Question

Explain various methods of valuation of goodwill.

Answer 1

The following are the various methods of valuation of goodwill.

1. Average Profit Method: Under this method, goodwill is calculated on the average basis of the profits of past few years. The formula for calculating goodwill is:

Goodwill = Average Profit × No. of Years Purchase

Number of Years Purchase implies number of years for which the firm expects to earn the same amount of profits.

Steps to Calculate Goodwill by Average Profit Method:

Step 1: Ascertain the total profit of past given years.

Step 2: Add all abnormal losses like, loss by fire, theft etc.

Step 3: Add all normal income, if not added previously.

Step 4: Less all non-business incomes and all abnormal gains and incomes like, speculation, lottery etc.

Step 5: Less all normal expenses, if not deducted previously.

Step 6: Calculate Average Profit, by dividing the total profit ascertained in Step 5 by number of years.

Step 7: Multiply the Average Profit to the Number of Year’s Purchases to calculate the value of goodwill.

Example:

The profits for last 5 years are 1,00,000, 3,00,000, (2,00,000), 5,00,000, 8,00,000.

Calculate goodwill on the basis of 4 years purchase

2. Weight Average Method: It is modified version of the Average Profit Method. Under this method, the weights are assigned for each year’s profit. Highest weights are assigned to the recent year’s profit and lower weights are assigned to the past year’s profits. The products of the profits and the weights are added and divided by the total weights to calculate Weighted Average Profits. The formula for calculating goodwill by this method is:

Steps to Calculate Goodwill by Weight Average Method:

Step 1: Assign highest weights to the recent year’s profit and lower weights to the past year’s profits, like 4,3,2,1.

Step 2: Multiply the weights with its corresponding year’s profits.

Step 3: Calculate the total of the products

Step 4: Divide the total of the product by the total of the eights in order to calculate Weighted Average Profit.

Step 5: Multiply the Weighted Average Profit by the number of years purchase.

For example:

The profits for the last 5 years are Rs 1,00,000, Rs 3,00,000, Rs (2,00,000), Rs 5,00,000, Rs 8,00,000.

Calculate goodwill on the basis of 4 years purchase

Profit/Loss Rs	Weights	Product Rs
1,00,000	1	1,00,000 × 1 = 1,00,000
3,00,000	2	3,00,000 × 2 = 6,00,000
(2,00,000)	3	(2,00,000) × 3 = (6,00,000)
5,00,000	4	5,00,000 × 4 = 20,00,000
8,00,000	5	8,00,000× 5 = 40,00,000
Total	15	Rs 61,00,000

3. Super Profit Method: Under this method, goodwill is calculated on the basis of excess profit earned by a firm over the normal profit earned by its counterparts in the same industry. The excess profit over the normal profit is termed as Super Normal Profit.

Steps to Calculate Goodwill by Super Profit Method:

Step 1: Calculate Average Profit

Step 2: Calculate Average Capital Employed as:

Step 3: Calculate Normal Profit by the formula:

Step 4: Calculate Super Normal Profit by the formula:

Super Normal Profit = Average Profit – Normal Profit

Step 5: Multiply the Super Normal Profit by the Number of Years Purchase to calculate goodwill.

4. Capitalisation Method: Under this method, goodwill is calculated by the following two methods :

a) By capitalisation of Average Profit.

b) By capitalisation of Super Profit.

a) Capitalisation of Average Profit

Step 1: Calculate Average Profit

Step 2: Calculate Capitalised value of Average Profit by the following formula:

Step 3: Ascertain Actual Capital Employed

Step 4: Deduct Actual Capital Employed from Capitalised Average Profit to calculate goodwill.

Goodwill = Capitalised Average Profit – Actual Capital Employed

b) Capitalisation of Super Profit

Step 1: Calculate the Capital Employed

Step 2: Calculate Normal Profit by the following formula:

Step 3: Calculate Average Profit.

Step 4: Calculate Super Normal Profit by the following formula:

Super Normal Profit = Average Profit – Normal Profit

Step 5: Calculate goodwill by the following formula: