VALUATION OF GOODWILL

INTRODUCTION Goodwill is an intangible (non visible) fixed asset having a realizable (economic) value. It is the reputation of business. Valuation of goodwill is very important in the case of admission, retirement and death of partners. DEFINITION OF GOODWILL Eric L. Kohler defined goodwill as under: Goodwill is the excess of the price paid for the business as a whole over the book value or over the computed value of all tangible assets purchased. Normally, goodwill thus acquired is only one type appearing on book of account and in financial statement. We can define goodwill as under: Goodwill is a monetary value of the reputation of a concern in terms of its future earning capacity.

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 6.Present Value of Super Profits Method

1. Average Profit Method: Under this method goodwill is calculated on the basis of the average profit of previous years. The average profit is multiplied by the number ofyear's purchase. Goodwill = Average Profit x Number of Years Purchase Example: 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 Solution: Total Profit for last four years = Rs.27,000+ Rs.39,000-Rs.16,000+Rs.40,000 = Rs.80,000 Average Profit = Rs.80,000/4 = Rs.20,000. Goodwill = Rs.20,000 x 2 = Rs.40,000.

2. 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 thetotal of weights in order to ascertain the weighted average profits. Goodwill = Weighted Average Profits x No. of years Purchase Weighted Average Profit = Total of Products of Profits Total of Weights Example: Calculate goodwill at twice the weighted average profits of last four years' profits. The profits of the last four years were: 2001. Rs. 37,000 2002. Rs. 29,000 2003. Rs. 26,000 2004. Rs. 40,000

Solution: Years Profits Weight 2001 37,000 1 2002 29,000 2 2003 26,000 3 2004 40,000 4 Total 10 Product 37,000 58,000 78,000 1,60,000 3,33,000

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

3. Super Profit Method: 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 calculated of on the following manner: Goodwill = Super Profit x Number of Years Purchase Example: 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: 2001 Rs.40,000 2002 Rs.50,000 2003 Rs.60,000 2004 Rs.70,000 2005 Rs.80,000 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: 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 Average Profit = Rs.3,00,000/5 =Rs.60,000 Normal Profit = Rs.4,50,000 x 10/100 = Rs.45,000 Super Profit = Actual/Average Profit - Normal Profit Super Profit = Rs.60,000 - Rs.45,000 = Rs.15,000 Goodwill = Rs.15,000 x 3 = Rs.45,000.

4. Capitalization of Average Profit Method: Under this method goodwill is difference between the total Capitalized value of the firm and the net assets of the firm. Goodwill = Capitalized Value the firm - Net Assets Capitalized Value of the firm = Average Profit x 100 Normal Rate of Return Net Assets = Total Assets - External Liabilities Example: 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. Solution: Total Capitalized value of the firm = Rs.65,000x 100/10 = Rs.6,50,000 Net Assets = Rs.6,80,000 - Rs.1,80,000 = Rs.5,00,000 Goodwill = Total Capitalized value of the firm - Net Assets Goodwill = Rs.6,50,000 - Rs.5,00,000 = Rs.1,50,000.

5. Capitalization of Super Profit Method:

1.Calculate Capitalized value of the firm 2.Calculate required profit on capital employed by using the following formula: Normal Profit = Capital Employed x Required Rate of Return/100

1.Calculate average profit 2.Calculate super profit Goodwill = Super Profit x 100/Normal Rate of Return Example: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. Solution: Normal Profit = Rs.4,00,000 x 15/100 = Rs.60,000 Super Profit = Rs.90,000 - Rs.60,000 = Rs.30,000 Goodwill = Super Profit x 100/Normal Rate of Return = Rs.30,000 x 100/15 = Rs.2,00,000

6. Present Value of Super Profit: Under this method, goodwill is estimated as the present value of the future super profits. The following steps are taken: 1.Calculate the future super profits for next years 2.Choose the required rate of return 3.Calculate present value factors 4.Multiply present value factors with future super profits 5.The sum of product of present value factors and superprofits is the value of goodwill.

Example: A firm has the forecasted profits for the coming 4 years as follows: YearsProfits 180,000 21,00,000 390,000 41,20,000 The total assets of the firm are Rs.9,00,000 and outside liabilities are Rs.3,00,000. The present value factors at 10% are as follows: Years 1 2 3 4 Present Value Factor .9279 .8029 .7056 .6978

Calculate the Value of goodwill.

Solution: Net Assets = Total Assets - Liabilities = Rs.9,00,000 - Rs.3,00,000 = Rs.6,00,000 Normal Profit = 10/100 x Rs.6,00,000 = Rs.60,000

YearsProfits (Rs.) 1 2 3 4 80,000 1,00,000 90,000 1,20,000

Normal Profit 60,000 60,000 60,000 60,000 Super ProfitP.V FactorPV of Super Profit 20,000.9279 40,000 .8029 30,000 .7056 60,000 .6978 18,558 32,116 21,168 41,868

Goodwill = Rs.18,558 + Rs.32,116 + Rs.21,168 + Rs.41,868 = Rs.1,13,710.

Electricity Company Accounts

Kite Electric Company laid down a plant at a cost of Rs. 10000000. After few years, it laid down an auxiliary plant for the 1/5th of the length of the old plant at a cost of Rs. 300000 and also replaced the rest of the length of the old plant at a cost of Rs. 1200000, the cost of material and labour have gone up by 30%. Sale of old material realized Rs.16000. Old material worth Rs. 20000 was used in the renewal and those valued at Rs. 10000 were used in the construction of the auxiliary plant. Give the necessary journal entries.