{"id":319,"date":"2018-10-12T05:08:23","date_gmt":"2018-10-12T05:08:23","guid":{"rendered":"http:\/\/mgmtp02.epgpbooks.inflibnet.ac.in\/?post_type=chapter&p=319"},"modified":"2019-01-10T08:31:08","modified_gmt":"2019-01-10T08:31:08","slug":"valuation-of-goodwill-needs-and-methods","status":"publish","type":"chapter","link":"https:\/\/ebooks.inflibnet.ac.in\/mgmtp02\/chapter\/valuation-of-goodwill-needs-and-methods\/","title":{"rendered":"Valuation of Goodwill: Needs and Methods"},"content":{"raw":"
\"epgp<\/a>\r\n<\/span><\/div>\r\n
\r\n\r\n \r\n\r\n \r\n\r\n \r\n\r\nLEARNING OBJECTIVES:<\/strong>\r\n\r\n \r\n

This module outlines a comprehensive framework for valuation of goodwill and briefs the circumstances where it may be necessary to value goodwill and the various factors determining the value of goodwill. There are various methods advocated for the valuation of goodwill which are briefly explained in this module with the help of examples to clear the concept deeply. In this module student may able to distinguish between Average profit & Super profit and bottom line difference between Average and Weighted average profit.<\/p>\r\n \r\n\r\nMETHODS FOR THE MEASUREMENT OF GOODWILL<\/strong>\r\n\r\n \r\n

As such there is no accurate formula laid down for the measurement of the value of goodwill because the value of goodwill vary from firm to firm and depends upon the nature of a particular business and the circumstances connected with it. Various methods are advocated for the valuation of goodwill. In many cases the methods adopted is a purely arbitrary one and is often governed by the custom of the particular trade in which the business is engaged.<\/p>\r\n \r\n\r\nThe more usual bases of valuation area as follows:\r\n\r\n \r\n

    \r\n \t
  1. \u00a0Average profits method<\/li>\r\n \t
  2. \u00a0Weighted average profits method<\/li>\r\n \t
  3. \u00a0Super profits method<\/li>\r\n \t
  4. Capitalization method<\/span><\/li>\r\n<\/ol>\r\n<\/div>\r\n
      \r\n \t
    1. Average Profits Method<\/strong>: Under the method of average profit for the measurement of goodwill the average profits of given number of past years is calculated and then multiplied by an agreed number is considered to be the value of goodwill. Average profit is calculated by dividing the total profits of the year by the number of years of profit. This method is purely arbitrary and will frequently produce figure for goodwill out of all proportions to it value.<\/li>\r\n<\/ol>\r\n \r\n\r\nFOLLOWING STEPS NEED TO BE FOLLOWED UNDER AVERAGE PROFIT METHOD TO ARRIVE AT THE VALUE OF GOODWILL<\/strong>\r\n\r\n\"\"\r\n\r\nFormulas: Average (adjusted profits) = Total Profits\/ Number of years\r\n\r\n \r\n\r\nValue of Goodwill = Average profit * No. of years purchase.\r\n\r\n \r\n\r\nMerits of Average Profit Methods<\/em>:\r\n
        \r\n \t
      1. This is one of the simple method and very easy to understand and apply.<\/li>\r\n \t
      2. Average profits are more reliable than one year\u2019s profits to know the future earning capacity of the firm.<\/li>\r\n \t
      3. Generally, this method is adopted when in a organization a partner retires or expires.<\/li>\r\n<\/ol>\r\nDemerits of Average Profit Method:<\/em>\r\n
          \r\n \t
        1. This method is restricted only up to the value of profits to ascertain the value of goodwill.<\/li>\r\n \t
        2. Capital Employed which is an important factor affecting the goodwill is completely ignored.<\/li>\r\n \t
        3. There is uncertainty regarding the number of years for finding out the average profits and number of years purchase. Therefore, results arrived are far from satisfactory.<\/li>\r\n<\/ol>\r\nConcept of number of years of purchases:<\/em>\r\n\r\n \r\n

