UNIT 11 VALUATION OF GOODWILL

Structure

11.0 Objectives
11.1 Introduction
11.2 Meaning of Goodwill
11.3 Characteristics of Goodwill
11.4 Nature of Goodwill
11.5 Factors affecting value of Goodwill
11.6 Need for the Valuation of Goodwill
11.7 Methods of Valuation of Goodwill
11.7.1 Average Profit Method
11.7.2 Weighted Average Profit Method
11.7.3 Super Profit Method
11.7.4 Capitalization Method
11.7.5 Annuity Method
11.7.6 Purchase Method
11.8 Let Us Sum Up
11.9 Key Words
11.10 Answers to Check Your Progress
11.11 Terminal Questions/Exercises

11.0 OBJECTIVES

After studying this unit, you should be able to:

 Understand the meaning of Goodwill;
 State the characteristics of Goodwill;
 Discuss the nature of Goodwill;
 Identify the factors affecting the value of Goodwill;
 Discuss the need for the valuation of Goodwill; and
 Explain the methods of valuation of Goodwill.

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11.1 INTRODUCTION
In unit 10, we have learnt about the various Holding company, subsidiary companies, wholly
owned subsidiary and partly owned subsidiary company and the regulations applicable in
case of preparation of consolidated financial statements. We have also learnt the procedure of
preparing consolidated financial statements without adjustments and with adjustments. In this
unit, we shall learn about the concept of Goodwill, its definition, characteristics, nature,
factors affecting the value of goodwill, need for the valuation of goodwill and finally various
methods of valuation of goodwill.

11.2 MEANING OF GOODWILL

Goodwill is the value of reputation of a firm in respect of the profits expected in the future
over and above the normal profits earned by the similar firms in the industry. Goodwill
represents the firm’s brand name, loyal customer base, reputation for high quality of products
due to which firm earns more profits above the normal profits. This excess of profits over the
normal profits is known as super profits. So, the goodwill exists when the firm earns super
profits and any firm which is earning only normal profits or incurring losses has no goodwill.
Goodwill consists of the advantages a business has in connection with its customers,
employees and outside parties with whom it has to contact. Goodwill has been defined by
various prominent authors and some of the definitions are:
Acceding to Lord Lindley, “The term goodwill is generally used to denote benefit arising
from the connections and the reputation.”
According to Kohler, “Goodwill is the current value of expected future income in excess of
the normal return on investment in net tangible assets.”

11.3 CHARACTERISTICS OF GOODWILL

Goodwill is an intangible asset. It is associated with the purchase of one company by another.
Specifically, goodwill is the portion of the purchase price that is higher than the sum of the
net fair value of all of the assets purchased in the acquisition and the liabilities assumed in the
process. Goodwill has many characteristics. Let us discuss some of the characteristics which
are as follow:

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 (1) It is an intangible asset: Goodwill basically is a type of intangible asset like patents
trademarks, etc. The question of depreciation does not arise on it as it does not duffer
wear and tear like the other assets.
(2) Its value tends to fluctuate: Goodwill cannot have an exact cost. Its value tends to
fluctuate from time to time. This is due to the internal and the external factors which
ultimately affect the fortune of the company.
(3) Valuable at the time of sale of business: Goodwill is valued and sold with the sale
of entire business and it cannot be sold in part. The exception to this feature is the
admission and retirement of the partner. At the time of retirement the retiring partner
gives up his shares to the remaining partners so, the remaining partners contribute the
retiring partner in the gaining ratio and on the other hand at the time of admission, the
new partners acquire the right of profits from the existing partners so, the new partner
contributes them in their sacrificing ratio.
(4) Difficulty in placing value of goodwill: It is difficult to place the value of goodwill
because its value fluctuates from time-to-time due to the changing circumstances.
(5) No objective valuation: There is no objective valuation of goodwill as the valuation
of goodwill is done in the subjective manner and differs from estimator to estimator.
Therefore, the value of goodwill is based on the subjective judgment of the valuer.
(6) Arising of goodwill: Goodwill either arises when on business is purchased by the
other business where purchase consideration is higher the actual value of net assets
acquired or the goodwill is generated by the business over a period of time due to
some favorable factors like efficient management, favorable location, etc.

11.4 NATURE OF GOODWILL

Goodwill is nothing but the reputation of a partnership firm. It is computed on the basis of
expected profits in excess of normal profits. It denotes the firm’s capacity to earn a greater profit in
the future based on its track record.
1. Goodwill is an intangible fixed asset. It is intangible because it has no physical
existence. It cannot be seen or touched.
2. It has a definite value depending on the profitability of the business enterprise.
3. It cannot be separated from the business.
4. It helps in earning more profit and attracts more customers.

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 5. It can be purchased or sold only when the business is purchased or sold in full or in
part.

Check Your Progress A

Fill in The Blanks:

a. Excess of Profits over the normal profits is known as …………

b. Firm earning only normal profits or incurring losses has no ……….
c. Goodwill is an ……….. Asset.
d. Value of the ………….tends to fluctuate from time to time.

11.5 FACTORS AFFECTING THE VALUE OF GOODWILL

The value of goodwill depends upon various factors. Let us identify those factors that
influence the value of goodwill.

(1) Location of Business: If the firm is located in the centralized place where there is
more traffic, has high sales, so earns more goodwill. Therefore, if the business is
located at the prominent place, it will attract more customers and will generate more
goodwill.

(2) Management: If the business has good and efficient management, it helps the
business to earn more profit and goodwill. So, the business with efficient and
experienced management will generate more goodwill.

(3) Business longevity: The business with higher longevity or the older business is
known by more customers and therefore will have more goodwill as with time
business can earn more reputation and with the number of customers also goes on
increasing.

(4) Nature of Product: The business which deals in the daily use products will have
stable profits and demand so will have more goodwill in comparison to those business
which deals in the fancy products.

(5) Risk: if the risk involved in the business is more than it will have less goodwill and
on the other hand if the risk involved is less, firm will have more goodwill.

36
 (6) Competition: If in the near future there are chances of increase in the competition of
the firm, it will reduce the goodwill of the business.

(7) Profit trend: If the profits of the firms are reducing from the past years, i.e. the
profits are showing the declining trend then, the goodwill of the firm will also reduce
and vice versa.

(8) License: If the firm has the import license, definitely its goodwill will increase
because it can take the advantage of their license which the other firms without
license cannot avail.

(9) Requirement of Capital: The capital requirement of the business also affects its
goodwill. If the two firms earn same rate of return then, the business with lesser
capital will enjoy more goodwill.

11.6 NEED FOR THE VALUATION OF GOODWILL

Goodwill arises when a company acquires another business. The amount of goodwill is the
cost to purchase the business minus the fair market value of the tangible assets, the intangible
assets and the liabilities obtained in the purchase. There are various situations in which the
need for the valuation of goodwill arises. Let us enumerate those situations

 The difference in the profit-sharing ratio (PSR) amongst the existing partners

 Admission of a new partner

 Retirement of a partner

 Death of a partner

 Dissolution of an enterprise involving the sale of the business as a trading concern

 Consolidation of partnership firms

11.7 METHODS OF VALUATION OF GOODWILL

It is very difficult to assess the value of goodwill, as it is an intangible asset. In case of sale of
a business, its value depends on the mutual agreement between the seller and the purchaser of
the business. There are many methods of valuing goodwill but some of the important
methods are as follow:
A. Average Profit Method

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 B. Weighted Average Profit Method
C. Super Profit Method
D. Capitalization Method
E. Annuity Method
F. Purchase Method

Check Your Progress B

State whether the following statements are True or False:

i) Business with efficient and experienced management will generate more

goodwill.
ii) The business with higher longevity will have more goodwill.
iii) The business which deals in the daily use products will have less goodwill.
iv) If the risk involved in the business is less than it will have less goodwill.
v) The amount of goodwill is the cost to purchase the business minus the fair
market value of the assets and the liabilities obtained in the purchase.

(A) Average Profit Method

It is the most simple and widely used method for the calculation of goodwill. Under this
method, the past profits of number of years are taken into consideration. The average of
the past profits is multiplied by the number of years of purchase for the purpose of the
valuation of goodwill. Following steps are followed for the valuation of goodwill under
this method:
Goodwill = Average Profits × Number of Years’ of Purchase
Illustration 11.1
Calculate the value of goodwill as on 1.1.2021 on the basis of three years’ purchase of
average profits of last six years. The profits and losses for the years were: 2015 Rs.
30,000, 2016 Rs. 40,000, 2017 Rs. 92,000, 2018 Rs. 55,000, 2019 Rs. 70,000, 2020 Rs.
90,000.
Solution
Total Profits = 30,000 – 40,000 + 92,000 + 55,000 + 70,000 + 90,000
= Rs. 2, 97,000
2,97,000
Average Profits = Total Profits/No. of years = = 𝑅𝑠. 49,500
6
Goodwill = Average Profits × No. of years’ of purchase
Goodwill = 49,500 × 3 = Rs. 1, 48,500

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 (B) Weighted Average Profit Method
This method is the modified version of the simple average profit method. Under this method
each year’s adjusted profits calculated in the step 2 above are multiplied with the respective
number of weights in order to calculate the total product. The total of products is then divided
by the total of weights to calculate the weighted average profits. Thereafter the weighted
average profits are multiplied by the number of years’ of purchase. This method is generally
used when the profits show the continuous increasing trend over the years.
Weighted Average Profits = Total of Products of Profits/Total of weights
Goodwill = Weighted average profits × No of years’ of purchase

Illustration 11.2
The profits of the firm from the last five years were as follows:
Year Profit (Rs.)
2017 30,000
2018 20,000
2019 40,000
2020 50,000
2021 60,000

Calculate the goodwill on the basis of three years’ purchase of weighted average
profits using weights 1,2,3,4 and 5 respectively.
Solution
Year Profits(Rs.) Weights Amount (Rs.)
2017 30,000 1 30,000
2018 20,000 2 40,000
2019 40,000 3 1,20,000
2020 50,000 4 2,00,000
2021 60,000 5 3,00,000
Total 15 6,90,000

Total Pr oduct 6,90,000

Weighted Average Profits =   Rs. 46,000
Total Weights 15
Goodwill = Weighted Average Profits × No. of years’ of purchase
Goodwill = Rs. 46,000 × 3 = Rs. 1, 38,000

Illustration 11.3
(i) Profits earned by X Ltd. for the preceding three years were: 2019: Rs. 1,50,000,
2020: Rs. 1,44,000, 2021: Rs. 1,56,000
(ii) Profits of 2019 have been derived after adjusting Rs. 9,000 being profit on sale of
machinery.

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(iii) Profits of 2020 were reduced by Rs. 15,000 due to an extraordinary loss on
account of theft.
(iv) Profits of 2021 include Rs. 6,000 income on investment.
(v) Salary of proprietor, not yet considered in calculation of profits is to be given Rs.
30,000 p.a.
(vi) The stock of raw material was not insured previously. Now, it is decided to insure
the stock of raw material. The insurance premium is estimated to be paid in future
at Rs. 1,500 p.a.
You are required to calculate goodwill on the basis of three years’ purchase of average of
last three years profits and on the basis of weighted average profit method weights 1, 2, 3
respectively.
Solution
Step 1: Calculation of Total Profit
Particulars 2019 (Rs.) 2020 (Rs.) 2021 (Rs.)
Profits during the year 1,50,000 1,44,000 1,56,000
Less: Profit on sale of machinery (9,000) - -
Add: Extraordinary Loss - 15,000 -
Less: Interest on Investment - - (6,000)
Less: Salary to proprietor (30,000) (30,000) (30,000)
Less: Insurance Premium to be paid (1,500) (1,500) (1,500
Adjusted Profits 1,09,500 1,27,500 1,18,500

Year Profits (Rs.)

