Goodwill- Nature and Valuation

Goodwill: Nature & Valuation

Goodwill

Goodwill is refers to brand image of a company and monetary valuation of income that it can generate due to its brand value in the market.

Goodwill is of two types:

Self Generated Goodwill – It is brand image of a business organisation generated over a period of time of its business in the market. It is not accounted or written in Balance Sheet.

Purchased Goodwill – It is excess of price paid for a business as a whole over the Book Value or Agreed Value of all tangible net assets purchased.

Methods of valuation of goodwill

There are three methods for valuing Goodwill:

1. Average Profit Method

2. Super Profit Method

3. Capitalisation Method

1. Average Profit Method

Under this Method, Goodwill can be calculated either by Simple Average Profit Method or Weighted Average Profit Method.

A. Simple Average Profit Method

Goodwill = Average Profit × Number of Years ‘Purchase.

Average Profit = Sum total of profits of Business ÷ Number of years of Normal Profit

Number of years’ Purchase means number of years for which Business Organisation who is paying for Goodwill will be able to earn same amount of Profit after change of Ownership of Business.

Calculation of Profit in case of Adjustments to be made Rs.
Profit or Loss before Adjustment
Add:
Abnormal Losses such as Loss by Fire, Loss on sale of Asset
Over Valuation of Opening Stock (It has led to reduction in Profit)
Undervaluation of Closing Stock (It has led to reduction in Profit)
Non Recurring expenses (expenses which do not occur on regular Basis)
Capital Expenditure charged as Revenue Expenditure
(Purchase of Machinery wrongly debited to Purchase Account)

Less:
Abnormal Gains (Profit on Sale of Fixed Assets)
Over Valuation of Closing Stock or Under Valuation of Opening Stock
(It has increased Profit)
Non Recurring Income (Incomes which do not occur on regular Basis)
Partners’ Remuneration, if not deducted

Profit after Adjustment / Adjusted Profit

B. Weighted Average Profit Method
Weighted Average Profit = ∑ (Pn × Wn) ÷ ∑W
= Sum total of (Profit of respective year × weight of Respective year) ÷ Sum Total of Weight.
Goodwill = Weighted Average Profit × Number of years’ Purchase

2. Super Profit Method

Excess of Actual profit over Normal Profit is known as Super Profit.

Goodwill = Super Profit × Number of Years’ Purchase.

Super Profit = Adjusted Profit – Normal Profit

Normal Profit = Average Capital Employed × Normal Rate of Return / 100

Average Capital Employed = (Opening Capital Employed + Closing Capital Employed)/2

Net Asset or Capital Employed = Capital + Reserve & Surplus – Fictitious Assets – Non Trade Investment

= All Assets (Except Goodwill & Fictitious Assets & Non Trade Investment) – Non Current Liability – Current Liability

Kindly Refer Ratio Analysis Chapter for more Details on Capital Employed / Net Asset

Normal Rate of Return (NRR) is the return earned by similar type of business of same Industry.

3. Capitalisation Method

Two Methods studied under it is:

A. Capitalisation of Average Profit

Goodwill = Total Capitalised Value of Business – Net Assets

Capitalised Value of Business = Average Profit × 100 /NRR

Net Asset or Capital Employed = Capital + Reserve & Surplus – Fictitious Assets – Non Trade Investment

= All Assets (Except Goodwill & Fictitious Assets & Non Trade Investment) – Non Current Liability – Current Liability

Kindly Refer Ratio Analysis Chapter for more Details on Capital Employed / Net Asset

B. Capitalisation of Super Profit

Goodwill = Super Profit × (100 / NRR)