Monday, October 22, 2012

Goodwill: Nature and Valuation

Goodwill is the value of the reputation of a firm in respect of profits expected in future over and above the normal profits.
In the words of Eric L. Kohler “Goodwill is the present value of expected future income in excess of a normal return on the investment in tangible assets.”

Reasons for Valuation of Goodwill
In case of a partnership firm, the need for valuation of goodwill may arise under the following circumstances:
(i)      When a new partner is admitted,
(ii)    When a partner retires or dies,
(iii)   When the firm is sold as a going concern,
(iv)  When there is a change in profit sharing ratio among partners,
(v)    When partnership firm is sold to a company.

Nature and Characteristics of Goodwill
(i)      It is an intangible and not a fictitious asset.
(ii)    It helps in earning more than normal profit.
(iii)   It is an attractive force which brings in customers to old place of business.
(iv)  It is composed of variety of elements.
(v)    It is difficult to ascertain the exact value of goodwill.

Factors affecting the value of Goodwill are:
(i)         Skill in Management: If the management is capable, the firm will earn good profits and that will raise the value of goodwill.
(ii)       Location Factor: If the business is located at a favourable place, resulting in good sale or in economics, the value of goodwill will be correspondingly higher.
(iii)      Favourable Contracts: Sometimes, a firm enters into long term contracts for sale and purchase of goods at favourable prices. This will also affect profits and goodwill of the firm.
(iv)     Risk Involved: When the risk is less in the business it creates more goodwill but if the risk is more, it creates less goodwill.

Types of Goodwill
Goodwill is mainly of two types:
a)      Purchased Goodwill
b)      Non-Purchased Goodwill
                Purchased Goodwill: When one business is taken over by another business, the excess of purchase consideration over its net value (assets-liabilities) is termed to as purchased Goodwill.
                Non Purchased Goodwill: Non Purchased Goodwill is an internally generated goodwill which arises because of favourable factors that a business possesses (e.g., favourable location, time factor and efficiency of management).
Methods of Valuation of Goodwill:
a)      Average profits method
b)      Super profit method
c)       Capitalisation method
d)      Annuity method

Average Profits Method: In this method, normal profits of business of a number of years are taken into account. Such profits are totaled up and their average is arrived at. The average profits are multiplied by the number year’s purchases to arrive at the value of goodwill.
For calculation of goodwill following steps are to be followed
a)      Calculate past normal profit. Past Normal Profit = Net Profit + Abnormal loss – Abnormal Gain
b)      Calculate Average normal Profit = Total Past normal profit/no of years
c)       Calculate goodwill = Average normal profit x no. of year’s purchase

Super Profit Method: Super Profits means profits earned in excess of the normal Profit, i.e., Actual Profit –Normal. Normal profits mean the profit which the firms could normally earns in a particular business.
Under this method, the following steps are to be followed for calculation of goodwill:
a)      Calculate average normal profit of business as mentioned above
b)      Calculate normal profit
c)       Calculate super profit. Super profit is the excess of average normal profit over normal profit
d)      Calculate goodwill = super profit x no. of year’s purchase

Capitalization Method: Under this method, the value of goodwill is obtained by capitalizing the average profit or super profit of the basis of normal rate.
Value of goodwill under capitalization of average profit is
                Goodwill = (Average normal profit of the business/ rate of return) – capital employed
Value of goodwill under capitalization of super profit is
Goodwill = Super profit/ rate of return

Annuity Method: Goodwill = Annuity Factor x Super Profit

Difference between Average Profits and Super Profits
Average Profits
Super Profits
1. Meaning
It is the average of the profits of the past few years.
It is the excess of average profits over normal profits.
2. Normal Profit
It need not to be calculated.
It is always required.
3. Normal rate of Profit
No function of normal rate.
Without it super profit cannot be calculated.
4. Relevance of Valuing Goodwill
It is relevant for average profits method, super profits method and capitalisation methods of valuation of goodwill
Super profit is relevant for super profit method and capitalization of super profit method of valuation of goodwill.


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