GOODWILL

Meaning: Goodwill is good name or the reputaion of the business, which is earned by a firm through the
hardwork and honesty of its owners. If a firm renders good service to the customers, the customers who
feel satisfied will come again and aain and the firm will be able to earn more profits in future.

Features of Goodwill

1. It is an intangible asset: Goodwill cannot be seen or touched, it does not have any physical existence,
thus it belongs to the category of intangible assets such as patents, trademarks, copyrights, etc.

2. It is a valuable asset

3. It is helpful in earning excess profits.

4. Its value is liable to constant fluctuations: While goodwill does not depreciate, its value is liable to
constant fluctuation, its vlaue is liable to constant fluctuations.It is always present as a silent asset in a
business where there are super profits (i.e.more than the normal) but declines in value with the decline
in earnings.

5. It is valuable only when entire business is sold: Goodwill cannot be sold in part. It can be sold with the
entire business only. The only exception is at the time of admission or retirement of the partner.

6. It is difficult to place an exact value on goodwill: This is beecause its value may fluctuate from time to
time due to changing circumsatnces which are internat and external to business.

Nature of goodwill

Accounting Standard 26 intangible asset prescribed Goodwill is not to be recognise in the book of
account unless consideration has exchange between knowledgeable person therefore self generated
Goodwill will not recognise in the book of account only purchase of goodwill will be recognised

Need for valuation of Goodwill

1) profit sharing ratio change

2) Partner is admitted

3) Partner retired or die

4) Firm sold

5) Two or more firm amalgamate

6) Firm converted into company

Factors affecting value of Goodwill

1. Location of the Firm:If the business unit is located in the prime market area, then the firm enjoys the
attention of more customers, which means more profit. When the profit of the firm is rising, the value of
goodwill also rises. Similarly, if the firm is located in a backward area, or is a part of an undeveloped
market area, less customers will visit the place due to which the firm’s earnings will be less, thereby
decreasing the value of goodwill of the firm.

2. Life Span of the Firm:A firm that has been serving society for a number of years has more satisfied
customers, a strong brand name, improved customer services, etc. Therefore, an older business unit will
have a strong customer base and a high reputation in the market compared to newly established units.
So, the older the business, the more is the value of the goodwill.

3. Efficient Management:The development of any business unit depends upon the efficiency of the
management. A business operated under the supervision of efficient managers will earn more profit,
and is likely, to enjoy a high value of goodwill in the market. If a manager fails to properly execute the
management plans, the financial position of the business is hampered, which ultimately decreases the
value of goodwill of the firm.

4. Risk Factor:A business with a high-risk factor fails to win the trust of the stakeholders, like investors,
bankers, lenders, customers, etc. When the risk involved is high, a business firm fails to attain its capital
requirements, which in turn hampers the execution of a managerial plan and the profit-making ability of
the firm. All this adversely affects the value of goodwill. So, it can be concluded that the higher the risk,
the lower the value of goodwill.

5. Nature of the Goods:If a firm deals in the necessary items or daily use products, it is likely to have a
more stable profit and regular customers, which increases the value of the goodwill. Similarly, firms
selling trendy goods have unstable sales and profits, as it fails to attract more customers and will have
less value of goodwill comparatively.

6. Nature of the Firm: The nature of the business firm highly affects the goodwill of the business unit. If
the firm enjoys monopoly rights in a market, there is an assured profit earning, as there is no
competition in the market. On the other hand, in a competitive market, every firm has to work harder
every day to build a reputation in the market. Hence, a competing firm has a low value of goodwill
compared to a monopoly firm.

7. Trend of Profit: A profit trend of a firm depends on a number of business factors, like a boom period,
efficient management, product trends, service quality, etc. If the profit of a firm is rising continuously,
the value of the goodwill will also rise simultaneously, and if the profit of a firm tends to fall, the value of
goodwill will also start falling.

8. Capital Requirement:A business unit with less capital requirement and a high rate of profit-making
shall enjoy more goodwill than a firm with more capital requirements and a low rate of profit-making.
This is because when a small or medium scale business with less financial investment makes a large
profit, it attracts more investors and has a strong financial position, which builds ups a good reputation
of the firm in the market, thereby increasing the value of the goodwill.
9. Product Quality:The market reputation of any firm depends upon its customer base and a satisfied
customer base is a result of the quality products. If the firm offers best quality products and services,
then it will rule the major part of the market, thereby earning high profit and a strong reputation in the
market. So, the better the quality of the goods, the more is the goodwill.

10. Technological Advancement: Technological Advancement requires huge capital investment. Such
capital investment by a firm indicates a strong financial position, which builds up the reputation of the
firm in the eyes of the stakeholders. Moreover, a business that uses advanced technology for production
has a high-profit margin, as the cost of production decreases. Such increased repetition and high profit
boost the value and goodwill of the firm.

Types of Goodwill

I. Purchased Goodwill: Purchased goodwill means goodwill for which a consideration has been paid e.g.
when business is purchased the excess of purchase consideration of its net assets i.e. Assets – Liabilities
is known as Purchased Goodwill. It is separately recorded in the books because as it is purchased by
payment in cash or kind.
Characteristics:
(i) It arises on purchase of a business or brand.
(ii) Consideration is paid for it. So, it is recorded in books.
(iii) Shown in Balance Sheet as on asset.
(iv) It is amortised (depreciated) at the earliest but not later than its estimated useful life.
(v) Value is a subjective judgment & ascertained by agreement of seller & purchaser. It is approximate
value and cannot be sold separately in the market or in parts.
II. Self-generated Goodwill: It is also called as inherent goodwill. It is an internally generated goodwill
which arises from a number of factors that a running business possesses due to which it is able to earn
more profits in the future.

Characteristics:
(i) It is generated internally over the years.
(ii) A true cost cannot be placed on this type of goodwill.

(iii) Value depends on subjective judgment of the value.

(iv) As per Accounting Standard 26 (Intangible Asset), it is not recorded in the books of accounts because
consideration in money or money's worth has not be paid for it.
Methods of valuation of goodwill:It is very difficult to assess the value of goodwill, as it is an intangible
asset. In case of sale of a business, its value depends on the mutual agreement between the seller and
the purchaser of the business. Usually, there are three methods of valuing goodwill:
A) Average profit method
B) Super profit method
C) Capitalization method
The above methods of Goodwill valuation are explained as followed:
A) Average Profit Method
(i) Simple Average Profit Method: This is a very simple and widely followed method of valuation of
goodwill. In this method, goodwill is calculated on the basis of the number of past years. Average of
such profits is multiplied by the agreed number of years (such as two or three) to find out the value of
goodwill.
Formula for calculation of goodwill is as follows:
Goodwill = Average Profits x Number of years’ purchase

Number of years’ of purchase means for how many years the firm will earn the same amount of profits
in future.

Average Profits = Total Profits/Number of years

A buyer always wants to estimate the future profits of a business. Future profits depend upon the
average performance of the business in the past. Past profits indicate as to what profits are likely to
accrue in the future. Therefore, the past profits are averaged. But before calculating the average profits,
the profits earned in the past must be adjusted in the light of future expectations and the following
factors should be taken into account while calculating the average profits:

(i) Abnormal income of a year should be deducted out of the net profit of that year.
(ii) Abnormal loss of a year should be added back to the net profit of that year.
(iii) Income from investments should be deducted out of the net profits of that year, because this
income is received from outside the business.
(ii) Weighted Average Profit Method: This method is a modified version of average profit method. In this
Method each year’s profit is assigned a weight. Mostly, the highest weight is attached to profit of most
recent year. For example, weights assigned to the years 2011, 2012, 2013 and 2014 may be 1, 2,3 and
4.Each year profits are multiplied by assigned weights. Products are added & divided by total number of
weights. Weighted average is multiplied by agreed Number of years of Purchase.
Weighted Average Profit: = Total Product of Profits/Total Weights
Goodwill = Weighted Average Profit x No. of years’ of purchase.
Weighted average profit method is considered better than the simple average profit method because it
assigns more weightage to the profits of the latest year which is more likely to be earned in future. This
method is preferred when profits over the past years have been continuously rising or falling.
B) Super profit Method: In this method goodwill is calculated on the basis of surplus (excess) profits
earned by a firm in comparison to average profits earned by other firms. If a business has no anticipated
excess earnings, it will have no goodwill. Super Profit are the excess of actual profit over normal profits.
Normal profits are profits earned by similar business. If a firm earns higher profit in comparison to
normal profit (generally earned by other firms of same industry) then the difference is called Super
Profit. Goodwill is calculated on the basis of Super profit due to future expectations of earning capacity
of the firm.
Goodwill is calculated by the following formula:
Goodwill = Super Profit x Number of years’ of purchase
where, Super Profit = Average profit - Normal profits
and Normal Profit = Investment (Capital Employed) x Normal Rate of Return/100
Capital Employed = Total Capital of all partners + Free Reserves – fictitious Assets (if any),or All Assets -
(Goodwill, fictitious assets and non-trade Investment) – Outsider’s Liabilities

Trade Investments are those investments that are made in another enterprise for the continuance of
own business.

Non-Trade Investments are those investments that are made to earn revenue by investing surplus funds
and not for the purpose of continuance of own business.Unless Investments are specified to be Trade
Investments, they are taken as Non-Trade Investments

(i) Capitalisation of Average Profit Method: Under this method first of all we calculate the average
profits and then we assess the capital needed for earning such average profits on th basis of normal rate
of return. Such capital is also called capitalised value of average profits.It is calculated as under.
Capitalised value of the firm = Average Profits x 100/Normal Rate of Return
Goodwill is calculated by deducting the actual capital employed in business from the capitalised value of
average profits. There will be no goodwill if the actual capital employed in the business exceeds or
equals the capitalised value of the average profits.
Net Assets or Capital Employed = Total assets – Outside liabilities
Goodwill = Capitalized value of Average Profits – Capital Employed
(ii) Capitalisation of Super Profit Method: Under this method first of all we calculate the super profits
and then we assess the capital needed for earning such super profits on the basis of normal rate of
return. Such capital is actually the amount of goodwill. Super profits are calculated in the same manner
as calculated in super profits method.
Goodwill of the firm = Super Profits x 100/Normal rate of return.