Contents -
1) Meaning and Definition of Goodwill.
2) Necessity of valuation of Goodwill.
3) Methods of valuation of Goodwill.
WHAT IS THE MEANING OF GOODWILL ?
Meaning of Goodwill -
It is often found that a business firm is in a position to earn more profit as compared to another firm dealing in the same or similar line of goods and services. Such extra earning capacity of a business is because of its 'Goodwill'. Thus Goodwill is the good name, good wishes or reputation of the business in the minds of all related parties like customers, suppliers, bankers, workers etc. The reputation is created, by the business due to many factors like quality of goods, relation with parties, service provided, consistency etc.
As Goodwill contributes extra profit to the business. It is an asset. Goodwill can be realised only a Goodwill cannot be seen, shown or touched, it is term as 'intangible asset'. When Goodwill contributes extra /additional /super profit it is termed as 'Real Asset'.
Goodwill is built up slowly and gradually by a business concern through great efforts over a long period of time. Goodwill is an extra value attached to an established business over and above the value of its other assets. In accounting, Goodwill is value and is shown in books. Thus the reputation of a business valued in terms of money is called Goodwill.
In other words, Goodwill is the value of business beyond its net worth as it is excess of purchase price over the fair market value of the Assets of the business. Goodwill is an intangible asset which has realizable value can and can be converted into cash.
In this way Goodwill is a good name and reputation of the firm which attracts the customers toward the business and thereby helps the firm earn super profit. In short, Goodwill refers to the reputation of a business enterprise which is acquired through successful operation and customer satisfaction. Thus it is the value of the attraction to customers arising from the name and reputation, effective business management and efficient services.
Definition of Goodwill -
According to Institute of Chartered Accountants of India :
"Goodwill is an intangible asset arising from business connection or reputation or trade name of an enterprise".
According to Lord Eldon :
"Goodwill is nothing more than the probability that, the old customers will Resort to old place".
Lord Macnaghten has defined goodwill as:
"The benefit and advantage of the good name, reputation and connections of the business".
Professor Dicksee puts it as :
"When a man pay for Goodwill, he pays for something which places him in the the position of being able to earn more money that he would be able to do by his own unaided efforts".
WHAT IS THE NEED FOR VALUATION OF GOODWILL ?
Necessity of valuation of Goodwill -
The need for valuation of goodwill depends on the circumstances prevailing in the business organisation. In case of sole trader, it is usually valued at the time of selling the business, so as to determine the amount payable by the buyer towards Goodwill. In case of partnership there are several circumstances when Goodwill has to be valued.
Generally the valuation of goodwill is necessary when there is a change in the ownership of the business. A change in the ownership may takes place in any or more of the following ways :
1) Sale of a firm as a Going Concern.2) Admission of a partner in the firm.3) Retirement or death of a partner.4) Change in profit sharing ratio of the partners.
Every business passes through various stages in the development, faces problems and puts in efforts to stabilize the earnings.
In someone buys the business, which has already settled he will not be required to undergo the pains of gestation or settlement period. Naturally seller of the business should get the compensation for his efforts in the past to establish the reputation in the market which is known as goodwill.
In case of partnership firm, when a new partner is admitted into the existing or well established firm, he gets share in the advantages for future profit of the firm without making any extra effort. In fact on account of admission of new partner, the old partners surrender their right to a fraction of all future profits and the new partner become entitled thereto. As a reward for their efforts in the past and their surrender of right by fraction of expected future profits, the new partner has to pay a certain sum of money for goodwill. Such amount of goodwill is shared by old partners.
In this way the valuation of goodwill is needed while buying the business of a sole trader or partnership firm as the buyer has to pay for firms assets plus for owners or partner efforts in building reputation of the firm.
Similarly, when a new partner is admitted in the existing partnership firm, he has to pay for existing partners efforts in building reputation for Goodwill in the past.
The valuation of goodwill is also needed at the time of retirement or death of a partner as retiring or deceased partners executor must get the reward for the efforts in building the firm's reputation in the past.