2019 1, 09,500
2020 1, 27,500
2021 1, 18,500
Total 3,55,500

Step 2: Calculation of Average Profits

Total Profit 3,55,000
Average Profit =   Rs.1,18,500
No. of Years 3
Step 3: Calculation of Goodwill
Goodwill = Average Profit × No. of Years’ of purchase
Goodwill = 1, 18,500 × 3 = Rs. 3, 55,500

Value of Goodwill on the basis of Weighted Average Profit Method

Year Profits Weights Amount
2019 1, 09,500 1 Rs. 1, 09,500
2020 1, 27,500 2 Rs. 2, 55,000
2021 1, 18,500 3 Rs. 3, 55,500
Total 6 Rs. 7, 20,000

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 Total Profits 7,20,000
Weighted Average Profit Method =   Rs.1,20,000
Total Weights 6
Goodwill = 1, 20,000 × 3 = Rs. 3, 60,000

Illustration 11.4
X Ltd proposed to purchase the business of Y Ltd. Goodwill for this purpose is to be
calculated after taking into consideration the following factors:
(i) Goodwill is to be valued at two and a half years’ purchase of the average profits of
last four years and on the basis of weighted average profit method by using
weights 1,2,3,4 respectively. The profits of last four years were as follows:
2018: Rs. 1,80,000, 2019: Rs. 1,00,000, 2020: Rs. 1,40,000, 2021: Rs. 1,60,000.
(ii) Profits of 2019 include profits for lottery of Rs. 10,000.
(iii) Profits of 2020 include Rs. 16,000 of income from Government Securities.
(iv) The existing tenancy contract has expired and X Ltd. will have to pay Rs. 6,000
per month instead of Rs. 4,000 per month.
Solution
Step 1: Calculation of Total Profit
Particulars 2018 (Rs.) 2019 (Rs.) 2020 (Rs.) 2021 (Rs.)
Profits during the year 1,80,000 1,00,000 1,40,000 1,60,000
Less: Profit on Lottery - (10,000) - -
Less: Income on Govt. Securities - - (16,000) -
Less: Additional Rent (6,000-4,000) × 12 (24,000) (24,000) (24,000) (24,000)
Adjusted Profits 1,56,000 66,000 1,00,000 1,36,000

Year Profits Weights Amount

2018 1, 56,000 1 1, 56,000
2019 66,000 2 1, 32,000
2020 1, 00,000 3 3, 00,000
2021 1, 36,000 4 5, 44,000
Total 4, 58,000 10 11, 32,000

Step 2: Calculation of Average Profit

Total Profit 4,58,000
Average Profit    Rs.1,14,500
No. of Years 4
Step 3: Calculation of Goodwill
Goodwill = Average Profit × No. of Years’ of Purchase
Goodwill = 1, 14,500 × 2.5 = Rs. 2, 86,250
Value of Goodwill = Rs. 2, 86,250

Value of Goodwill on the basis of Weighted Average Profit Method

11,32,000
Weighted Average Profit =  Rs.1,13,200
10
Goodwill = 1, 13,200 × 2.5 = 2, 83,000

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Illustration 11.5
X Ltd. proposed to purchase the business of Y Ltd. Goodwill for this purpose is to be
calculated after taking into consideration the following factors:
(i) Goodwill is to be valued at three years’ purchase of the weighted average profits
of last four years. The profits of last four years were as follows:
2018: Rs. 90,000, 2019: Rs. 1, 08,000, 2020: Rs. 93,200, 2021: Rs. 1, 50,000.
(ii) The closing stock for the year 2019 was overvalued by Rs. 4,000.
(iii) On July 1, 2020, a major repair was made in respect of plant incurring Rs. 40,000
which was charged to revenue. It was to be capitalized for the purpose of valuing
goodwill subject to 10% depreciation on the diminishing balance method.
(iv) Managerial remuneration of Rs. 15,000 should be provided for.
Calculate the value of Goodwill.

Solution
Calculation of Total Profit
Particulars 2018 2019 2020 2021
(Rs.) (Rs.) (Rs.) (Rs.)
Profits during the Year 90,000 1,08,000 93,200 1,50,000
Less: Overvaluation of closing stock - (4,000) - -
Less: Overvaluation of opening Stock - - 4,000 -
Add: Capitalized value of repairs - - 40,000 -
Less: Depreciation @10% - - (2,000) (3,800)
Less: Managerial remuneration (15,000) (15,000) (15,000) (15,000)
Adjusted Profits 75,000 89,000 1,20,200 1,31,200
Weights 1 2 3 4
Products 75,000 1,78,000 3,60,600 5,24,800

Year Products (Rs.)

2018 75,000
2019 1, 78,000
2020 3, 60,600
2021 5, 24,800
Total 11, 38,400

Step 2: Calculation of Weighted Average Profit

Total Profit 11,38,400
Weighted Average Profit =   Rs.1,13,840
Total Weights 10

Step 3: Calculation of Goodwill

Goodwill = Weighted Average Profit × No. of years’ of purchase
Goodwill = 1, 13,840 × 3 = Rs. 3, 41,520
Value of Goodwill = Rs. 3, 41,520

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(C) Super Profit Method

Super profit method: In super profit method, the average/actual profits of the business are
compared with the normal profit which would have earned with the same capital in the same
type of business. If the average profit of the company exceeds the normal profit the difference
is known as super profit. Under this method value of goodwill is calculated on the basis of
super profit and the following steps are followed for this:
Step 1: Calculate Capital Employed by the following Formula
Capital employed = Fixed Assets + Working Capital
Or
Capital Employed = Capital + Reserve/Accumulated Profits – Fictitious Assets

Step 2: Calculation of Current Year profits after tax

Current years’ Profit after Tax = [Current year’s Profits – Abnormal Gain + Abnormal Loss
– Normal Loss + Normal Gain] – Tax

Step 3: Calculation of Average Capital Employed

Average Capital Employed = Capital Employed – ½ of Current Year’s Profit after tax