          Accounting literature is silent on defining the term of number of years of purchases. The logic for the multiplication of average profits with number of years purchase seems to be that the new partner has to compensate the old partners for assured profits, which former would derive its future for a certain period of time from the date of admission. The period of time for which the profits are assured to new partner is called \u2018Number of years of purchase\u2019. It is important to note the number of year\u2019s purchase is based purely on approximation rather than on scientific basis.<\/p>\r\n \r\n\r\nConcept of Average profits:<\/em>\r\n\r\n \r\n

          Goodwill (good reputation of the firm) is linked with profits. In case the firms earn more profits there will be more goodwill. In contrary to this, if the profits are less, the amount of goodwill will also be less. Profits are not earned by the business uniformly because business passes through different stages sometime boom and sometime depression which have affect on the earnings of the business. Extraordinary situations such as: power failure, change in economic policies, workers strike, short supply of raw material, fire, war, etc. influence the earnings of business. During the adverse situation the profits are abruptly decreased where as during the favorable situations the profits are sharply increased. If goodwill is calculated on the basis of each year profit there will be too many fluctuations in the amount of goodwill. Therefore, in order to set right all the fluctuations and to ensure better results the concept of average profit is preferred to calculate goodwill.<\/p>\r\n \r\n\r\nExample 1: <\/em><\/strong>Calculate goodwill of a ABC Ltd from the following details:\r\n\r\n \r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n
          Year<\/td>\r\nProfits<\/td>\r\n<\/tr>\r\n
          2010<\/td>\r\n8,000<\/td>\r\n<\/tr>\r\n
          2011<\/td>\r\n9,000<\/td>\r\n<\/tr>\r\n
          2012<\/td>\r\n6,000<\/td>\r\n<\/tr>\r\n
          2013<\/td>\r\n10,000<\/td>\r\n<\/tr>\r\n
          2014<\/td>\r\n8,000<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n \r\n\r\nGoodwill is 3 year purchase of average profits\r\n\r\n \r\n\r\nSolution:<\/em><\/strong>\r\n\r\n \r\n

          Total of five year profit = 8,000+9,000+6,000+10,000+8,000 = 41,000<\/p>\r\n \r\n\r\nAverage Profit = 41,000\/5 = 8,200\r\n\r\n \r\n\r\nGoodwill = Average Profit * Number of year of purchase\r\n\r\n \r\n\r\nGoodwill = 8,200 * 3 = 24,600\r\n\r\n \r\n\r\nExample 2<\/em><\/strong>: A firm of partners X,Y and Z has the following profits:\r\n\r\n \r\n\r\nYear\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Profit\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n
          I<\/td>\r\n20,000<\/td>\r\n<\/tr>\r\n
          II<\/td>\r\n30,000<\/td>\r\n<\/tr>\r\n
          III<\/td>\r\n40,000<\/td>\r\n<\/tr>\r\n
          IV<\/td>\r\n60,000<\/td>\r\n<\/tr>\r\n
          Total<\/td>\r\n1,50,000<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n

          Goodwill is to be calculated at three year purchase of average profit or last four year profit. Calculate Goodwill.<\/p>\r\n \r\n\r\nSolution: <\/em><\/strong>Total Profits = 20,000+30,000+40,000+60,000 = 15,0000\r\n\r\n \r\n\r\nAverage Profit = Total profit\/Number of years\r\n\r\n \r\n\r\nAverage Profit = 1,50,000\/4 =37,500\r\n\r\n \r\n\r\nGoodwill = Average Profit * Number of year of purchase\r\n\r\n \r\n\r\nGoodwill = 37,500 * 3 = 1,12,500\r\n\r\n \r\n\r\nConcept of Abnormal Items:<\/em>\r\n\r\n \r\n

          The annual profit calculated as per profit & loss account should not be taken as it is, as the basis of goodwill valuation. Such profits must be carefully scrutinized, and if need be adjusted in the light of conditions likely to prevail in future.<\/p>\r\n \r\n\r\nSome of the adjustments and their treatment are given below:\r\n\r\n \r\n\r\nItems to be deduct from the profits:\r\n\r\n \r\n

