Valuation of Goodwill depends upon reputation of a business organization. Goodwill of a business may be termed as the credibility of the business in the market earned over a period of time. Goodwill is qualitative in nature. It is the reputation of the business which increases with the passage of time. It is included under the head of Intangible Assets. Good will depends upon many factors such as:
- Location of business
- Nature of products and their reputation
- Personal reputation of partners
- After sale service and sale promotion including advertisement
- Maintaining the quality of products
- Possession of efficient employees
- Order in hands etc.
The necessity of calculating valuation of goodwill arises when the:
- Profit sharing ratio is being changed
- A new partners is being introduced
- A partner retires or dies
Methods of Valuation of Goodwill
Various methods of valuation of goodwill are used to calculate the goodwill of a firm at a particular date. Some of the commonly used methods are explained below:
1. Average Profit Method
Under average profit method profit of some years, say 5 years, are averaged out and adjusted for any change that is expected to incur in near future. The average profit is then multiplied by an assumed purchase period to calculate the goodwill.
Exercise # 1: If profits of a firm for past 4 years are Rs. 9,000, Rs. 10,000, Rs. 12,000 and Rs. 15,000 and the good will is to be calculated at 2 years purchase, the valuation of goodwill may be calculated under average profit basis as:
= 9,000 + 10,000 + 12,000 + 15,000 / 4
= 11,500 X 2 years of purchase
= Rs. 23,000
In above method of valuation of goodwill suggested that Rs. 23,000 is goodwill of business.
2. Super Profit Method
Super profit method is one step ahead of the average profits method. In this method the normal profits for the year under consideration are taken after deduction of interest on capital and salary of partners. The net profits so derived are then compared with average profit and the excess of normal profit are the super profit. The super profits are multiplied by number of year’s purchase to calculate the goodwill.
Exercise # 2: If profits of a firm for past 4 years are Rs. 9,000, Rs. 10,000, Rs. 12,000 and Rs. 15,000, interest on capital is Rs. 2,000 and the goodwill is to be calculated at 2 years purchase, the valuation of goodwill may be calculated under super profit basis as:
Normal profit 15,000
Less interest on capital (2,000)
Average profit (11,500)
Super Profit 1,500
Valuation of goodwill = 1,500 X 2 years of purchase
= Rs. 3,000
3. Capitalization Method
Under capitalization method goodwill of the firm may be calculated by comparing the net assets and value of whole business. The value of business is calculated by dividing normal profits by reasonable or return (i.e. profit to capital employed ratio). The bet assets or the capital employed is then deducted from value of business to determine the goodwill. Under capitalization method, valuation of goodwill may be calculated as:
Step 1: profit /reasonable rate of return X 100 = Value of whole business
Step 2: value of whole business less net assets appearing in the financial statement is the amount of goodwill of the company.
Mukharji, A., & Hanif, M. (2003). Financial Accounting (Vol. 1). New Delhi: Tata McGraw-Hill Publishing Co.
Narayanswami, R. (2008). Financial Accounting: A Managerial Perspective. (3rd, Ed.) New Delhi: Prentice Hall of India.
Ramchandran, N., & Kakani, R. K. (2007). Financial Accounting for Management. (2nd, Ed.) New Delhi: Tata McGraw Hill.