500,000. To calculate the
amount of goodwill:

Total capitalized value of the firm = 40,000 100/10 = 400,000

Capital Employed = 1,000,000 500,000 = 500,000

Goodwill = 500,000 400,000 = 100,000

(ii)Capitalisation of Super Profits:

Under this method first of all we calculate the Super Profits and then calculate the capital needed for
earning such super profits on the basis of normal rate of return. This Capital is the value of our
Goodwill . The formula is:-

Goddwill = Super Profits X (100/ Normal Rate of Return)

For example ABC Ltd earns a profit of $ 50,000 by employing a capital of $ 200,000, The normal rate
of return of a firm is 20%. To calculate Goodwill:

Normal Profits = 200,000 20/100 =$ 40,000

Super profits = 50,000 40,000 = $10,000

Goodwill = 10,000 100 / 20 = $50,000


Accounting Procedure for
Valuation of Goodwill (4
Methods)
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The valuation of goodwill depends upon assumptions made by the valuer.
Methods to be adopted in valuation of goodwill would depend on
circumstances of each case and is often based on the customs of the trade.

The various methods that can be adopted for valuation of goodwill are
follows:
1. Average Profit Method

2. Super Profit Method

ADVERTISEMENTS:

3. Capitalization Method

4. Annuity Method.

1. Average Profit Method:


Under this method the value of Goodwill is calculated by multiplying the
Average Future profit by a certain number of years purchase.

Goodwill = Future maintainable profit after tax x No. of years purchase

ADVERTISEMENTS:

The first step under this method is the calculation of average profit based on
past few years profit. Past profit are adjusted in respect of any abnormal
items of profit or loss which may affect future profit. Average profit may be
based on simple average or weighted average.

If profits are constant, equal weight-age may be given in calculating the


average profits i.e., simple average may be calculated. However, if the trend
shows increasing or decreasing profit, it is necessary to give more weight-age
to the profits of recent years.

Number of years purchase:


After calculating future maintainable average profits, the next step is to
determine the number of years purchase. The number of years of purchase is
determined with reference to the probability of new business to catch up with
an existing business. It will differ from industry to industry and from firm to
firm. Normally the number of years ranges between 3 to 5.

Steps Involved under Average Profits Method:


(i) Calculate past profits before tax.

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(ii) Calculate future-maintainable profit before tax after making past


adjustments.

(iii) Calculate Average Past adjusted Profits (taking simple average or


weighted average as applicable).

(iv) Multiply Future Maintainable Profits by number of years purchase.

Value of Goodwill = Future Maintainable Profits x No. of years purchase.

ADVERTISEMENTS:

Illustration 1:
X Ltd. agreed to purchase business of a sole trader. For that purpose,
goodwill is to be valued at 3 years purchase of average profits of last 5 years.

Illustration 2:
Y Ltd. proposed to purchase business carried on by Mr. A. Goodwill for this
purpose is agreed to be valued at 3 years purchase of the weighted average
profits of the past four years.

The profit for these years and respective weights to be assigned are as
follows:

On a scrutiny of the accounts, the following matters are revealed:


(a) On 1st September, 2012 a major repair was made in respect of plant
incurring Rs. 6,000 which was charged to revenue, the said sum is agreed to
be capitalized for goodwill calculation subject to adjustment of depreciation of
10% p.a. on reducing balance method.

(b) The closing stock for the year 2011 was over valued by Rs. 2,400; and

(c) To cover management cost an annual charge of Rs. 4,000 should be made
for the purpose of goodwill valuation.
Required:
Compute the value of goodwill of the firm.

Solution:
Before calculating goodwill, it is necessary to compute adjusted profit on the
basis of information given.

2. Super Profit Method:


Super profit is the excess of estimated future maintainable profits over normal
profits. An enterprise may possess some advantages which enable it to earn
extra profits over and above the normal profit that would be earned if the
capital of the business was invested in some other business with similar risks.
The goodwill under this method is ascertained by multiplying the super profits
by certain number of years purchase.

Steps Involved in Calculating Goodwill under Super Profit


Method:
Step 1: Calculate capital employed (it is the aggregate of Shareholders equity
and long term debt or fixed assets and net current assets).

Step 2: Calculate Normal Profits by multiplying capital employed with normal


rate of return.

Step 3: Calculate average maintainable profit.

Step 4: Calculate Super Profit as follows:

Super Profit = Average maintainable profits Normal Profits.

Step 5: Calculate goodwill by multiplying super profit by number of years


purchase.

Illustration 3:
From the following information calculate the value of goodwill on the
basis of 3 years purchase of super profits of the business calculated on
the average profit of the last four years (simple average and weighted
average):
(i) Capital employed Rs. 50,000

(ii) Trading profit (after tax):

2010 Rs. 12,200;

2011 Rs. 15,000;

2012 Rs. 2,000 (loss); and


2013 Rs. 21,000

(iii) Rate of interest expected from capital having regard to the risk involved is
10%.

(iv) Remuneration from alternative employment of the proprietor (if not


engaged in business) Rs. 3,600 p.a.

3. Capitalization Method:
Goodwill under this method can be calculated by capitalizing average normal
profit or capitalizing super profits.
(i) Capitalisation of Average Profit Method:
Under this method goodwill is ascertained by deducting Actual Capital
Employed (i.e., Net Assets as on the valuation date) from the capitalised value
of the average profits on the basis of normal rate of Return (also known as
value of the firm or capitalised value of business)

Goodwill = Capitalised Value Net Assets of Business

Steps involved in calculating goodwill as per capitalisation of Average


Profits Method:
Step 1: Calculate Average future maintainable profits

Step 2: Calculate Capitalised value of business on the basis of Average


Profits

Step 3: Calculate the value of Net Assets on the valuation date

Net Assets = All Assets (other than goodwill, fictitious assets and non-trade
investments) at their current values Outsiders Liabilities

Step 4: Calculate Goodwill

Goodwill = Capitalised Value Net assets of business.

Illustration 5:
From the following calculate the value of goodwill according to
capitalisation of Average Profits Method:
(ii) Capitalisation of Super Profit Method:
The goodwill under this method is ascertained by capitalizing the super profits
on the basis of normal rate of return. This method assesses the capital
needed for earning the super profit.

The value of goodwill is computed as follows:

Illustration 6:
Balance Sheet of X Ltd. on 31st March, 2013 was as under:
4. Annuity Method:
Under this method, goodwill is calculated by taking average super profit as the
value of an annuity over a certain number of years. The present value of this
annuity is computed by discounting at the given rate of interest (normal rate of
return). This discounted present value of the annuity is the value of goodwill.
The value of annuity for Rupee 1 can be known by reference to the annuity
tables.

If the value of annuity is not given, it can be calculated with the help of
following formula:

Illustration 7:
The net profit of a company after providing for taxation for the past five
years is:

The net tangible assets in the business are Rs. 4, 00,000 on which the normal
rate of return is expected to be 10%. It is also expected that the company will
be able to maintain its super profits for next five years. Calculate the value of
goodwill of the business on the basis of an annuity of super profits, taking
present value of an annuity of Rs. 1 for five years at 10% interest is Rs. 3.78.