Step 4: Calculate Normal Profits by the following formula

Normal Rate
Normal Profits  Average Capital Employed 
100

Step 5: Calculate the Average Profit after tax as per the Average Profit Method
Step 6: Super Profit = Average Profit after Tax – Normal Profit
Step 7: Goodwill = Super Profit × Number of years of Purchase
Calculation of Capital Employed
The capital employed helps in calculating the normal profits of the business. The following
points are considered while calculating the capital employed:
(i) Both current and fixed assets should be included in the capital employed. These
assets should be valued at the current market prices. Following assets should not
be included:
Fictitious assets like discount on issue of share/debentures, preliminary expenses,
etc.
Outside investments should not be included in the assets.
Goodwill appearing in the balance sheet should also not be included.
(ii) From the total assets the outside liabilities should be deducted. The outside
liabilities will include: debentures, creditors, provision for tax, outstanding
expenses, bills payable, loans, etc.
So, Net Capital Employed = Fixed Assets + Current Assets – Outside Liabilities

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Illustration 11.6
The Balance Sheet of X Ltd. discloses the following information as on 31 st March, 2021.
Equity and Liabilities (Rs.)
Share Capital
60,000 Equity Shares of Rs. 10 each fully paid up 6,00,000
Capital Reserve 1,20,000
Creditors 1,42,000
Provision for Tax 1,10,000
Profit and Loss A/c 52,000
Total 10,24,000
Assets (Rs.)
Goodwill 60,000
Land and Building 3,50,000
Plant and Machinery 1,80,000
Stock 2,30,000
Debtors 1,96,000
Less: Provision 6,000 1,90,000
Cash 14,000
Total 10,24,000
Calculate the Value of Goodwill on the basis of two years purchase of Average Super Profits
on the basis of the following information:
(i) The reasonable return on average capital employed invested in the class of
business done by the company is 12%.
(ii) The rate of tax is 50%.
(iii) Profits of the company before tax are Rs. 2, 20,000.

Solution
Step 1: Calculation of Capital Employed
Capital Employed = Fixed Assets + Current Assets – Outside Liabilities
Rs.
Land and Building 3, 50,000
Plant and Machinery 1, 80,000
Stock 2, 30,000
Debtors 1, 90,000
Cash 14,000
Less: Creditors (1, 42,000)
Less: Provision for Tax (1, 10,000)
Capital Employed 7, 12,000

Step 2: Calculation of Current year’s Profit after tax

Current Year’s profit 2, 20,000
Less: Tax @50% 1, 10,000

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Current year’s profit after tax 1, 10,000

Step 3: Calculation of Average Capital Employed

Average Capital Employed: Capital Employed – ½ of Current Year’s Profit and Tax
Average Capital Employed: 7, 12,000 – ½ × 1, 10,000 = RS. 6, 57,000

Step 4: Calculation of Normal Profit

Normal Rate
Normal Profit = Average Capital Employed ×
100
12
Normal Profit = Rs. 6, 57,000 × = Rs. 78,840
100

Step 5: Calculation of Average/Actual profit after Tax

Current Year’s profit 2, 20,000
Less: Tax @50% 1, 10,000
Actual Profit after tax 1, 10,000

Step 6: Calculation of Super Profit

Super Profit = Average/Actual Profit after Tax – Normal Profit
Super Profit = Rs. 1, 10,000 – Rs. 78,840 = Rs. 31,160
Step 7: Calculation of Goodwill
Goodwill = Super Profit × Number of Years of Purchase
Goodwill = Rs. 31,160 × 2 = Rs. 62,320
Value of Goodwill = Rs. 62,320

Illustration 11.7
The Balance Sheet of X Ltd. discloses the following information as on 31 st March, 2021
Equity and Liabilities Rs.
10%, 10,000 Preference Shares of Rs. 10 each 1,00,000
20,000 Equity Shares of Rs. 10 each fully paid up 2,00,000
Reserves 1,80,000
8% Debentures 1,00,000
Creditors 50,000
Provision for Tax 20,000
Total 6,50,000
Assets Rs.
Goodwill 20,000
Fixed Assets 3,60,000
Investments (5%) 40,000
Current Assets 2,00,000
Preliminary Expenses 20,000
Discount on Debentures 10,000

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Total 6,50,000
Calculate the value of Goodwill on the basis of five years’ purchase of Average Super Profits
on the basis of the following information:
Current Year’s Profit (after deducting interest on debentures and taxes) is Rs. 62,000. The
market value of the machinery included in Fixed Assets is Rs. 10,000 more. Expected Rate of
Return is 10%. Rate of Tax may be assumed 50%.

Solution
Step 1: Calculation of Capital Employed
Capital Employed = Fixed Assets + Current Assets – Outside Liabilities
Rs.
Fixed Assets (3, 60,000 + 10,000) 3, 70,000
Current Assets 2, 00,000
Less: Creditors (50,000)
Less: 8% Debentures (1, 00,000)
Less: Provision for Tax (20,000)
Capital Employed 4, 00,000

Step 2: Calculation of Current year’s Profit after tax Rs.

Current year’s profit after tax 62,000
Add: tax @50% 62,000
Current year’s profit after tax 1, 24,000
Less: Income from Investments (5%) 2,000
Actual profit after tax 1, 22,000
Less: Tax @50% 61,000
Current year’s profits after tax 61,000
Step 3: Calculation of Average Capital Employed
Average Capital Employed = Capital Employed – ½ of Current year’s Profit after tax
Average Capital Employed = 4, 00,000 × ½ × 61,000 = Rs. 3, 69,500

Step 4: Calculation of Normal Profit

Rate
Normal Profit = Average Capital Employed 
100
10
Normal Profit = Rs. 3,69,500   Rs.36,950
100
Step 5: Calculation of Average/Actual Profit after Tax
Current year’s Profit after Tax 62,000
Add: Tax @50% 62,000
Current year’s Profit before Tax 1, 24,000
Less: Income from Investments (5%) 2,000

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Actual Profits before Tax 1, 22,000
Less: Tax @50% 61,000
Actual Profits after Tax 61,000
Step 6: Calculation of Super Profit
Super Profit = Average/Actual Profit after Tax – Normal Profit
Super Profit = Rs. 61,000 – Rs. 36,950 = Rs. 24,050
Step 7: Calculation of Goodwill
Goodwill = Super Profit × Number of Years’ of Purchase
Goodwill = Rs. 24,050 × 5 = Rs. 1, 20,250
Value of Goodwill = Rs. 1, 20,250

