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GOODWILL : Nature and valuation

 

financial accountInG (class-xIi)

 

Chapter-2  GOODWILL : Nature and valuation

 

Meaning of Goodwill/Definition

Goodwill is the present value of expected future income in excess of a normal return on the investment.

According to Lord Eldon “Goodwill is nothing more than the probability that the old customers will resort to the old place”.

According to Lord Macnaghten. “Goodwill is a thing very easy to describe, very difficult to define. It is   the benefit and advantage of the good name, reputation and connections of a business. It is the attractive force which brings in customers.Itis one thing which distinguishes an old established business from new business at its first start”.

Characteristics of Goodwill

  1. It is an intangible assets and not a fictitious asset.
  2. It cannot have and existence separate from that of an enterprise.
  3. It comes into existence due to various factors.
  4. Its value depends on subjective judgement of the value.
  5. It is an attractive force which brings in customers to old place of business.

Nature of Goodwill

Goodwill is an intangible asset. Intangible asset mean an asset not having physical existence. But it is not a fictitious asset.

 

Factors Affecting the Value of Goodwill

  1. Efficient Management
  2. Location
  3. Favourable contracts
  4. Access to supplies
  5. Nature of Business
  6. Quality of products and services

 

Need for Valuing Goodwill

  1. When there is change in the profit sharing ratio.
  2. When a new partner is admitted.
  3. When a partner retires or dies.
  4. When partnership firm is sold as a going concern.
  5. When two firms amalgamate.

 

Classification of Goodwill

            Goodwill can be classified into two categories :

  1. Purchased goodwill
  2. Self-generatedgoodwill.

 

  1. Purchased Goodwill :

It is the goodwill that is acquired by making a payment. For example, when a business is purchased the excess of purchase consideration over its net assets (Assets-liabilities) is the purchased goodwill.

  1. Self-Generated Goodwill.

It is an internally generated goodwill which arises from a number of factors that a running business possesses due to which it is able to earn higher profit.

Features of Self-Generated Goodwill.

(i)         It is generated internally, generally over the years.

(ii)        As per AS-26 internally generated goodwillis not to be recognized as an asset, i.e. is not to be recorded in the books of accounts.

(iii)       Valuation depends on the subjective judgement of the valuer.

 

METHODS OF VALUATION OF GOODWILL

  1. Average Profit Method : – Under this, there are two sub-methods :-
  • Simple Average Profit Method : Under this method, normal business profits earned by business for the specified number of years are considered. Profits earned are totaled and average is determined. Average profit as calculated is multiplied by a number of years purchased to arrive at the value of goodwill.

Number of years Purchase : No. of years purchase means for how many years the firm will earn the same amount of profit because of its past efforts after change of ownership.

UnderAverage Profit method we calculate goodwill applying the following formula :

Value of Goodwill = Average Profit × Number of Years’ Purchase.

We should take normal past business profit for each year by deducting abnormal gains and non-business income and adding abnormal losses and non-business expenses.

Example :

Goodwill of a firm is to be valued at three years purchase of four years average profit. The firm earned in the previous four years’ profits of `15,000, `11,000, `18,000 and
`16,000. Goodwill will be valued as follows :

=  `15,000

Goodwill = `15,000 × 3 = `45,000

Example :

A purchased B’s Business with effect from 1stApril, 2014. It was agreed that the firm’s goodwill is to be valued at two years’ purchase of normal average profits of the last three years. The profits of B’s business for the last three years were :

2011-12 :`80,000(including abnormal gain of `10,000)

2012-13 :`1,00,000 (after charging an abnormal loss of `20,000)

2013-14 :`90,000 (excluding `10,000 as insurance premium on firm’s property – now to be insured).

Calculate value of the firm’s goodwill.

Solution :

                        Average Maintainable Profits are as under

Profit for – 2011-12 (`80,000 – `10,000)                     70,000

Profit for – 2012-13 (`1,00,000 + `20,000)      1,20,000

Profit for – 2013-14 (`90,000 – `10,000)                     80,000

2,70,000

Normal

Goodwill = 2 years purchase of 3 years normal

                Weighted Average Profit Method :

Under this method each year’s profit is multiplied by the assigned weight. i.e. 1, 2, 3, 4 etc. and the value is ascertained. The product is added and divided by the total of weight to arrive at the average profit. The weighted average profit so arrived at is multiplied by the agreed.

“Number of years’ purchase” to arrive at the value of goodwill.

Goodwill = Weighted Average Profit × Number of Years purchase

Example :       

The profit of a firm for the year ended 31st March for the last five years were :

Years 2009 2010 2011 2012 2013
Profit ` 40,000 48,000 60,000 50,000 36,000

 

Calculate the value of goodwill on the basis of three years purchase of the weighted average profit after assigning weight 1, 2, 3, 4 and 5 respectively to the profit for 2009, 2010, 2011, 2012 and 2013.

Solution :

Years (A) Profit (B) Weights (C) Product (D) (B × C)
2009 40,000 1 40,000
2010 48,000 2 96,000
2011 60,000 3 1,80,000
2012 50,000 4 2,00,000
2013 36,000 5 1,80,000
Total   15 6,96,000

           

Goodwill = 46,400 × 3 = 1,39,200

  1. Super Profit Method –Goodwill under this method is calculated by multiplying the super profit with the agreed number of years’ purchase.

The excess of actual profit(or average profit) over the normal profit is called  Super Profit. Normal profit is calculated as return on capital employed or Net Assets. The rate of return in the industry is taken, as normal rate of return.

Goodwill = Super Profit × Number of Years Purchase.

  1. Capitalisation Method : – Under the capitalisation method goodwill can be valuedin two ways:

(i)         Capitalisation of Average Profit or

(ii)        Capitalisation of Super Profit.

(i)         Capitalisation of Average Profit : Under this method, goodwill is calculated by deducting Capital Employed (i.e. Net Assets as on the date of valuation) in the business from the capitalized value of average profit on the basis of Normal Rate of Return. Capitalized value of the business is ascertained by capitalising profits earned at the normal rate of profit. It is calculated as follows  :

 

Net Assets = All Assets (other than goodwill, fictitious assets and non trade investment) at their current value minus outsiders’ liabilities. For calculating goodwill under this method, the steps are :

(i)         Calculate average normal profit earned.

(ii)        Calculate capitalized value of the firm by using the above formula.

(iii)       Determine the value of net assets, on the date of valuation of goodwill.

(iv)       Goodwill = Capitalised Value – Net Assets.

Example :

            A firm earns profit of ` 1,00,000.The normal rate of return in a similar type of business is 10%. The value of total assets (excluding goodwill) and total outsiders’ liabilities as on the date of valuation of goodwill are ` 11,00,000 and ` 2,80,000 respectively. Calculate the value of goodwill according to capitalization of Average Profit Method.

Average Profit = ` 1,00,000

Capitalised Value = = ` 10,00,000

Net Assets = 11,00,000 – 2,80,000 = `8,20,000

Goodwill = 10,00,000 – 8,20,000 = ` 1,80,000

  1. 2. Capitalisation of Super Profit :

The goodwill under this method is ascertained by capitalizing the super profit on the basis of normal rate of return. The various steps involved in valuing the goodwill according to this method are given below :

Step-I : Calculate Super Profits

Super Profit = Average Future Maintenable Profit – Normal Profit

Step-II :

Example :

Average Profit of a firm is` 1,50,000. Total assets in the firm are ` 14,00,000 and outside liabilities are ` 4,00,000. In the same type of business, the normal rate of return is 10% of the capital employed. Calculate the value of goodwill by caitalisation of Super Profit method.

Capital Employed = `14,00,000 – `4,00000 = `10,00,000

Normal Profit = ` = `1,00,000

Super Profit = Average Profit – Normal Profit = 1,50,000 – 1,00,000 = 50,000

Practical Questions

  1. A firm earned Net Profit during the last five years as follows :

I – ` 7,000, II – ` 6,500, III – ` 8,000, IV – ` 7,000 and V – ` 6,000.

The capital investment of the firm is ` 40000. A fair return on capital in the market is 12%. Find out the value of Goodwill of the business if it is based on three years’ purchase of average super profits of the past five years.

  1. A firm earned profits of ` 8,000, ` 10,000, ` 12,000 and ` 16,000 during the years I, II, III and IV respectively. The firm has capital investments of ` 50000. 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.
  2. Calculate value of goodwill on the basis of three years’ purchase of average profit of the preceding five years which were as follows:

`

Year ended 31.3.2014                                                   8,00,000

Year ended 31.3.2013                                                 15,00,000

Year ended 31.3.2012                                                 18,00,000

Year ended 31.3.2011                                                   4,00,000 (loss)

Year ended 31.3.2010                                                 13,00,000

 

  1. A and B are partners sharing profits in the ratio of 3 : 2. They decided to admit C as a partner from 1st April, 2014 on the following terms :

(i)         C will be given 2/5th share of the profit.

(ii)        Goodwill of the firm will be valued at two years’ purchase of three years’ normal average profits of the firm.

Profits of the previous three  years ended 31st March were :

2014 – Profit `30,000 (after debiting loss of stock by fire  ` 40,000).

2013 – Loss ` 80,000 (includes voluntary retirement compensation paid  ` 1,10,000).

2012 – Profit ` 1,10,000 (including a profit of ` 30,000 on the sale of assets).

You are required to value the goodwill.

  1. X and Y are partners sharing profits and losses in the ratio of 3 : 2. They admit Z into partnership for 1/4th share in goodwill, Z brings in his share of goodwill in cash. Goodwill for this purpose is to be calculated at two year’s purchase of the average normal profit of past three years.

Profits of the last three years were :

2012 – Profit ` 50,000 (including profits on sale of asssets  ` 5,000).

2013 – Loss ` 20,000 (including loss by fire ` 30,000).

2014 – Profit ` 70,000 (including insurance claim received ` 18,000 and interest on investments and dividend received ` 8,000).

Calculate value of goodwill. Also, calculate goodwill brought in by Z.

  1. A partnership firm earned net profit during the last three years as follows :

Years                                                                                       Net Profit

2011-12                                                                                   1,90,000

2012-13                                                                                   2,20,000

2013-14                                                                                   2,50,000

The capital employed in the firm throughout the above mentioned period has been ` 4,00,000. Having regard to the risk involved, 15% is considered to be a fair return on capital. The remuneration of all the partners during this period is estimated to be ` 1,00,000 per annum.

Calculate the value of goodwill on the basis of (i) two years’ purchase of super profits earned on average basis during the above mentioned three years and (ii) by Capitalization Method.

  1. The average net profits expected of a firm in future are ` 68,000 per year and capital invested in the business by the firm is ` 3,50,000. The rate of interest expected from capital invested in this class of business is 12%. The remuneration of the partners is estimated to be ` 8,000 for the year. You are required to find out the value of Goodwill on the basis of two year’s purchases of Super-Profits.
  2. On April, 1st, an existing firm had assets of ` 75,000 including cash of ` 5,000. The partners’ capital accounts showed a balance of ` 60,000 and reserves constituted the rest. If the normal rate of return is 10% and the goodwill of the firm is valued at ` 24,000 at 4 year’s purchase of super profits, find the average profits of the firm.
  3. From the following information, calculate value of goodwill of the firm by applying capitalization Method :

Total Capital of the firm ` 16,00,000

Reasonable rate of return 10%

Profit for the year 2,00,000

  1. A firm earns ` 3,00,000 as its annual profits, the rate of return being 12%. Assets and liabilities of the firm amounted to ` 36,00,000 and ` 12,00,000 respectively. Calculate value of goodwill by capitalization method.
  2. A firm earns profit of ` 5,00,000. Normal Rate of return in a similar type of business is 10%. The value of total assets (excluding goodwill) and total outsiders liabilities as on the date of goodwill are ` 55,00,000 and ` 14,00,000 respectively. Calculate value of goodwill according to Capitalization of Super Profit Method as well as Capitalization of Average Profit Method.
  3. From the following particulars, calculate value of goodwill of a firm by applying Capitalization of Average Profit Method :

(i)         Profits of last five consecutive years are :

2013 – ` 54,000; 2012 – ` 42,000; 2011 – ` 39,000; 2010 – ` 67,000 and 2009 –
` 59,000.

(ii)        Capitalisation rate 20%

  • Net Assets of the firm ` 2,00,000.
  1. A business has earned average profit of ` 4,00,000 during the last few years and the normal rate of return in similar business is 10%. Find value of goodwill by

(i)         Capitalisation of Super Profit Method and

(ii)        Super Profit Method if the goodwill is valued at 3 years’ purchase of super profits.

Assets of business were ` 40,00,000 and its external liabilities ` 7,20,000.

  1. Ajit and Baljit were sharing profits in the ratio of 3 : 2. They decided to admit Chaman into the partnership for 1/6th share of the future profits. Goodwill, valued at 4 times the average super profits of the firm, was ` 18000. The firm had Assets worth ` 15,00,000 and Liabilities
    ` 12,00,000. The normal earning capacity of such firms is expected to be 10% p.a. Find the Average Profits/Actual Profits earned by the firm during the last 4 years.
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