Goodwill Valuation Methods, Key Formulas & Solved Questions
Goodwill is an important concept in commerce and accounting. It represents the intangible value a business holds, such as its reputation, loyal customer base, efficient management, and other non-physical attributes that allow it to earn higher profits than competitors. Goodwill commonly arises during events like admission or retirement of a partner, merging of firms, or the sale of a business. Understanding how to value goodwill is crucial for making fair and strategic business decisions.
Definition and Meaning of Goodwill
In accounting, goodwill refers to the excess value that a business enjoys over and above the value of its net tangible assets. This intangible asset can stem from factors like a strong brand, favorable location, quality service, monopoly position, or efficient management. Goodwill helps a business generate profits exceeding the standard rate of return in its industry.
Why Value Goodwill?
The valuation of goodwill becomes necessary when there are changes in the structure or ownership of a business. It ensures equitable settlements among partners or helps determine the right price during acquisitions, mergers, or reconstitution of a firm. When a business is sold or a new partner is admitted, the calculation of goodwill protects the interest of existing stakeholders and reflects the true earning potential of the firm.
Methods of Goodwill Valuation
Several methods are used to value goodwill, each suited to specific business circumstances. The main methods include:
- Average Profit Method: Calculating goodwill based on the average profits of previous years, multiplied by the number of years’ purchase.
- Super Profit Method: Goodwill is determined using the profits earned above the normal profits expected, multiplied by the number of years’ purchase.
- Capitalisation Method: This considers the total capital required to earn the average or super profits at the normal rate of return, then subtracts net assets to determine goodwill.
| Method | Key Formula | Best For |
|---|---|---|
| Average Profit Method | Goodwill = Average Profits × Years’ Purchase | Firms with stable profits and steady operations |
| Super Profit Method | Goodwill = (Average Profits – Normal Profits) × Years’ Purchase | Firms earning above-average profits in their field |
| Capitalisation of Average Profits | Goodwill = (Average Profits × 100 / Normal Rate of Return) – Net Assets | Acquisitions, mergers, or changes in capital structure |
| Capitalisation of Super Profits | Goodwill = Super Profits × (100 / Normal Rate of Return) | Firms with significant abnormal profit margins |
Stepwise Approach to Valuing Goodwill
- Calculate average profits (and adjust for irregular items if needed).
- Find normal profits by multiplying capital employed by the normal rate of return.
- Compute super profits: Average Profits – Normal Profits.
- Select the appropriate method and plug values into the formula.
- Review calculation for accuracy in units (₹, %, numbers of years).
Example: Capitalisation of Average Profits
Suppose Ram and Mohan each have ₹1,25,000 in the firm's capital account. Their current accounts hold ₹15,000 and ₹10,000. The average annual profit of the business is ₹50,000, and the normal rate of return is 10%. Use the capitalisation of average profit approach to value goodwill.
Step 1: Calculate capitalised value of average profit:
= Average Profit × 100 / Normal Rate of Return
= ₹50,000 × 100 / 10 = ₹5,00,000
Step 2: Find total capital employed:
= ₹1,25,000 + ₹1,25,000 + ₹15,000 + ₹10,000 = ₹2,75,000
Step 3: Goodwill = Capitalised Value – Capital Employed
= ₹5,00,000 – ₹2,75,000 = ₹2,25,000
Important Aspects Influencing Goodwill Value
- Goodwill may equal one or more years’ profits, especially if a key leader drives the firm's success.
- Higher super profits or strong buyer interest can lead to a higher goodwill valuation.
- A firm with poor current performance but strong future prospects may still command goodwill payments.
- Efficient management, good location, product quality, and a strong market position all increase goodwill value.
Quick Practice Problems
- A firm's profits for three years are ₹80,000, ₹90,000, and ₹1,10,000. Find goodwill using three years’ purchase of average profits.
- If capital employed is ₹6,00,000, average profit ₹80,000, and normal rate is 10%, calculate goodwill using super profits method for two years’ purchase.