(D) Capitalization Method

Capitalization Method: Under this method, Goodwill is calculated in two ways:

1. Capitalization of Super Profit Method
2. Capitalization of Average Profit Method

Capitalization of Super Profit Method

Step 1: Calculate super profit according to the super profit method
100
Step 2: Goodwill = Super Profit Method ×
Normal Rate of Re turn

Capitalization of Average Profit Method

Step 1: Calculate average profit after tax as per average profit method
Step 2: Calculate capitalized value of average profits as under
100
Capitalized value of average profit = Average Profit after Tax ×
Normal Rate

Step 3: Calculate Average Capital Employed as calculated in Super Profit Method

Step 4: Goodwill = Capitalized Value of Average Profit – Average Capital Employed
Note: The use of average or actual capital employed will deepened on the rate of return
which is mentioned in the question. If rate is on actual capital employed then actual capital
employed will be used for the purpose otherwise average capital employed.

Illustration 11.8
From the following you are required to calculate the value of Goodwill by Capitalization
Method:
(1) Capitalization of Actual Average Profit
(2) Capitalization of Super Profit
a. Actual Average Profit Rs. 60,000

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 b. Normal Rate of Return 10%
c. Actual Capital Employed Rs. 4,50,000

Solution
(1) Calculation of Goodwill by Capitalization of Actual/Average Profit Method
Step 1: Calculation of Capitalized Value of Average Profit
100
Capitalized value of Average Profit = Average Profit 
Normal Rate of Return
100
Capitalized value of Average Profit = 60,000   Rs. 6,00,000
10

Step 2: Calculation of Goodwill

Goodwill: Capitalized Value of Average Profit – Actual Capital Employed
Goodwill = Rs. 6, 00,000 – Rs. 4, 50,000 = Rs. 1, 50,000
(2) Calculation of Goodwill by Capitalization of Super Profit Method
Step 1: Calculation of Normal Profit
Normal Rate of Return
Normal Profits = Actual Capital Employed ×
100
10
Normal Profits = 4,50,000   Rs. 45,000
100
Step 2: Calculation of Super Profit
Super Profits = Actual/Average Profit – Normal Profits
Super Profits = 60,000 – 45,000 = Rs. 15,000

Step 3: Calculation of Goodwill

100
Goodwill = Super Profit ×
Normal Rate
100
Goodwill = Rs. 15,000 ×  Rs . 1,50,000
10
Illustration 11.9
X Ltd. is desirous of selling its business to another company. It has earned in the past an
average profits of Rs. 1, 60,000 per annum. It is considered that such average profit fairly
represents the profit likely to be earned in the future, except that:
(i) Director’s fees Rs. 12,000 p.a. charged against such profits will not be payable by
the purchasing company whose existing board can easily cope with the
administrative work.
(ii) Rent at Rs. 20,000 p.a. which had been paid by the vendor company will not be
charged in the future, since the purchasing company owns its owns premises.

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The value of net tangible assets of the vendor company at the proposed date of sale was Rs.
14, 00,000. It was considered that the reasonable return of capital invested for this type of
company was 12%. Calculate the amount of Goodwill by Capitalization Method.
Solution
Step 1: Calculation of Actual/Average Profit Rs.
Profits for the year 1, 60,000
Add: Director’s Fees 12,000
Add: Rent 20,000
Actual Profit 1, 92,000
Step 2: Calculation of Capitalized Value of Average Profit
100
Capitalized value of Average Profit = Actual/Average profit ×
Normal Rate of Re turn
100
Capitalized value of Average profit = 1, 92,000 ×  Rs.16,00,000
12
Step 3: calculation of Goodwill
Goodwill =Capitalized value of Average Profit – Actual Capital Employed
Goodwill = Rs. 16, 00,000 – Rs. 14, 00,000 = Rs. 2, 00,000

Illustration 11.10
The Balance Sheet of X Ltd. discloses the following information as on 31 st March, 2021
Equity and Liabilities Rs.
Share Capital 5,00,000
50,000 Equity Shares of Rs. 10 each fully paid up
Reserves 2,00,000
Loan 1,00,000
Creditors 80,000
Total 8,80,000
Assets
Plant 4,00,000
Investments 50,000
Stock 2,00,000
Debtors 1,20,000
Prepaid Expenses 5,000
Bank 97,000
Preliminary Expenses 8,000
Total 8,80,000

Telco Ltd. intends to purchase the business and the assets are revalued as follows:

49
Plant Rs. 3, 00,000, Stock Rs. 2, 40,000 and Prepaid Expenses Nil, 5% provision for doubtful
debts is deemed necessary. The profits of the firm for the past four years 2018: Rs. 60,000,
2019: Rs. 80,000, 2020: Rs. 1, 18,000, 2021: Rs. 1, 00,000. These profits include income
from investments of Rs. 4,000 each year.
Calculate the value of Goodwill according to Capitalization Method if the Normal Rate of
Return is 14%.
Solution
Step 1: Calculation of Capital Employed
Capital Employed = Fixed Assets + Current Assets – Outside Liabilities
Rs.
Plant and Machinery 3, 00,000
Stock 2, 40,000
Debtors (1, 20,000 – 6,000) 1, 14,000
Bank 97,000
Less: Creditors (80,000)
Less: Loan (1, 00,000)
Capital Employed 5, 71,000
Step 2: Calculation of Current Year’s Profit and Tax Rs.
Current Year’s Profit before Tax 1, 00,000
Less: income from investments (4,000)
Less: Provision for doubtful debt (6,000)
Actual Profits before Tax 90,000
Less: Tax Nil
Current Year’s Profit after Tax 90,000
Step 3: Calculation of Average Capital Employed
Average Capital Employed = Capital Employed – ½ of Current year’s Profit and Tax
Average Capital Employed = 5, 71,000 – ½ × 90,000 = Rs. 5, 26,000
Step 4: Calculation of Average/Actual Profit
Year Profit (Rs.) Adjusted Profits (Rs.)
2018 60,000-4,000 = 56,000
2019 80,000 – 4,000 = 76,000
2020 1, 18,000 – 4,000 = 1, 14,000
2021 1, 00,000 – 4,000 – 6,000 = 90,000
Total = 3, 36,000

