Goodwill - Meaning
Goodwill is the benefit of reputation and links of the business, an attractive force that brings in customers. This is the privilege enjoyed by an old business over the new business, other factors remaining same.
It is an intangible asset but not a fictitious asset as it has resale value.
It can be purchased or generated by the business.
It can be purchased by a new business from a running business or can be generated with the own efforts over a number of years.
Purchased goodwill is recorded in books
but Self-generated goodwill cannot be recorded in the books of the firm.
When is Goodwill valued ?
Goodwill is valued whenever then is:
- Change in Profit sharing ratio.
- Admission of a new partner.
- Retirement of a partner.
- Death of a partner.
- Sale of partnership business.
- Amalgamation of partnership.
Methods of Valuation of Goodwill
There are mainly three methods of valuation of Goodwill
You can watch video here: Methods of Valuation of Goodwill
(1) Average profit method:
This method has further two types;
- Simple average profit method
- Weighted average profit method.
(2) Super profit method.
(3) Capitalization method:
This method has further two types;
- Capitalization of average profits method.
- Capitalization of super profits method.
Simple Average Profit Method:
Goodwill is calculated by multiplying the normal average profits with the number of purchase years.
Goodwill = (Total Normal Profits /No. of years) X No. of Purchase Years.
Normal Profits = Actual profits + abnormal losses - abnormal gains.
No. of purchase years is the number of years for which the new owners of business will continue to earn profits because of purchase of an old business.
Weighted Average Profit Method:
In this case weights are assigned to the profits of every year. Then these are to be used to multiply with the annual profits.
Goodwill = (Total of products of Adjusted profits and weight/Total of weights) X No. of Purchase years.
Super Profit Method:
In this case super profit is used to calculate the value of goodwill. Super profit is the actual profit earned over and above the normal profits. Normal profit is the amount of profit expected from the business in the same industry.
Goodwill = Super profit x No. of Purchase years, where
Super Profit = Actual Profit - Normal Profit
Normal Profits = (Normal Rate of Return X Capital Employed)/100.
Capital employed = Capital + Free reserves - Fictitious assets OR
Capital employed = All assets - outside liabilities (goodwill, fictitious assets and non-trading investments are not to be considered for this purpose.)
Capitalization of Average Profits Method:
In this case capitalized value of business is used to calculate goodwill.
Goodwill = Capitalized value of business - Capital employed.
Capitalized value of business = (Average Profits X 100)/Normal rate of return.
Capitalization of Super Method:
Goodwill = (Super profits X 100)/Normal rate of return.
Note: In exam, the method of calculating goodwill to be used is mentioned but if it is not mentioned, information given would determine the choice of method.
Difficulties in Calculating the Value of Goodwill
Difficult points in calculation of Goodwill have been explained in this video.
Check your understanding here: