Goodwill:-definition, classification and valuation

▶     here is the information that how can we identify the goodwill and how we can compute it's value by different method.

what is goodwill? basic introduction and it's types. 

definition:-goodwill is the value of reputation of a firm in respect of profits expected in future over and above the normal rate of profit.

In simpler terms, goodwill is nothing more than the probability that old customer will resort to old place again and again. the capacity of a business to earn super profit in the future is basically what is meant by term goodwill. goodwill is an intangible asset; it cannot be seen; it cannot be felt; it cannot be transported physically.

basic introduction with an example;

goodwill represents the value of  the  acquired business brand, superior customer relations etc. 

To determine goodwill in a simplistic formula, take the purchase price of a company and subtract the net fair market value of identifiable assets and liabilities.

(goodwill= p-(A-L), where; P= purchase price of a target company, A= fair market value of assets, L= fair market value of liabilities.)

classification of goodwill

   there are two types of goodwill.

1.self generated goodwill.

2.purchased goodwill.

1. self generated goodwill= self generated goodwill is not purchased or bought for consideration but rather generated as a result of the hard work and efforts of the members of the firm. It, therefore, arises

because of factors such as consistence quality, satisfied customers, favorable location, etc. since all these factors are internal to an organization hence the goodwill is an internally generated goodwill boosting the revenues for the firm.

2. purchased goodwill= 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.

 methods of valuation of goodwill

1. average profit method

2. super profit method

3. capitalization method

4. hidden goodwill

1. Average profit method= In this case the average profit of past years are adjusted for any expected change in future. the number of years are decided on the basis of judgement and negotiation.

     ⏩  Let's take an example;

   1.  the pats profit of five years of partnership firm are: ₹50000; ₹40000; ₹52000;₹48000 and ₹56000 respectively. calculate the value of goodwill on the basis of 4 years' purchase of the average profits of the last five years. 

       Answer;

  total profits for five years=Rs(50000+40000+52000+48000+56000)

Average profit= sum of profits/ no. of years 

Average profit = ₹ 2,46,000÷5= ₹49,200

value of goodwill (being four year's purchase of the average profit of five years)= 4×₹49,200= ₹1,96,800.

2. super profit method=  In the case of super method, goodwill is valued on the basis of super profits earned by the firm. 

 super profit= Actual profit- normal profit 

Actual profit is average maintabale profit 

Normal profit= Normal rate of Return(NRP)× capital employed

🧮calculation of super profit:

1. identify the capital employed by the partnership firm. 

2. identify the average profit earned by the partnership firm based          on past few year's figure;

3. determine normal rate of return prevailing in the locality of similar firms;

4. Apply normal rate of return on capital employed to arrive at normal profit;

5. deduct normal profit from the average profit of the firm. if the average profit of the firm is more than the normal profit, there exist super profit and goodwill. 

Example:

let's suppose, total capital employed by a partnership firm was ₹1,00,000 and it's average profit was ₹25,000. Normal rate of return is 22% in case of similar firms working under similar conditions. So, Normal profit is ₹22,000 and average profit is₹25,000. the partnership firm earns ₹3,000 super profit. 

3. Capitalization method= under this basis, value of whole business is determined applying normal rate of return. if such (arrived at by applying normal rate of return) is higher than the capital employed in the business, then the difference is goodwill. the steps to be followed under this method are given below:

a. determine the normal rate of return.

b. find out the average profit of the partnership firm form which goodwill is to be determined.

c. determine the capital employed by the partnership firm for which goodwill is to be determined.

d. find out normal value of the business by dividing average profit by normal rate of return.

e. deduct average capital employed from the normal value of the business to arrive at goodwill. 

     Goodwill= Normal capital-Actual capital

Normal capital=Average profit/NRR

Example:

let's suppose capital employed by a partnership firm is ₹1,00,000. its average profit is ₹20,000. normal rate of return is 15%. 

   Normal value of business= ₹20,000 = ₹ 1,33,333

                                                 15%

  Value of goodwill = ₹1,33,333 -₹1,00,000 = ₹33,333

 

4. Hidden goodwill = sometimes the value of goodwill is not specifically given and has to be inferred or implied from the arrangement of capital or profit-sharing ratio. For example A's capital is ₹ 20,000 and B's capital is ₹15,000 and they share profits equally. C is admitted as a partner with ₹ 18,000 as his capital for 1/4 share in profits. the total capital of the firm now ought to be ₹ 72,000 for the simple reason that if C contributes ₹18,000 for 1/4 share, then for full or unit profit he ought to have contributed ₹72,000 (18,000×4). But the total capital of A, B and C becomes only ₹ 50,000. So the hidden value of the goodwill should be taken as   ₹ 22,000 So that the total capital becomes ₹ 72,000

let's take an example for understanding all method

Lee and Lawson are in equal partnership. They agreed to take hicks as one fourth partner. for this it was decided to find out the value of goodwill. M/s Lee and Lawson earned profits during 2016-2017 as follows:

On 31/12/2019 capital employed by M/s Lee and Lawson was ₹5,00,000. Rate of normal profit is 20%.

Required 

find out the value of goodwill following various methods.

Average profit:

Weighted Average profit = ₹1,36,000 divided  by 10 = ₹1,36,000

Method(1):Average profit basis 

assumption: Goodwill is valued at 3 year's purchase

Value of goodwill: ₹1,36,000×3= ₹4,08,000

Method(2): super profit basis 

                                                                                 ₹

         average profit                                          1,36,000

       less: Normal profit      

              20% on ₹5,00,000                             (1,00,000)

                                                                           ₹36,000

assumption: goodwill is valued at 3 year's of purchase. value of goodwill = ₹36,000×3 = ₹1,08,000

Method(3): Annuity basis

Assumptions:

(a)   Interest rate is equivalent to normal profit rate i.e 20% p.a.

(b)   goodwill is valued at 3 year's purchases

Valuation of goodwill: ₹36,000×2.1065= ₹75,834

Method(4): capitalization basis

normal value of business: ₹1,36,000×100            =  ₹6,80,000

                                                 20

Less: capital employed in M/s. Lee and Lawson   = (₹5,00,000)

Goodwill                                                                 = ₹1,80,000

     click here:- For more clarification