Goodwill: Nature and Valuation

Goodwill is the value of a firm's reputation — the extra earning power that lets it earn more than the normal profit expected from the capital employed. It is the price a buyer is willing to pay for the firm over and above the value of its net assets, because of its established name, loyal customers and market position.

Goodwill is an intangible asset (it has no physical form) but it is not a fictitious asset — it has real value. Two kinds:

• Purchased goodwill — paid for when a business is bought; it is recorded in the books and shown in the balance sheet.
• Self-generated (inherent) goodwill — built up over years by the firm's own efforts; as per AS-26 it is not recorded in the books (only purchased goodwill is).

The main factors affecting goodwill are: the firm's location, the quality and nature of its products, the efficiency of management, favourable contracts and licences, the risk involved, the trend of profits, market reputation and after-sales service, and the degree of competition.

In partnership, goodwill needs valuing whenever the mutual rights of partners change — at the admission, retirement or death of a partner, on a change in profit-sharing ratio, on dissolution, or when the firm is sold. Because there is no single "correct" figure, accountants use agreed valuation methods, which the next topics explain.

The simplest method is the Average Profit Method. Goodwill is valued as a number of years' purchase of the average profit.

Goodwill = Average Profit × Number of Years' Purchase

For example, profits of the last three years are Rs 50,000, Rs 60,000 and Rs 70,000; average = 1,80,000 ÷ 3 = Rs 60,000. At 3 years' purchase, goodwill = 60,000 × 3 = Rs 1,80,000. (A refinement, the weighted average method, gives more weight to recent years — useful when profits show a clear trend.)

The Super Profit Method is more scientific. Super profit is the excess of the firm's actual average profit over the normal profit the capital would ordinarily earn.

• Normal Profit = Capital Employed × Normal Rate of Return.
• Super Profit = Average Profit − Normal Profit.
• Goodwill = Super Profit × Number of Years' Purchase.

For example, capital employed Rs 5,00,000, normal rate 10%, so normal profit = Rs 50,000. If the average profit is Rs 80,000, super profit = 80,000 − 50,000 = Rs 30,000. At 3 years' purchase, goodwill = 30,000 × 3 = Rs 90,000. The logic is sound: goodwill exists only because the firm earns more than the normal return — so we value only that excess.

The Capitalisation Method values goodwill by capitalising profit at the normal rate of return. There are two forms.

1. Capitalisation of Average Profit. We find the capitalised value of the business (the capital it should have to earn its average profit at the normal rate), then subtract the actual net assets.

• Capitalised Value = Average Profit × (100 ÷ Normal Rate).
• Goodwill = Capitalised Value − Capital Employed (Net Assets).

For example, average profit Rs 60,000, normal rate 10%: capitalised value = 60,000 × 100/10 = Rs 6,00,000. If net assets (capital employed) are Rs 4,50,000, goodwill = 6,00,000 − 4,50,000 = Rs 1,50,000.

2. Capitalisation of Super Profit. Here we capitalise only the super profit at the normal rate:

• Goodwill = Super Profit × (100 ÷ Normal Rate).

For example, super profit Rs 20,000 and normal rate 10%: goodwill = 20,000 × 100/10 = Rs 2,00,000.

Note that Capital Employed = total assets (excluding goodwill and any non-trade investments) − outside liabilities. The three methods can give different figures, so in practice partners agree which method to use and write it into the deed. With goodwill valued, we are ready to handle the events that disturb a partnership — a change in ratio, an admission, a retirement or a dissolution — where goodwill must be adjusted between the partners.