UNIT-I (B).

VALUATION OF GOODWILL
Goodwill?
Goodwill is an intangible asset which is not visible or cannot be touched but can be purchased and
traded and is real. The value of an enterprise’s brand name, solid consumer base, functional consumer
associations, good employee associations and any patents or proprietary technology represent some
instances of goodwill.

In other words, goodwill is a firm worth or reputation established over time. In partnership, the
valuation of goodwill is very significant. In this article, we will discuss the meaning of the valuation
of goodwill and its different methods of assessment .

What is the valuation of Goodwill?

The valuation of goodwill is based on the assumption obtained by the valuer. A successful business
earns a reputation in the industry, develops trust with its clients, and has more extensive business
links, unlike new companies. All these points contribute while evaluating the business, and its
financial worth that a customer is eager to give is known as goodwill.

Customers who buy a company looking at its goodwill hopes to gain super-profits. Hence, goodwill
applies to only firms that make super-profits and not to those who earn regular losses or profits

Nature of Goodwill
We have to treat goodwill in accounting terms as an asset. It is not a physical asset because we
cannot see or touch it. Despite this, we treat it as an intangible asset because we derive some
value from it.

According to Accounting Standards, an intangible asset must contain the following

features. Since goodwill contains all these characteristics, we can conclude that it is an
intangible asset.

a. It must have characteristics of assets. This means that it must have some clearly
identifiable value.

b. The asset must have future economic benefits. The firm must be able to expect
and predict what value they will get from it.
 c. Its value must be measurable. It is not an asset if we cannot measure its value in
monetary terms.

The important features of goodwill:

1. Goodwill has no existence separate from business, i.e. goodwill cannot exist
independently of business. It is attached to the business.

2. Goodwill can be sold or purchased with entire business. It is valuable only when
entire business is sold or purchased.

3. The value of goodwill and the assessment of its existence is based upon
subjective judgement of the valuer, inspite of different methods of its valuation.

4. It is difficult to place an exact value to goodwill since its value fluctuates from
time due to changing circumstances of business.

5. It represents a non-physical value, intangible in nature, goodwill does not

depreciate by wear and tear. However, the goodwill becomes a fictitious asset if it
appears in the books of a losing concern.

Types of Goodwill
There are two distinct types:

 Purchased: Purchased goodwill is the difference between the value paid for an enterprise as a
going concern and the sum of its assets less the sum of its liabilities, each item of which has been
separately identified and valued.
 Inherent: It is the value of the business in excess of the fair value of its separable net assets. It is
referred to as internally generated goodwill, and it arises over a period of time due to the good
reputation of a business. It can also be called as self generated or non-purchased goodwill.

Classes of Goodwill
It is very interesting to study the classification of Goodwill based on consumer
behavior. P.D. Leake first coined this theory in 1921. He also defines goodwill
as “the right which grows out of all kinds of past effort in seeking profit, an
increase of value or other advantages.”

1).Dog Goodwill:-A dog is an animal that develops a fondness for its

owner and not the place where he resides. When the owner moves, the dog
also follows. Similar behaviour is portrayed by consumers of an entity with dog
goodwill.
2).Cat Goodwill
A cat is often pictured as a self-sufficient animal with a “couldn’t-care-less”
personality. It does not care where the fish is coming from as long as it is
coming every day. Think of an alley where you will always notice the same
group of cats.

3).Rat Goodwill
Rat is a scurried animal rushing over to wherever the next piece of cheese is. It
does not care “who” is putting out the cheese or “where” is it coming from.

4).Rabbit Goodwill
Rabbits remain confined to a patch and do not like to venture far away.
Similarly, the rabbit consumers will only pick a product if it is available within
their acceptable radius.

Factors Affecting Goodwill

The following factors have an impact on the goodwill, which are:

1. Location of the business : A business which is located in a suitable location will have a more
favourable chance of higher goodwill than a business located in a remote location.
2. Quality of goods and services: A business which is providing a higher quality of goods and
services stands a great chance of earning more goodwill than competitors who provide inferior
goods and services.
3. Efficiency of management : An efficient management results in increase in profit of the business
which enhances the goodwill of the business.
4. Business Risk : A business having lesser risk has a better chance of creating goodwill than a high
risk business.
5. Nature of business: It means the type of products that business deals with, the level of
competition in the market, demand for the products and the regulations impacting the business. A
business having a favourable outcome in all these areas will have a greater goodwill.
6. Favourable Contracts: A firm will enjoy a higher goodwill if it has access to favourable
contracts for sale of products.
7. Possession of trade mark and patents : Firms that have patents and trademarks will enjoy
monopoly in the market, which will contribute to the increase in the goodwill of the firm.
8. Capital : A firm with a higher return on investment along with lesser capital investment will be
considered by buyers as more profitable and having more goodwill.

Methods for Valuation of Goodwill

A company adopts the valuation method consistent with the market practices of the trade
and the position maintained by it. The different methods of valuation of goodwill are
mentioned below.
1.Average Profits Method -The average profits method primarily takes the
following two forms
a).Simple Average Here, the goodwill is evaluated by the calculation of average profit
against the number of years purchased.
Goodwill = Average profit X Number of years of purchase
b).Weighted Average
This method is usually used in the instances of alterations of profit while also focusing on
the current year’s profit. It calculates the previous year’s profit for obtaining the
valuation.
Goodwill = Weighted Average Profit X Number of years of purchase

2.Super Profits Method

The super profit method of valuation of goodwill covers the excess of the
maintainable profits in the future as opposed to the normal profits.

The formula is indicated below.

Goodwill = Super profit X Number of years of purchase

(Super profit = Average / Actual profit – Normal profit

Normal profit = (Capital employed X Normal ratsssse of return) / 100)

The super-profits method can be undertaken by either of the two following methods.

Annuity Method of Goodwill

The annuity method in the valuation of goodwill uses the average super profit over a
specific number of years. The current value of an annuity is found on the basis of a
discounted amount of super profit at the established rate of interest.

Purchase Method by Number-of-Years Super profits in a definite number of

purchase years are evaluated for establishing goodwill.

3.Capitalisation Method
In the goodwill capitalization method, there are two ways in which the
calculation can be done.
a).Average Profits Method

The calculation covers the deduction of its actual capital that has been
employed from the average profits of the capitalized value.
It is undertaken based on the normal rate of return.
Goodwill = Capitalised Average profits – Actual capital employed

(Capitalised average profits = Average profits X 100 / Normal rate of return

Actual capital employed = Total assets (excluding goodwill) – Outside
liabilities)

b).Super Profits Method of Valuation of Goodwill

In these methods, super profits are directly capitalized for the valuation of
goodwill.

Goodwill= (Super Profit/Normal Profit)X100

Goodwill Valuation With Arbitrary Assessment Method

In Arbitrary Assessment Method either the purchaser or seller or both parties may estimate the
value to be placed on the goodwill. Arbitrary Assessment Method normally applies in
situations where the profits cannot be used as a guide to future profit like in cases where no
profits may have been earned in the years immediately prior to the sale so that goodwill is
unable be based on the profit earning capacity.

Or the proposed acquire business may be acquired and converted into one of a different
nature of business from that existing prior to the date of purchase.

Valuation of goodwill can be higher if there are explicit benefits / gains by acquiring the
business like: Trading advantages ( e.g. quotas, more sales territories), Certain important
licenses (like Gambling License) or a Shop located in extremely good location where the lease
can be pass on to the buyers.