Total Profit 3,36,000

Average Profit    Rs. 84,000
No.of years 4

Step 5: Calculation of Capitalized Value of Average Profit

100
Capitalized value of Average Profit = Average/Actual Profit ×
Normal Rate

50
 100
Capitalized value of Average Profit = 84,000 ×  Rs. 6,00,000
14
Step 6: Calculation of Goodwill
Goodwill = Capitalized value of Average Profit – Average Capital Employed
Goodwill = Rs. 6, 00,000 – Rs. 5, 26,000 = Rs. 74,000

(E) Annuity Method

The reason for using the super profit method is that the amount paid for the goodwill in lump
sum will be recovered in the coming years. For example, Rs. 60,000 goodwill is paid today
but this amount purchaser will get in the shape of super profits as Rs. 20,000 in the first year,
another Rs. 20,000 in the second year, and Rs. 20,000 in the third year. The purchaser will
lose the amount of interest over Rs. 60,000. In the annuity method the loss of interest is
compensated.

(F) Purchase Method

The purchase consideration is the price received for the sale of the assets. Goodwill is the
excess of purchase consideration over the net assets of the business.
Goodwill = Purchase consideration – Net Assets of the firm
Net Assets = Assets – Outside Liabilities

Illustration 11.11
The profits of the company during the last four years were Rs. 32,000, Rs. 56,000, Rs. 40,000
and Rs. 64,000. The capital employed is Rs. 4, 00,000 and return in similar business is 10%
on the capital employed. Calculate goodwill by annuity method based on super profits. The
present value of Rs. 0.282012 annuity for 4 years @5% return is Rs. 1.

Solution
Step 1: Calculation of Normal Profit
Normal Rate
Normal Profit = Actual Capital Employed ×
100
10
Normal Profit = Rs. 4, 00,000 ×  Rs. 40,000
100
Step 2: Calculation of Average/Actual Profit after Tax
Total Profit 1,92,000
Total Profit =   Rs. 48,000
No.of Years 4

Step 3: Calculation of Super Profit

Super Profit = Average/Actual Profit after Tax – Normal Profit
Super Profit = Rs. 48,000 – Rs. 40,000 = Rs. 8,000
Step 4: Calculation of Goodwill

51
When annuity is 0.282012, present value = Rs. 1
1
When annuity is Rs. 1, present value = Rs .
0.28201
1
When annuity is Rs. 8,000, present value = Rs.  8,000  Rs. 28,367.58
0.28201
Goodwill = Rs. 28,367.58

Illustration 11.12
The following information is given:
(i) Capital employed Rs. 3,00,000
(ii) Normal rate of return @10% on capital employed
(iii) Present value of annuity of Rs. 1 for five years at 10% is 3.79
(iv) Net profits for five years: Rs. 30,800, Rs. 28,000, Rs. 33,800, Rs. 34,800, Rs.
35,800.
(v) The profits include the non-recurring profits on an average basis of Rs. 2,000 out
of which it was deemed that even non-recurring profits had a tendency of
appearing at a rate of Rs. 1,200 p.a.
You are required to calculate the value of Goodwill as per Annuity Method.
Solution
Step 1: Calculation of Normal Profit
Rate
Normal Profit = Actual Capital Employed ×
100
10
Normal Profit = Rs. 3, 00,000 ×  Rs.30,000
100
Step 2: Calculation of Average/Actual Profit after Tax
Total Profits: 28,800 + 30,800 + 33,800 + 34,800 + 35,800 = Rs. 1, 64,000
Total Profit 1,64,000
Average Profit =  = 32,800
No.of Years 5
Less: non recurring Income (2,000)
Add: Recurring Profit 1,200
Actual Profits 32,000
Step 3: Calculation of Super Profit
Super Profit = Average/Actual Profit after Tax – Normal Profit
Super Profit= Rs. 32,000 – Rs.30, 000 = Rs. 2,000
Step 4: Calculation of Goodwill
Goodwill = Super Profits × Annuity Rate; Goodwill = Rs. 2,000 × 3.79 = Rs. 7,580

Illustration 11.13
The Balance Sheet of X Ltd. discloses the following information as on 31 st March, 2021

52
Equity and Liabilities Rs.
Share Capital
20,000 Equity Shares of Rs. 10 each fully paid up 2,00,000
General Reserve 20,000
Profit and Loss A/c 22,500
Workmen Compensation Fund 10,000
Creditors 37,500
Total 2,90,000
Assets Rs.
Land and Building 1,00,000
Plant and Machinery 62,500
Trade Marks 5,000
Debtors 90,000
Cash at Bank 30,000
Advertisement Outlay 2,500
Total 2,90,000
The company was purchased by Y Ltd. which pays Rs. 3, 00,000 in all Assuming Plant and
Machinery is valued at Rs. 65,000. Calculate the value of Goodwill as per Purchase
Method.

Solution
Step 1: Calculation of Capital Employed
Capital Employed = Fixed Assets + Current Assets – Outside Liabilities
Rs.
Land and Building 1, 00,000
Plant and Machinery 65,000
Trade Marks 5,000
Debtors 90,000
Cash 30,000
Less: Creditors (37,500)
Capital Employed 2, 52,500

Step 2: Calculation of Value of Goodwill Rs.

