Valuation

of
Goodwill
 Introduction
Goodwill is that element arising from the
reputation, connection with customers, employees
and outside parties and other advantages possessed
by a business which enables it to earn greater
profits than returns normally to be expected on the
capital represented by net tangible assets
employed in the business. It is thus the present
value of a firm’s anticipated super normal earnings.
 It is said to be an attractive force that brings in
customers.
 Goodwill is the estimated value of the reputation
of an enterprise.
 Definition

According to Kohler, “ Goodwill is the current

value of expected future income in excess of a
normal return on investment in net tangible
assets.”

According to Institute of Chartered

Accountants of India “ Goodwill is an intangible
asset arising from business connections or trade
name or reputation of an enterprise.”
 Features of Goodwill
Goodwill can be sold with the entire business except on
admission or retirement of a partner where new partner
compensate the old partners or retiring partner gives up his
rights in favour of remaining partners
 Goodwill is valuable only if it is capable of being transferred
from one person to another.
 Goodwill represents a non physical value over and above the
physical assets.
 Goodwill cannot have an exact cost as its value fluctuates
from time to time due to internal or external factors which
ultimately affect the fortune of the company.
 The value of goodwill is based on the subjective judgement
of the valuer.
 Need for Valuation of Goodwill
Following are the circumstances when goodwill is valued and recorded:
 In case of sole trader, when the business is sold or a new person is
admitted in the firm becomes a partnership firm, or the business is
converted into a company for tax purposes.
 In case of partnership where there is change in the profit sharing ratio
on admission, death and retirement of a partner or when two firms are
amalgamated, or when the firm is sold to other person or firm or to a
company
 In case of a joint stock company the need for valuation of goodwill
arises in following circumstances:
 When the company is taken over by another company, e.g. in case of
amalgamation or absorption.
 When the company’s shares are not quoted on the stock exchange and
their value is to be determined for the purposes of estate duty and wealth
tax
CONTD.

When a person wants to purchase a large block of shares with a

view to acquire control over the management of company.
When the business of the company is being taken over by the
government
When the management wants to write back goodwill which it
wrote off earlier to reduce or eliminate the debit balance in the
profit and loss account.
 Where a person or a company desires to purchase another
business, the vendor will generally require an amount for
goodwill and the purchaser will generally require his accountant
to investigate the value so declared to be attached to the
goodwill.
 Goodwill is to be brought into account upon consolidation of
the assets and liabilities of a holding company and its
subsidiaries.
 Factors Affecting Value of Goodwill
1. Profitability: Profitability refers to the profit which the
firm is expected to earn in future . The buyer of
goodwill when paying for goodwill looks to the future
profits which he expects to earn and not the profits
earned in past. However, if past good profitability was
due to nature of business, favourable location,
ownership of patents and trademarks, access to
supplies, stable political conditions, exceptionally
favourable contracts or good management (which is
likely to continue) the buyer will be prepared to pay a
good amount for goodwill.
2. Capital Employed: The value of goodwill depends on
the capital employed in the business to earn the
average maintainable profits. it represents the equity
shareholder’s funds in the company.
CONTD.

While calculating equity shareholder’s funds any profit or

loss on revaluation of assets should also be taken into
account. Non trading assets, fictitious assets and goodwill
appearing in balance sheet should be excluded.
3.Goodwill can be said to have value only when it can be
transferred for valuable considerations.
4. A prospective buyer of business will be very much
concerned with the possible future taxation liability. Buyer of
goodwill expects to recoup what he has paid for goodwill out
of future profits. The future profits are likely to be reduced by
taxation and the buyer will not be ready to pay any large
amount for goodwill.
 Methods of Valuation of Goodwill

