Methods for Evaluating Goodwill

Presented by: Rajkaran Chhina

Goodwill
ƒ An intangible asset which provides a competitive advantage, such as a strong brand, reputation, or high employee morale. In a acquisition, goodwill appears on the balance sheet of the acquirer in the amount by which the purchase price exceeds the net tangible assets of the acquired company.

Goodwill
ƒ Accounting for goodwill does spark some controversy in the accounting field. Because it is an intangible asset, goodwill is very hard to value, identify, and measure.

Methods of Valuation of Goodwill
1. Average Profit Method 2. Weighted Average Profit Method 3. Super Profit Method 4. Capitalization of Average Profit Method 5. Capitalization of Super Profit Method

Average Profit Method
ƒ Under this method goodwill is calculated on the basis of the average profit of previous years. The average profit is multiplied by the number of year's purchase. ƒ Formula Goodwill = Average Profit x Number of Years Purchase

Example
ƒ Calculate goodwill at twice the average profits of last four years' profits. The profits of the last four years were: 1. Rs. 27,000 2. Rs. 39,000 3. Rs. 16,000 (Loss) 4. Rs. 40,000 ƒ Solution: Total Profit for last four years = Rs. 27,000+ Rs. 39,000-Rs. 16,000+Rs. 40,000 = Rs. 80,000 ƒ Average Profit = Rs. 80,000/4 = Rs. 20,000. ƒ Goodwill = Rs. 20,000 x 2 = Rs. 40,000.

Weighted Average Profit Method 
This method is a modified version of the average profit method. Under this method the respective number of weights i.e. 1,2,3,4 multiplies profit of every year, in order to find out value product and the total of products is then divided by the total of weights in order to ascertain the weighted average profits. Formula Goodwill = Weighted Average Profits x No. of years Purchase Weighted Average Profit = Total of Products of Profits/ Total of Weights

Example
ƒ Calculate goodwill at twicethe weighted average profits of last four years' profits. The profits of the last four years were:

ƒ 2001. Rs. 37,000 ƒ 2002. Rs. 29,000 ƒ 2003. Rs. 26,000 ƒ 2004. Rs. 40,000

Solution
year 2001 2002 2003 2004 total Profit Rs. 37,000 29,000 26,000 40,000 weight 1 2 3 4 10 ProductRs. 37,000 58,000 78,000 1,60,000 3,33,000

ƒ Weighted Average Profit =Rs. 3,33,000/10 = Rs. 33,300 ƒ Goodwill =Rs. 33,300 x 2 = Rs. 66,600

Super Profit Method
ƒ When the actual profit is more than the expected profit or normal profit of a firm, it is called 'Super Profit.' Under this method goodwill is to be calculate of on the following manner:

ƒ Formula Goodwill = Super Profit x Number of Years Purchase

Example
ƒ The books of a business showed that the capital employed on January 1, 2001 was Rs. 4,50,000 and the profits for the last five years were as follows: ƒ 2001-Rs. 40,000 ƒ 2002 -Rs. 50,000 ƒ 2003 - Rs. 60,000 ƒ 2004 -Rs. 70,000 ƒ 2005 -Rs. 80,000 ƒ You are required to find out the value of goodwill, based on three years' purchase of the super profit of the business given that the normal rate of return is 10%.

Solution
ƒ Total Profit of last five years = Rs. 40,000 + Rs. 50,000 + Rs. 60,000 + Rs. 70,000 + Rs. 80,000 = Rs. 3,00,000 ƒ Average Profit = Rs. 3,00,000/5 =Rs. 60,000 ƒ Normal Profit = Rs. 4,50,000 x 10/100 = Rs. 45,000 ƒ Super Profit = Actual/Average Profit - Normal Profit ƒ Super Profit = Rs. 60,000 - Rs. 45,000 = Rs. 15,000 ƒ Goodwill = Rs. 15,000 x 3 = Rs. 45,000.

Capitalization of Average Profit Method
ƒ Under this method goodwill is difference between the total Capitalized value of the firm and the net assets of the firm.
ƒ Formula Goodwill = Capitalized Value the firm - Net Assets ƒ Capitalized Value of the firm = Average Profit x 100/ Normal Rate of Return ƒ Net Assets = Total Assets - External Liabilities

Example
ƒ A firm earns Rs. 65,000 as its average profits. The usual rate of earning is 10%. The total assets of the firm amounted to Rs. 6,80,000 and liabilities are Rs. 1,80,000. Calculate the value of goodwill.
ƒ Solution : Total Capitalized value of the firm = Rs. 65,000 x 100/10 = Rs. 6,50,000 ƒ Net Assets = Rs. 6,80,000 - Rs. 1,80,000 = Rs. 5,00,000 ƒ Goodwill = Total Capitalized value of the firm - Net Assets ƒ Goodwill = Rs. 6,50,000 - Rs. 5,00,000 = Rs. 1,50,000.

Capitalization of Super Profit Method
ƒ Calculate Capitalized value of the firm ƒ Calculate required profit on capital employed by using the following formula: ƒ Normal Profit = Capital Employed x Required Rate of Return/100 ƒ Calculate normal profit ƒ Calculate super profit ƒ Goodwill = Super Profit x 100/Normal Rate of Return

Example
ƒ Verma Brothers earn a profit of Rs. 90,000 with a capital of Rs. 4,00,000. The normal rate of return in the business is 15%. Use Capitalization of super profit method to value the goodwill.
ƒ Solution ƒ Normal Profit = Rs. 4,00,000 x 15/100 = Rs. 60,000 ƒ Super Profit = Rs. 90,000 - Rs. 60,000 = Rs. 30,000 ƒ Goodwill = Super Profit x 100/Normal Rate of Return ƒ = Rs. 30,000 x 100/15 = Rs. 2,00,000

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