In brief, when there is a change in the profit sharing ratio among the partner, the valuation of goodwill is must as the partners who sacrifice their share in future on account of admission of new partner. Thus the existing partner must be awarded for sacrificing a part of the asset that is built up by them in the past.
In case of a limited company also, Goodwill is valued in few circumstances like amalgamation of companies, acquisition of a company etc. Necessity of valuation of goodwill can be made short.
BEST METHODS OF VALUATION OF GOODWILL ?
Methods of valuation of Goodwill -
Goodwill is the reputation created and enjoyed by a firm. It reflects superior management, superior products, superior location, superior workforce etc. But these are abstract things for which no money value can be given. The results of the above superior factors can be measured in terms of profit. Therefor, profit is taken as the basis for the valuation of goodwill. Goodwill generates a profit, therefore the value of goodwill is calculated on the basis of profit of the concern. Generally the future profit is taken into account while ascertaining the value of goodwill as the buyer will pay a little more than the fair value of other assets only when he expects that he will enjoy some extra benefits from such Goodwill in the near future. Thus the payment for Goodwill is made for future profit.
Future profit can only be an estimate. The future profits of concern are estimated on the basis of past profit. So the value of goodwill is based on future profits estimated with the help of past profits, The valuation of goodwill of the firm is made based on certain methods.
There are various methods of valuation of goodwill of which the following two main method :
1) Average Profit Method -
As the value of goodwill depends on Profit earning capacity under this method, Goodwill is calculated /valued at certain number of years purchase of the average profit of the firm.
Why average profit?
A single year's profit may be abnormally low or abnormally high. So it can not be a representative figure. Average profit smoothes out the abnormal variations and produces a representative figure. Thus the average profit is to be considered as a base because a single year performance is not sufficient basis for judgement.
Why this multiplication by numbers of years ?
If it is expected that the firm will earn average profit for the next two years, then the average will be multiplied by 2, And if it is expected that the firm will earn average profit for the next three years then the average will be multiplied by 3.
Thus, while ascertaining the value of goodwill as per this method, the following three steps are to be taken :
- Step No. 1 : Calculation of Total Profit -
In this step the total profit is to be calculated on the basis of past few years profit and losses. While calculating the total profit the amount of loss of a particular year is to be deducted e.g. trading result of the last five years are as follows :
Years | Amount |
1 | 30,000 (Profit) |
2 | 45,000 (Profit) |
3 | 15,000 (Loss) |
4 | 40,000 (Profit) |
5 | 50,000 (Profit) |
Total profit = (30,000+45,000+40,000+50,000) Profits - (15,000) Loss
= 1,65,000 - 15,000
Rs. = 1,50,000 /-
- Step No. 2 : Calculation of Average Profit -
Average profit refers to the profit earned by the firm for one year. It can be calculated by using the following formula :
Total Profit
Average Profit = -------------------
No. of Years
In the above example the average profit will be calculated as follows :
1,50,000
Average Profit = --------------- = Rs. 30,000/-
5
Adjustments while calculating Actual Average Profit -
Actual average profit refers to the actual amount of profit, which is arrived after adjusting non recurring income and expenses. Such as lottery winning, manager salary, partners remuneration not provided etc. All such items may not be recurring but they might have affected the profit of a particular year. Since they are non recurring the profit of coming years may not be affected by them.
Hence, while ascertaining actual average profit such item should be considered.
For example : Average profit before deducting the partners remuneration is rupees 35,500/- and partners remuneration is Rupees 1,500/- p.a. The actual average profit will be calculated as under :
Actual average profit = Average profit - Partners Remuneration
Actual average profit = 35,500 - 1,500
Rs. = 34,000/-
- Step No. 3 : Calculation of Goodwill -
Under average profit method, Goodwill is valued at certain number of years purchases of average profit. Thus Goodwill can be calculated by using the following formula :
Goodwill = Average Profit ✕ Number of years Purchases
Average profit is calculated in step no. 2 is rupees 30,000/- and if Goodwill is agreed to be valued at three years purchase of average profit. The Goodwill will be ascertained as under :
Goodwill = Average profit ✕ Number of years Purchases
Goodwill = 30,000 ✕ 3
Goodwill = Rs. 90,000/-
Advantages of Average Profit Method -
Average profit method is easy to understand and simple to calculate goodwill. Because in this method Goodwill is based on simple average of the profit of the previous years.