1. Simple Profit Method:

In this method, goodwill is valued on the basis of a certain number of
years purchase of the average profits of the past few years. Average may
be simple or weighted. The value of goodwill is calculated by multiplying
The adjusted annual profits by the number of years of purchase.
For calculating Adjusted future profit or Maintainable profits:
 All expenses and losses not likely to incur in future as extraordinary
salary of a person , abnormal losses are added to profits.
 All profits likely to come in the future as profit due to new line of
business are added to profits.
 All expenses and losses expected to occur in future as salary of
directors, depreciation in future, cost of management are deducted
from profits.
 Profit not likely to recur are deducted from profits.
Calculation of Adjusted average profit:
 Simple average profit method is applied when there is
fluctuation in profits and can be calculated by using
following formula:
Adjusted Average Profits = Total Adjusted Profits for all the
given years ÷ Number of Years
 Weighted Average Profit Method is used when either
weights for each year are given or when the profits are
following an increasing or decreasing trend.
Weighted Adjusted Average Profit = Total Product / Total Weights
Value of Goodwill = Adjusted Average Profit × Number of Years of
Purchase
Example: P ltd. proposed to purchase the business of Shri Chintoo.
Goodwill for this purpose is agreed to be valued at three year’s purchase
of i) simple average profits and ii) weighted average profits of the past
four years. The appropriate weights to be used are: 2010 – 1, 2011 – 2,
2012- 3, 2013 – 4.
The profits for these years are: 2010: Rs.1,01,000; 2011: Rs.1,24,000;
2012: Rs. 1,00,000 and 2013: Rs. 1,50,000. a) On 1st September, 2012 a
major repair was made in respect of plant incurring Rs. 30000 which
was charged to revenue. The said sum is agreed to be capitalised subject
to adjustment of depreciation of 10 % p.a. on reducing balance method.
b) The closing stock for year 2011 was over- valued by Rs.12000.
c) To cover management cost an annual charge of Rs. 24000 is to be
made.
Solution:
Calculation of Adjusted Profits:
 2010 2011 2012 2013
Profit 1,01,000 1,24,000 1,00,000 1,50,000
Add: Repair _ _ 30,000 _
charged to revenue
1,01,000 1,24,000 1,30,000 1,50,000
Less: Depreciation _ _ 1,000 2,900

1,01,000 1,24,000 1,29,000 1,47,100

Less: overvaluation _ 12,000 _ _
of closing stock in
2011
1,01,000 1,12,000 1,29,000 1,47,100
Add: Overvaluation _ _ 12,000 _
of opening stock in
2012
1,01,000 1,12,000 1,41,000 1,47,100
Less: Management 24,000 24,000 24,000 24,000
cost
Adjusted (Future) 77,000 88,000 1,17,000 1,23,100
Profit
i) Simple Average Profit Method: Rs.
Total of Adjusted Profits 4,05,100
(Rs.77,000 +Rs. 88,000 +Rs. 1,17,000 +Rs. 1,23,100)
Average Profit (Rs.405100 ÷ 4) 1,01,275
Value of Goodwill (Rs.101275 ×3) 3,03,825
ii) Calculation of Weighted Average Profits
Year Profit (Rs.) Weight Product (Rs.)
2010 77,000 1 77,000
2011 88,000 2 1,76,000
2012 1,17,000 3 3,51,000
2013 1,23,100 4 4,92,400
10,96,400
Average profit = 10,96,400 ÷ 10 = 1,09,640
Goodwill at 3 years’ purchase = 1,09,640 × 3 = 3,28,920
2. Capitalisation of Profit Method:

Following are the main steps for computing goodwill by this method:
a) Ascertain the average net profit which it is expected will be earned in
future;
b) Capitalise this net profit at the rate which is considered a suitable
return on capital invested in a business of the type under
consideration.
c) Find the value of the net tangible assets used in the business, i.e. assets
less outside liabilities;
d) Deduct the net tangible assets as per (c) from the capitalised profit
obtained in (d) and the difference is Goodwill. Therefore,
Goodwill = Capitalised Value of the business - Actual Capital
Employed
While making an estimate of future maintainable profit on the basis of
past profits, the following points need consideration:
i) All unusual working expenses should be excluded. Interest on
debentures and depreciation on fixed assets should be excluded.
ii) Non trading assets should be excluded from capital employed and
income derived from such assets should also be excluded from profit.
iii) All necessary provisions for liabilities should be made but
appropriation of profits shall not be taken into account.
iv) Preference dividend shall be deducted.
v) While calculating average profits, profits for the past years during
which conditions have remained normal should be considered.
vi) In case the profits for the past years used for calculating average
profit, show a marked rising trend, it will be more appropriate to give
more weightage to the profits of the later years as compared to former
years. However, if the profits are showing a constantly falling trend, it
will be appropriate to estimate the future profits on the basis of trend .
Example: Balance Sheet of P. Co. Ltd.
As on 31st December, 2012
Liabilities Amount Assets Amount

Paid up Capital 2,50,000 Goodwill 25,000

Surplus Account 56,650 Land and Building at cost 1,10,000
Bank Overdraft 58,350 Plant and Machinery at 1,00,000
Sundry Creditors 90,500 cost less Depreciation
Provision for Taxation 19,500 Stock at cost 1,50,000
Book Debts less Provision 90,000
for Doubtful Debts

4,75,000 4,75,000
Additional information:
The company commenced operations in 2008. The profits earned before
providing for taxation have been as:
2008:Rs.61,000,2009:Rs.64,000,2010:Rs.71,500,2011:Rs.78,000,2012:
Rs. 85,000
You may assume that income tax at the rate of 50% have been payable on
these profits. The average dividend paid by company for four years is 10%
which is taken as reasonable return expected on the capital invested in
business.
Solution:
Profit for 5 years (61,000+ 64,000+ 71,500+ 78,000+ 85,000) = 3,59,500
Less: 50% income tax 1,79,750
1,79,750
Average Profit (189750 ÷ 5) 35,950
Future Profits Capitalised at 10% = 35,950 ×100 / 10 = 3,59,500
Total Assets 4,75,000
Less: Goodwill 25,000
Less: Liabilities
(58,350+ 90,500+ 19,500) 1,68,350
1,93,350
Net Tangible Assets 2,81,650
Capitalised Profits 3,59,500
Less: Net Tangible Assets 2,81,650
Goodwill 77,850
3. Super Profit Method:
In case of this method, goodwill is based on the average annual super
earned by the business. The term super profit means the profit over and
above the normal profit. For computation of super profits, the following
three factors are required:
i) Normal rate of return: This is the rate of return which an investor
expects on his investment. It may be aggregate of pure rate of
return and risk rate of return.
ii) Capital employed: It may be calculated on the basis of asset side
items and liabilities side items.
Proceeding from asset side:
Capital employed: Fixed assets + Trade investments + Current assets –
Debentures – Current liabilities
Proceeding from liabilities side:
Capital employed: Paid up Equity and Preference Share Capital+
Accumulated Balance in Capital Reserves, General Reserves and
Credit Balance in Profit and Loss account ± Revaluation Profits(or
Loss) – Fictitious assets - Non trading assets
Average capital employed:
= Capital Employed at the end of the year – ½ of Current Year’s Profit
after Tax
Or = Capital Employed at the beginning of the year- ½ of Current
Year’s Profit after Tax
iii) Normal profit: It is calculated by multiplying the normal rate of
return with capital employed or average capital employed.
Goodwill can be calculated by any of following methods:
i) Purchase of super profit method: Super profits are those profits
remaining after deducting the estimated annual future profit :
a) A reasonable remuneration of proprietors and management
b) An amount considered to be a reasonable return on the amount of
capital invested in the tangible assets
 Allowance should be made for expenses charged against past
profits which are not likely to recur and also for expenses which
are likely to recur in future.
 There must be deducted an amount which is calculated to be a
reasonable return on the capital invested in tangible assets.
This percentage is then applied to capital invested and the resulting
figure deducted from already adjusted average profit, the final result
giving the average annual super profit.
Under this method, goodwill is ascertained as follows:
Goodwill = Average Annual Super Profit × Number of Years
 Example : Balance sheet of Vishnu Ltd.
As on 31 -03-2013
Liabilities Amount Assets Amount