Purchase Consideration 3, 00,000
Less: Capital Employed 2, 52,500
Goodwill 47,500

11.8 LET US SUM UP

Goodwill is the value of reputation of a firm in respect of the profits expected in the future
over and above the normal profits earned by the similar firms in the industry. Goodwill has
many characteristics such as: i) It is an intangible asset; ii) Its value tends to fluctuate; iii)

53
No objective valuation; Valuable at the time of sale of business; Difficulty in placing value of
goodwill etc. Goodwill has its own nature like it is intangible fixed asset; It cannot be
separated from the business; it has a definite value; and it helps in earning profit. Goodwill is
influenced by many factors. Some of the factors are: Business longevity; Location of the
business; Management; Nature of the product; Risk, Competition, Profit trend etc. There are
various circumstances where need for the valuation of goodwill arises. Some of the
circumstances are: At the time of admission of a new partner; At the time of retirement of a
partner; At the time of death of a partner; at the time of Dissolution of an enterprise involving
the sale of the business as a trading concern; Consolidation of partnership firms etc. There are
various methods of valuing Goodwill. Some of them are: Average Profit Method; Weighted
Average Profit Method; Super Profit Method; Capitalization Method; Annuity Method; and
Purchase Method etc.

11.9 KEY WORDS

Goodwill: is the value of reputation of a firm in respect of the profits expected in the future
over and above the normal profits earned by the similar firms in the industry.
Intangible Asset: An intangible asset is an asset that lacks physical substance. Examples are
patents, copyright etc
Capital Employed: Capital Employed is the total funds deployed for running the business
with the intent to earn profits and is usually calculated by adding working capital to fixed
assets.
Super Profit: Super profits refer to the profits in excess of normal profits that a business
expects to earn.
Purchase Consideration: It refers to the amount payable by the purchasing company to the
vendor company for taking over the assets and liabilities of Vendor Company.
Current Assets: It refers to the asset of a company which can be converted into cash in any
given fiscal year such as cash, cash equivalents, accounts receivable, stock inventory,
marketable securities, pre-paid liabilities, and other liquid assets.
Current Liabilities: These are company’s debts or obligations that are due within one year
or within a normal operating cycle such as accounts payable, creditors, short terms loan etc.
Fixed Assets: Fixed assets refer to long-term tangible assets that are used in the operations
of a business to generate income such as Building, Plant, Machine, and Furniture etc.

54
11.10 ANSWER TO CHECK YOUR PROGRESS

A a. Super Profit b. Goodwill c. Intangible d. Goodwill

B i) True ii) True iii) False iv) False v) True

11.11 TERMINAL QUESTIONS/EXERCISES

Questions
1. What do you mean by Goodwill? Describe the factors affecting the value of goodwill.
2. Define Goodwill. Discuss the circumstances in which the need of valuation of
goodwill arises.
3. Explain the characteristics of Goodwill in detail.
4. Explain the various methods of valuation of Goodwill with suitable examples.
Exercises
1. The following particulars are available in respect of a business:
(i) Profits 2019: Rs. 1, 00,000, 2020: Rs. 96,000, 2021: Rs. 1, 04,000.
(ii) Profit of 2020 is reduced by Rs. 10,000 due to stock destroyed by fire and profit of
2019 included a non-recurring income of Rs. 6,000.
(iii) Profit of 2021 includes Rs. 4,000 income on investment.
(iv) The stock is not insured and it is thought prudent to insure the stock in future. The
insurance premium is estimated at Rs. 1,000 p.a.
(v) Fair remuneration to the proprietor (not taken in calculation of profits) is Rs.
20,000 p.a.
Calculate the amount of Goodwill on the basis of two years’ purchase of Average
Profits of last three years.
Ans: Goodwill = Rs. 1, 58,000

2. Following information is available from the business of Mr. X

Profits of 2017: Rs. 50,000, 2018: Rs. 60,000, 2019: Rs. 90,000, 2020: Rs. 5,000 (Loss),
2021: Rs. 60,000.
Mr. Y is interested to purchase the business. You are required o calculate the Goodwill
after considering the following points:

55
 (i) Mr. X earned Rs. 30,000 relating to speculative nature in the year of 2018. Out of
this extraordinary gain Rs. 20,000 were credited to profit and loss A/c in the same
year and for the balance no entry has been made.
(ii) In the year 2019, the profit includes non-recurring income of Rs. 15,000.
(iii) In the year 2020, machinery costing Rs. 1, 20,000 destroyed by fire. Loss
amounting to Rs. 76,000 was set off against profit and loss a/c.
(iv) Mr. Y at the time of purchasing the business was the manager in a Trading
company and was drawing the salary of Rs. 3,000 per month Y intends to replace
the manager of the business who at present is getting the salary of Rs. 2,000 p.m.
(v) Goodwill is to be calculated at 3 years’ purchase of the Average Profits of the last
five years.
Ans. Goodwill = Rs. 1, 41,600

3. Following information is available in respect of a business:

(i) Profit in 2019: Rs. 1, 40,000, 2020: Rs. 2, 00,000, 2021: Rs. 2, 50,000
(ii) Non-recurring income of R.s 18,000 is included in the profits of 2021.
(iii) Profits in 2020 have been reduced by Rs. 26,000 on account of goods destroyed by
fire.
(iv) Goods have not been insured but it is decided to insure them in future. The
insurance premium is estimated at Rs. 1,800 p.a.
(v) The proprietor thinks to appoint an accountant in the business to maintain the books
of accounts. Salary will be paid to the accountant @3,000 per month.
(vi) Reasonable remuneration of the proprietor of business is Rs. 24,000 per year but it
has not taken in account for the computation of the above profits.
(vii) Profit of 2019 includes Rs. 22,000 income from investments.
Goodwill is to be valued at 2 years’ purchase of the Weighted Average Profit of the
past three years. The appropriate weights to be used are 2001: 1, 2002: 2, 2003: 3.
Ans: Goodwill Rs. 2, 98,400

Super Profit Method

4. From the following information calculate the value of Goodwill on the basis of three
years’ purchase of Super Profit.
(i) Average Capital employed in the business: Rs. 3, 50,000.
(ii) Net trading profits of the firm for the past three years: Rs. 53,800, Rs. 45,350, and Rs.
56,250.
(iii) Rate of interest expected from the capital having regard to the risk involved 12%.
(iv) Fair remuneration to the partners for their services Rs. 6,000.
Ans. Actual Average Profit: Rs. 45,800, Goodwill: Rs. 11,400.

