Name: Sanket J Gaude
Roll No: 2024/08/182
Course: Bcom(p)
Sec: A
Goodwill and its
Valuation
Introduction to Goodwill
Goodwill refers to an intangible asset which captures a company's reputation, customer base,
brand name, and other intangible assets that give the company a competitive edge. It happens
when a company is acquired at a price greater than the fair value of its identifiable assets.
Goodwill does capture the future economic advantages arising from the assets that are not
individually identified and separately valued.
In short, goodwill is the premium paid above the book value of a business due to its good name,
effective management, faithful customers, convenient location, talented workers, or other
intangible items not measured by account numbers.
Features of Goodwill
1. Intangible Nature: Goodwill cannot be seen or touched. It is not a physical asset.
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3. Valuable Asset: Despite being intangible, goodwill has a definite value and is considered
an asset in accounting.
4. Subjective Valuation: The valuation of goodwill is not straightforward. It depends on
many subjective factors like reputation, location, and efficiency.
5. Inseparability: Goodwill cannot be separated from the business. It exists only as long as
the business continues.
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6. Fluctuates with Business Performance: The value of goodwill may increase or
decrease based on the performance of the business.
7. Arises from Acquisition or Partnership Changes: Goodwill is typically recognized during
the purchase of a business or when a new partner is admitted.
Types of Goodwill
Purchased Goodwill: It arises when a business is acquired for a consideration more than the net
assets. It is recorded in the books of accounts.
● Example: If Company A buys Company B for ₹10 lakh and the net assets of Company B
are ₹8 lakh, the purchased goodwill is ₹2 lakh.
Self-Generated Goodwill: It arises over time due to the company’s reputation, loyal customers,
and efficient management. It is not recorded in the books as there is no transaction to verify its
cost.
Need for Valuation of Goodwill
● During Sale or Purchase of a Business: To determine the extra price to be paid for the
reputation and other intangible factors.
● Admission or Retirement of a Partner: To fairly compensate for the goodwill contributed
or lost.
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● Amalgamation or Merger of Companies: To determine the exchange ratio of shares.
● Conversion of Partnership into Company: For accurate valuation of the firm’s total
worth.
● Taxation and Legal Cases: For estate duties, capital gains tax, and in cases of legal
disputes.
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Methods of Valuation of Goodwill
There are several methods used to value goodwill. The choice of method depends on the
nature of the business and the purpose of valuation.
A. Average Profit Method
This method involves calculating the average profit of the business over the past few years and
multiplying it by a certain number of years (called Years' Purchase).
Formula:
Goodwill = Average Profit × Number of Years’ Purchase
Example:
Average profit of past 4 years = ₹2,00,000
Years’ Purchase = 3
Goodwill = ₹2,00,000 × 3 = ₹6,00,000
B. Super Profit Method
Super profit is the profit earned above the normal expected return. It shows how much more
profit a business earns compared to similar businesses.
Formula:
Super Profit = Actual Average Profit − Normal Profit
Goodwill = Super Profit × Number of Years’ Purchase
Example:
Actual Average Profit = ₹3,00,000
Capital Employed = ₹20,00,000
Normal Rate of Return = 10%
Normal Profit = ₹20,00,000 × 10% = ₹2,00,000
Super Profit = ₹3,00,000 − ₹2,00,000 = ₹1,00,000
Goodwill = ₹1,00,000 × 4 = ₹4,00,000
C. Capitalization Method
There are two approaches under this method:
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i. Capitalization of Average Profit
Goodwill = (Average Profit × 100 / Normal Rate of Return) − Capital
Employed
ii. Capitalization of Super Profit
Goodwill = Super Profit × (100 / Normal Rate of Return)
This method focuses on converting profits into capital value to estimate goodwill.
Factors Affecting the Value of Goodwill
1. Nature of Business: Businesses with stable and consistent demand for their
products/services tend to have higher goodwill.
2. Location: A business located in a prime area attracts more customers.
3. Efficiency of Management: Skilled and experienced management increases profitability
and goodwill.
4. Market Reputation: A strong brand and customer loyalty enhance goodwill.
5. Competition: Less competition in the market usually increases goodwill.
6. Government Policies: Policies affecting business operations may impact goodwill.
Accounting Treatment of Goodwill
● Purchased Goodwill is recorded as an intangible asset in the balance sheet.
● Internally Generated Goodwill is not recorded due to uncertainty in valuation and lack of
transaction.
As per Accounting Standards (AS 26 in India), goodwill is recognized only when it is purchased.
It should be amortized over its useful life, not exceeding 10 years unless a longer life can be
justified.
Conclusion
Goodwill plays a vital role in evaluating the true worth of a business. It reflects the non-physical
strengths of a company that contribute to its continued success and customer loyalty. The
valuation of goodwill becomes crucial during mergers, acquisitions, partnership changes, or
business restructuring. Although its valuation can be subjective, proper methods and judgment
ensure a fair and reasonable value.
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Understanding goodwill helps businesses make informed financial decisions and ensures
transparency and fairness in transactions involving ownership or partnership changes.