Equity Share Capital 1,50,000 Goodwill 15,000

Capital Reserve 30,000 Land and Building 95,000
Surplus Account 13,000 Machinery 60,000
Creditors 63,000 Stock 57,500
Depreciation Fund Debtors 49,000
Land and Building 7,500 Less: Provision for
Machinery 15,000 Doubtful Debts 1,500 47,500
Cash and Bank Balances 3,500

2,78,500 2,78,500

The company’s business is to be purchased by Shiv Ltd. Calculate the

value of goodwill using following information:
1. The reasonable rate of return on capital employed in the class of
business done by the company is 12%.
2. The company’s average profits for the last five years after making 50%
provision for taxation amounted to 47,500.
3. The present market value of land and building is 1,10,000.
4. The assets are to be taken at their book values.
5. The directors of Vishnu ltd. (two in number) are to be appointed on
Board of Directors of Shiv ltd. The worth of their services is 5,000
p.a. for each of the directors but no charge has been made regarding
this against the profits of Vishnu ltd.
The goodwill of business of Vishnu ltd. is to be taken at four years
purchase of super profits of the company.
Solution:
Calculation of Capital employed:
Land and Building 1,10,000
Machinery 60,000
Stock 57,500
Debtors less Provision for Doubtful Debts 47,500
Cash and Bank Balances 3,500
2,78,500
Less: Creditors 63,000
Depreciation Fund 22,500
85,500
Capital Employed 1,93,000
Calculation of Super Profit:
Average profits of last five years after tax 47,500
Average profit before 50% tax(47,500×100/50) 95,000
Less: Director’s Remuneration (2 × 5,000) 10,000
Average Profits (in future) 85,000
Less: 50% Tax 42,500
Average profits (after tax in future) 42,500
Less: Reasonable Return on Capital Employed
12% on 193000 23,160
Super Profits 19,340

Calculation of Goodwill:
Goodwill at 4 years’ purchase of super profits = (19,340×4) = Rs. 77,360
ii) Sliding Scale Valuation of Super Profit: This method is a slight
variation of the purchase of super profit method. It has been advocated
by A.E. Cut forth. The method is based on the theory that the greater the
amount of super profit, the more difficult it would be to maintain it. The
super profit, in this case is divided into two or three divisions. Each of
these divisions is multiplied by a different number of years’ purchase in
descending order from first division.
For example, if the amount of super profit is estimated at Rs. 6,000, the
value of goodwill will be calculated as under:
First Rs. 2000 at (say) 3 years’ purchase 6,000
Second Rs. 2000 at (say) 2 years’ purchase 4,000
Third Rs. 2000 at (say) 1 years’ purchase 2,000
Total Value of Goodwill Rs.12,000
iii) Annuity Method of Super Profit: This method is based on the logic
that the purchaser should pay now for goodwill only the present value of
super profits calculated at a proper rate of interest. Thus, goodwill is the
discounted value of the total amount calculated as per purchase of super
profit method.
Value of goodwill = Average Annual Super profit × Annuity rate
Example : Balance sheet of Taj Ltd.
As on 31st December, 2006
Liabilities Amount Assets Amount
Share capital (in shares Goodwill 50,000
of Rs. 100 each) Freehold property 3,75,000
1500 6% Preference 1,50,000 Plant and machinery less 3,50,000
shares depreciation
6500 Equity Shares 6,50,000 Stock 3,70,000
Profit and Loss 4,50,000 Debtors net 3,99,250
account 3,00,000 Bank balance 2,45,000
5% Debentures 2,39,350
Sundry creditors

