Goodwill: What It Is and How to Value It

Meaning and nature of goodwill

Goodwill is the value of the reputation of a firm that helps it earn profit above the normal profit of similar firms. It is:

• an intangible asset (cannot be seen or touched), but not a fictitious asset;
• not separable from the business (it cannot be sold alone);
• its value can go up or down quickly;
• valued only when the business, or a share in it, changes hands.

Under AS 26, only purchased goodwill is recorded in the books; self-generated goodwill is not.

Factors affecting goodwill

• Nature of business: a stable product with steady demand earns more goodwill.
• Location: a busy, easy-to-reach place.
• Efficient management: good planning cuts costs.
• Market situation: monopoly or little competition.
• Special advantages: licences, patents, cheap power, import quotas.
• Quality of goods and service and a long, good history.

Valuation by the average profit method

Goodwill = Average profit × Number of years' purchase.

First normalise past profits: remove abnormal gains or losses (for example, a fire loss or a profit on sale of land) and adjust for items like a missing partner's salary.

Weighted average profit

If profits show a rising or falling trend, give more weight to recent years: Weighted average = Σ(profit × weight) ÷ Σ weights.

Valuation by the super profit method

1. Capital employed = total assets (excluding goodwill and fictitious assets) − outside liabilities.
2. Normal profit = capital employed × normal rate of return ÷ 100.
3. Super profit = average profit − normal profit.
4. Goodwill = super profit × number of years' purchase.

Valuation by the capitalisation method

(a) Capitalising average profit: capitalised value = average profit × 100 ÷ normal rate. Goodwill = capitalised value − actual capital employed (net assets).

(b) Capitalising super profit: Goodwill = super profit × 100 ÷ normal rate.

Both methods give the same answer for the same data.

Adjusting goodwill through capital or current accounts

When the profit-sharing ratio changes, a partner is admitted, or a partner retires or dies, the gaining partner pays the sacrificing partner for goodwill.

Entry (AS 26, no goodwill account opened): Gaining Partner's Capital/Current A/c Dr, To Sacrificing Partner's Capital/Current A/c — in the ratio of sacrifice/gain.

If old goodwill already stands in the books, write it off first among old partners in the old ratio: Old Partners' Capital A/cs Dr, To Goodwill A/c.

Key formulas and definitions

• Average profit = Total of normalised profits ÷ Number of years
• Goodwill (average profit) = Average profit × Years' purchase
• Weighted average profit = Σ(Profit × Weight) ÷ Σ Weight
• Capital employed = Assets (excl. goodwill, fictitious) − Outside liabilities
• Normal profit = Capital employed × Normal rate ÷ 100
• Super profit = Average profit − Normal profit; Goodwill = Super profit × Years' purchase
• Capitalised value = Average profit × 100 ÷ Normal rate; Goodwill = Capitalised value − Capital employed
• Goodwill = Super profit × 100 ÷ Normal rate

Worked examples

Common mistakes

• Using profits with an abnormal loss or gain in them. Normalise first.
• Counting existing goodwill as an asset when finding capital employed.
• Mixing up years' purchase with the normal rate. Years' purchase multiplies; the rate divides into 100.
• Crediting goodwill to all partners. Only the sacrificing partners get credit, in the sacrifice ratio.