56
5. From the following particulars relating to the business of X Ltd. computed the value of
Goodwill on the basis of 3 years’ purchase of Super Profit taking Average of Profit of last
four years:
(i) Capital invested Rs. 1, 40,000.
(ii) Market rate of interest on investments @10%.
(iii) Rate of risk on capital employed @2%.
(iv) Management remuneration of proprietor if employed elsewhere Rs. 20,000 p.a.
(v) Trading results: Rs.
2018 Profit 50,000
2019 Profit 60,000
2020 Loss 6,000
2021 Profit 80,000
Ans: Super Profit Rs. 9,200, Goodwill Rs. 27,600

6. The Balance Sheet of X Ltd. discloses the following information as on 31 st March,

2021.
Equity and Liabilities Rs.
10%, 2000 Preference shares of Rs. 10 each 20,000
4,000 Equity Shares of Rs. 10 each fully paid up 40,000
General Reserve 35,000
8% Debentures 20,000
Creditors 10,000
Provision for Taxation 7,500
Total 1,32,500
Assets Rs.
Goodwill 4,000
Fixed Assets 75,000
Investments 5,000
(5% in govt. securities)
Current Assets 41,000
Preliminary Expenses 7,500
Total 1,32,500
Current years’ profit (after deducting interest on debentures and taxes) is Rs. 13,000.
The market value of the Machinery included in the Fixed Assets is Rs. 2,000 more.
Expected Rate of Return is 8%. Rate of Tax may be assumed 50%. Calculate the
value of Goodwill according to Super Profit method assuming 4 years purchase.
Ans. Average Capital Employed Rs. 74,125, Goodwill Rs. 27,280.
7. The Balance Sheet of X Ltd. discloses the following information as on 31 st March,
2021.
Equity and Liabilities Rs.
10%, 10,000 Preference shares of Rs. 10 each 1,00,000

57
 5,000 Equity Shares of Rs. 100 each fully paid up 5,00,000
Reserves 70,000
P&L A/c
Balance on 1st April, 2006 60,000
Profit for 2006-07 (Pre-tax) 2,00,000 2,60,000
Depreciation Fund:
Plant and Machinery 30,000
Buildings 14,000
Investment 16,000
Creditors 40,000
Total 10,30,000
Assets Rs.
Plant and Machinery 1,50,000
Building at Cost 2,10,000
Furniture 10,000
10% Government Bonds 3,00,000
Debtors 1,50,000
Less: Provision 10,000 1,40,000
Cash at Bank 1,20,000
Preliminary Expenses 1,00,000
Total 10,30,000

The following information is supplied to you:

(i) Present value of Plant and Machinery Rs. 2, 50,000
(ii) Normal Rate of Return is 8%.
(iii) Profits for the past three years showed an increase of Rs. 40,000 annually.
(iv) Assume Taxation @50%.
Calculate value of Goodwill according to Super Profit method assuming 3 years’
purchase.
Ans. Average Capital Employed Rs. 6, 33,500, Super Profit Rs. 20,998, Goodwill Rs.
62,964

8. X has invested an average sum of Rs. 5, 00,000 in his own business which is a very
profitable one. The annual profit earned from this business is Rs. 1, 00,000 which
includes a sum of Rs. 16,000 received as compensation for acquisition of a part of his
business premises.
The money could have been invested in deposits for a period of 6 years and over at
8% interest and he himself could earn Rs. 10,000 per annum in alternative
employment.

58
 Considering 2% as fair compensation for the risk involved in the business, calculate
the value of Goodwill on the basis of Capitalization of Super Profit at the Normal
Rate of Return.
Ans: Goodwill Rs. 2, 40,000, Super Profits Rs. 24,000.
9. The Balance Sheet of X Ltd. discloses the following information as on 31 st March,
2021.
Equity and Liabilities Rs.
50,000 shares of Rs. 10 each 5,00,000
Profit and Loss A/c 40,000
Bank Overdraft 3,11,600
Creditors 5,08,400
Provision for Taxation 71,000
Total 14,31,000
Assets Rs.
Goodwill 80,000
Land and Building 4,00,000
Plant 3,00,000
Current Assets 5,75,000
Advertisement Expenses 76,000
Total 14,31,000

Profits earned during the past three years (before providing for the taxation @50%)
have been as follows:
2019: Rs. 1, 20,000, 2020: Rs. 1, 00,000, 2021: Rs. 1, 52,000
It is agreed that the present value of Land and Building is Rs. 5, 00,000. The average
dividend payable by company during the last three years is 10% which is taken as
reasonable return in the capital invested in the business.
Ans: Goodwill Rs. 1, 74,000, Average Capital Employed Rs. 4, 46,000

10. The following information is available:

(i) Average Capital Employed Rs. 1, 00,000
(ii) Present value of annuity Rs. 1 for 5 years at 10% is 3.78.
(iii) Normal Rate of Profit is 10%.
(iv) Net Profits for five years are 1st Year Rs. 16,000, 2nd year Rs. 15,000, 3rd year Rs.
17,000, 4th year Rs. 18,000, 5th year Rs. 20,400.
(v) Profits included non-recurring profit on an average basis of Rs. 1,500 out of which
Rs. 300 had the recurring tendency. Remuneration of the proprietor is Rs. 800 p.a.
which is not charged from Profit and Loss A/c. Find out the value of Goodwill.
Ans: Goodwill Rs. 19,958, Super Profit Rs. 5,280

59
11. From the following method calculate the value of Goodwill as per the Annuity Method:
(i) Net Profits for five years are 1st year Rs. 64,000, 2nd year Rs. 1, 12,000, 3rd year
Rs. 80,000, 4th year Rs. 1, 28,000
(ii) Average Capital Employed Rs. 8, 00,000
(iii) Normal Rate of Return is 10%.
(iv) The Present Value of Rs. 0.282012 annuity for four years @5% return is Rs. 1.
Ans. Goodwill Rs. 56,736, Super Profit Rs. 16,000

60