- Average profit is ₹2,40,000, normal rate 12%, net assets ₹15,00,000. Compute goodwill by capitalisation of average profits method.
Next Steps for Learning
- Explore detailed examples and further readings on Valuation of Goodwill.
- Download concise notes and resources through Vedantu’s Commerce section to prepare for exams with clarity and confidence.
FAQs on Goodwill Valuation Explained for Commerce Students
1. What is goodwill in the context of accounting?
Goodwill in accounting is an intangible asset that represents the extra value of a business due to its brand reputation, loyal customer base, skilled staff, and other non-physical advantages. It is the premium a buyer pays over the fair value of net assets during acquisition, reflecting the business's earning capacity over and above normal returns.
2. Why is it necessary to calculate the value of a firm's goodwill?
Valuing goodwill is essential for fair financial settlement during major business changes. Main reasons include:
- Change in profit sharing of existing partners
- Admission, retirement, or death of a partner
- Sale or amalgamation of a business
- Mergers or reconstructions
It ensures transparency and fairness in transactions involving business value.
3. What are the three main methods for the valuation of goodwill?
The three main methods for valuing goodwill are:
- Average Profits Method: Based on the average profits of previous years.
- Super Profits Method: Based on profits that are above the industry’s normal profits.
- Capitalisation Method: Calculates value by capitalising average or super profits at the normal rate of return.
4. Can you explain the Average Profit Method with a simple example?
The Average Profit Method values goodwill by multiplying the average profit by the agreed number of years’ purchase.
Example: If a firm’s average profit over 3 years is ₹50,000 and goodwill is valued at 2 years’ purchase, then Goodwill = ₹50,000 × 2 = ₹1,00,000.
5. How does the Super Profit Method work?
The Super Profit Method values goodwill using the following steps:
1. Calculate Average Profit for the period.
2. Compute Normal Profit = Capital Employed × Normal Rate of Return.
3. Find Super Profit = Average Profit – Normal Profit.
4. Value Goodwill = Super Profit × Number of Years’ Purchase.
6. What is the key difference between the Average Profit and Super Profit methods?
The key difference is that the Average Profit Method values the business on its entire average profit, while the Super Profit Method values only the profit made in excess of the normal expected return. The latter isolates the firm's unique earnings advantage.
7. What is meant by capitalisation method in goodwill valuation?
Capitalisation Method determines goodwill by estimating the capital needed to earn either average or super profits at the industry’s normal rate of return. It has two forms:
- Capitalisation of Average Profits: Goodwill = Capitalised Value of Average Profits – Net Assets
- Capitalisation of Super Profits: Goodwill = Super Profits × (100 / Normal Rate of Return)
8. What factors can increase or decrease the value of a company's goodwill?
Goodwill value is influenced by factors such as:
- Increasing factors: Skilled management, strong brand reputation, prime business location, monopolistic market position, loyal customer base.
- Decreasing factors: Poor management, rising competition, weak market position, declining profits.
9. What is 'hidden' or 'inferred' goodwill?
Hidden (or inferred) goodwill arises when no specific value is mentioned in the agreement but can be estimated indirectly. It is often calculated during a partner’s admission by comparing the total implied capital of the firm (based on new partner’s contribution and share) with the actual combined capital.
10. What is the difference between purchased goodwill and self-generated goodwill?
Purchased goodwill results from acquiring another business and is recorded as an asset when price exceeds fair value of net assets. Self-generated goodwill develops internally through strong performance, but is not recorded in the books because it cannot be objectively measured or sold separately.
11. Can a company's goodwill be negative?
In accounting, goodwill recorded in the books is always positive. However, negative goodwill can arise during acquisitions if the purchase consideration is less than the fair value of net assets, usually indicating a bargain purchase or business difficulties.
12. When is the valuation of goodwill required?
Goodwill valuation is required in situations such as:
- Admission, retirement, or death of a partner
- Change in profit sharing ratio
- Sale or merger of a business
- Amalgamation or reconstruction
This ensures a fair division of business value among stakeholders.