17,89,250 17,89,250
Profit after tax for the three years 2004, 2005 and 2006, after charging
debentures interest were Rs. 220500, Rs. 322500 and Rs. 240000
respectively.
i) The normal rate of return is 10% on the net assets attributed.
ii) Goodwill may be calculated at 3 times adjusted average super profits of
the 3 years referred to above (present value of Re.1 is 2.487)
iii) The value of freehold property is to be ascertained on the basis of 8 %
return. The current rental value is Rs. 50400
iv) Rate of tax applicable is 50%
v) 10% of profits for 2005 referred to above arose from a transaction of a
non- recurring nature.
vi) A provision of Rs. 15750 on sundry debtors was made in 2006 which
is no longer required; profit for the year 2006 is to be adjusted for
this item.
vii) A claim of Rs. 8250 against the company is to be provided and
adjusted against profit for 2006.
Ascertain the value of goodwill of the company.
Solution:
1. Computation of Capital Employed:
Net asset of the company Rs. Amount (Rs.)
Freehold property at market value 6,30,000
((50400 × 100) ÷ 8 )
Plant and Machinery 3,50,000
Stock 3,70,000
Debtors 3,99,250
Add: Provision no more necessary 15,750 4,15,000
Bank balance 2,45,000
20,10,000
Less: Liabilities
5 % Debentures 3,00,000
Sundry creditors 2,39,250
Outstanding claim 8,250
5,47,500
Capital employed as on 31.12.2006
14,62,500
2. Computation of future maintainable profits:
Profits for: Rs. Amount (Rs.)

2004 2,20,500
2005 3,22,500
Less: Non- recurring profit 10% 32,250 2,90,250
2006 2,40,000
Add: Provision of sundry debtors 15,750
no more necessary
2,55,750
Less: Claim omitted 8,250
2,47,500
Less: 50% tax on (Rs.15,750 – 8,250) 3,750
= 50 % of Rs. 7500
2,43,750
7,54,500

Average Profit = Rs. 754500 ÷3years = Rs. 2,51,500

3. Calculation of Super Profit:
Future maintainable profit (average profit as above) Rs. 2,51,500
Less:Normalprofit10%oncapitalemployed Rs. 1,46,250
Super Profit 1,05,250

Valuation of Goodwill:
Present value of Re.1 per annum for three years @ 10% annum (2.487)
Goodwill = 1,05,250 × 2.487 = 2,62,000

iv) Capitalisation of Super Profit Method: Under this method, the

value of goodwill is calculated by calculated by capitalising the super
profit at the normal rate of return. This method attempts to determine
the amount of capital needed for earning super profit.
Value of Goodwill = Average annual super profit × 100/Normal rate
of return
Example: Shri Rajesh has invested a sum of Rs. 6,00,000 in his own
business which is very profitable one. The annual profit earned from his
own business is Rs. 1,20,000 which included a sum of Rs. 20,000 received
as compensation for acquisition of part of his business premises. The
money could have been invested in deposits for a period of five years at
10% interest and he could have earned Rs.14,400 p.a. in alternative
employment. considering 2 % as fair compensation for the risk involved in
the business calculate the value of goodwill of his business on
capitalisation of super profits at a normal rate of return of 12%.
Solution:
Calculation of Adjusted Average Profit:
Profit from business Rs. 1,20,000
Less: Compensation for premises Rs. 20,000
Notional salary of Shri Rajesh Rs. 14,400
Rs. 34,400

85,600
Calculation of Normal profit:
Normal profit = Capital employed × Normal rate of return
= 6,00,000 × 12/100 = 72,000
Calculation of Super profit:
Adjusted average profit – Normal profit
85,600 – 72,000 = 13,600
Goodwill = Super profits × 100 / Normal rate of return
13,600 × 100 / 12 = 13,333
Reference:
JR Monga, Corporate Accounting
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