          (a) Abnormal profits or extra ordinary gains credited to profit & loss account such as: profit on sale of assets, profit on sale of manufacturing license etc.<\/p>\r\n

          (b) Future expenses and provisions likely to be incurred such as: provision for doubtful debts, additional depreciation, if any. Add to the profits<\/p>\r\n \r\n\r\nItems to be added in the profits:\r\n\r\n \r\n

          (a) Revenue likely to accrue in future from pending contracts.<\/p>\r\n

          (b) Abnormal losses or extra-ordinary losses debited to profit & loss account.<\/p>\r\n

          (c) Expenses debited to profit & loss account but not likely to occur in future.<\/p>\r\n(This concept can be clear with the help of this example)\r\n

          Example 3<\/em><\/strong>: Mohan Purchased Ram\u2019s business w.e.f., 1st April 2015. The profits disclosed by Ram\u2019s business for the last three years were as follows:<\/p>\r\n \r\n\r\nYears:\r\n\r\n \r\n\r\n31-3-13\u00a0\u00a0 Rs 40,000(Including an abnormal gain of 5000)\r\n\r\n \r\n\r\n31-3-14\u00a0 Rs 50,000(after charging an abnormal loss of 10,000)\r\n\r\n \r\n

          31-3-15\u00a0\u00a0 Rs 45,000 (excluding 5000 on insurance premium of firm\u2019s property now to be insured)<\/p>\r\n \r\n

          Calculate the value of firm\u2019s goodwill on the basis of two year\u2019s purchase of average adjusted profits of the last three years.<\/p>\r\n \r\n\r\n \r\n\r\nSolution<\/em><\/strong>:\r\n\r\n \r\n\r\nCalculation of average profit:\r\n\r\n \r\n\r\n31-3-13 = 40,000 \u2013 5000 = 35000 (abnormal profit is to be excluded)\r\n\r\n \r\n\r\n31-3-14\u00a0 Rs 50,000 +10,000 = 60,000 (abnormal loss is to add back)\r\n\r\n \r\n\r\n31-3-15\u00a0\u00a0 Rs 45,000 \u2013 5000 = 40,000\r\n\r\n \r\n\r\nTotal Profits = 35,000 + 60,000+ 40,000 = 1,35,000\r\n\r\n \r\n\r\nAverage Profits = Total Profits\/Number of years\r\n\r\n \r\n\r\nAverage Profits = 1,35,000\/3 = 45,000\r\n\r\n \r\n\r\nGoodwill = Average Profits * No of years of purchase\r\n\r\n \r\n\r\nGoodwill = 45,000 * 2\r\n\r\n \r\n\r\nGoodwill = 90,000\r\n

            \r\n \t
          1. WEIGHTED AVERAGE PROFIT METHOD<\/strong>:<\/li>\r\n<\/ol>\r\n \r\n

            This is a modified method of years\u2019 purchase of average profits. This method is applicable particularly in the rising trend of profits. Under this method, each year\u2019s profit is multiplied by the respective number of weights e.g. 1,2,3,4, etc. in order to find out value of product. The sum of the product is then divided by the total weights to get weighted average profits the weighted profit is then multiplied by Number of year\u2019s purchase.<\/p>\r\n\"\"\r\n

            During 2013 there was an abnormal loss of Rs 500 due to fire and in 2015 there was a gain of 500 from sale of machinery. In 2014 the closing stock was under -valued 600. The weights are 1,2,3 and 4 in the year 2012, 2013, 2014 and 2015. Goodwill is 3 years\u2019 purchase of average weighted profits.<\/p>\r\n\"\"\r\n

              \r\n \t
            1. SUPER PROFIT METHOD:<\/strong><\/li>\r\n<\/ol>\r\n

              If a business earns profits in a normal course more than what the other business are earning in the same trade, then it means such a business has some superiority over other business. Such superiority is due to super profits.<\/p>\r\n \r\n