Limitations of Average Profit Method -
Every business firm has to earn profit, So earning profit only can not be the test of having Goodwill. A firm can claim Goodwill only when, it is able to earn extra profit as compared to profit earned by similar firms. This ability to earn extra profit is not considered in average profit method. Hence, all the firms may claim to have goodwill under this method.
Profit should be compared with the capital employed to earn profit. A firm earning more profit with similar capital employed can claim to have goodwill. This comparison of profit with capital employed is not done in average profit method.
2) Super Profit Method -
The earlier method which was based on average profit has few limitations as it takes into account the absolute, profit of the firm. Such profit figure may not give a true picture regarding the firm's business ability.
For example : The firm A and company has earned profit rupees 20,000/- in a particular year and the Firm B and company as earned a profit of rupees 15,000/- in the same year. Hence, the firm A and company appears to be a better firm.
But this may not be true as A and company has earned a profit of rupees 20,000/- on a capital of rupees 2,00,000/- giving a return of 10%. On the other hand B and company has earned a profit of rupees 15,000/- on a capital of rupees 1,00,000/- giving a return of 15%. In reality B and company is better in performance as compared to A and company because rate of return on capital employed of B and company is more.
Therefore by considering rate of return on capital employed and excess earning capacity of the business, another method is used to find out the value of goodwill, which is called as 'Super Profit method'.
Under super profit method Goodwill is to be valued at certain number of years purchase of super profit of the firm. To value the Goodwill under this method the following four steps are taken.
- Step No. 1 : Calculation of Average / Actual Average Profit -
The procedure for the calculation of average or actual average profit is already explain with example in point 1, step no. 2.
- Step No. 2 : Calculation of Normal Profit -
Normal profit refers to a reasonable expected profit to be earned by a business concern after meeting all its business expenses. It is ascertained by using the following formula :
NRR
Normal Profit : Capital Employed ✕ ---------
100
NRR : Normal Rate of Return
Capital Employed : Amount of capital used by the firm to run and manage its business activities is called capital employed.
The term capital employed is made up of fixed assets + current assets - current liabilities.
Surplus funds the investment of the firm should be ignored because it refers to the invested in some other organisation. It has nothing to do with profit earning capacity of the firm. They are called as non trade investment. However if investment are trade investment, they become a part of capital employed and hence not deducted.
Normal Rate of Return -
Normal rate of return is the return or profit - Normal expected by the investors on the capital employed by considering the returns or profit actually earned by other firm in the same industry. Normal rate of return depends on the nature of business and element of risks involved therein. This rate of return being percentage investment of Rs. 100.
- Step No. 3 : Calculation of Super Profit -
Super profit is the profit earned by the business concern over and above the normal profit of capital employed. It denotes extra earning of the firm. In other words, it is nothing but the excess of average profit over the normal profit.
For example : The normal earning rate of X and company is 15% on capital employed of Rs. 2,00,000/- therefore the normal profit of such company is rupees 30,000/- if its actual profit or earning is rupees 50,000/-. X and company has earned super profit of rupees 20,000/- ( 50,000 - 30,000 )
Thus, super profit is calculated as per the following formula :
Super profit = Average actual profit - Normal expected profit.
- Step No. 4 : Calculation of Goodwill -
Under super profit method, Goodwill is valued at certain number of years purchase of super profit. It is calculated as per the following formula :
Goodwill = Super profit ✕ Number of years purchase
Obviously if there is no super profit the firm will have no goodwill.