              Super profits refers to the excess of actual profit over normal profit.<\/p>\r\n \r\n

              Normal Profits refers to that profit which the firm could reasonably or normally earns in a particular business. It is calculated by multiplying the normal rate of return with the capital employed.<\/p>\r\n\r\n

                \r\n \t
              1. SUPER PROFIT METHOD:<\/strong><\/li>\r\n<\/ol>\r\n

                If a business earns profits in a normal course more than what the other business are earning in the same trade, then it means such a business has some superiority over other business. Such superiority is due to super profits.<\/p>\r\n \r\n

                Super profits refers to the excess of actual profit over normal profit.<\/p>\r\n \r\n

                Normal Profits refers to that profit which the firm could reasonably or normally earns in a particular business. It is calculated by multiplying the normal rate of return with the capital employed.<\/p>\r\n \r\n\r\n\"\"\r\n

                \r\n\r\nExample 6<\/em><\/strong>:\r\n\r\n \r\n

                The average net profits expected of a firm in future are Rs 68,000 per year and capital invested in the business by the firm is Rs 3,50,000. The rate of interest expected from capital invested in this class of business is 12%. The remuneration of the partners is estimated to be 8,000 for the year.<\/p>\r\n \r\n\r\nFind out the value of Goodwill on the basis of two year\u2019s purchase of super profits.\r\n\r\n \r\n\r\nSolution<\/em><\/strong>:\r\n\r\n \r\n\r\nNormal Profit = <\/strong>12% of (capital invested) 3,50,000 = 42,000\r\n\r\n \r\n\r\nExpected Profit <\/strong>= 68,000 \u2013 (remuneration) 8,000 = 60,000\r\n\r\n \r\n\r\nSuper Profits <\/strong>= (Expected Profit) 60,000 \u2013 (Normal Profit) 42,000 = 18,000\r\n\r\n \r\n\r\nGoodwill <\/strong>= (Super profit )18,000* 2 = 36,000\r\n\r\n \r\n\r\nExample 7:<\/em><\/strong>\r\n\r\n \r\n

                On 1st April, 2014 an established firm had assets of Rs 26000 including cash of Rs 520. Its creditors amounted to Rs1300 on that date. The partner\u2019s capital account showed a balance of Rs 20,800 while the reserve fund amounted to Rs 3900. If the normal rate of return is 15% and the goodwill of the firm is valued at Rs 4,680 at 3 years purchase of super profits. Find the average profits of the firm.<\/p>\r\n \r\n\r\nSolution:<\/em><\/strong>\r\n\r\n \r\n\r\nGoodwill = Super Profit *3\r\n\r\n \r\n\r\n4680 = Super profit*3\r\n\r\n \r\n\r\nSuper profit = 4680\/3\r\n\r\n \r\n\r\nSuper profit <\/em>= 1,560\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026..(1)\r\n\r\n \r\n\r\nSuper profit = Average profit \u2013 Normal profit\r\n\r\n \r\n\r\nNormal profit = Capital employed* Normal Rate\/100\r\n\r\n \r\n\r\nCapital Employed = Assets \u2013 Liabilities\r\n\r\n \r\n\r\nCapital employed = 26000 \u2013 1300\r\n\r\n \r\n\r\nCapital employed <\/em>= 24,700\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026.. (2)\r\n\r\n \r\n\r\nNormal Profit = 24,700 * 15%\r\n\r\n \r\n\r\nNormal Profit <\/em>= 3,705\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026\u2026.. (3)\r\n\r\n \r\n\r\nAverage Profit = 1,560 + 3,705\r\n\r\n \r\n\r\n<\/div>\r\nAverage Profit <\/em>= 5,265\r\n\r\n \r\n

                  \r\n \t
                1. CAPITALIZATION METHOD<\/strong><\/li>\r\n<\/ol>\r\n

                  Under the method of capitalization, the goodwill may be calculated in two ways:<\/p>\r\n \r\n