Concept of Goodwill - Valuation of Goodwill & Shares, Advanced Corporate Accounting Notes | Study Advanced Corporate Accounting - B Com

Concept of Goodwill

When one company buys another company, the purchasing company may pay more for the acquired company than the fair market value of its net identifiable assets (tangible assets plus identifiable intangibles, net of any liabilities assumed by the purchaser). The amount by which the purchase price exceeds the fair value of the net identifiable assets is recorded as an asset of the acquiring company. Although sometimes reported on the balance sheet with a descriptive title such as “excess of acquisition cost over net assets acquired”, the amount is customarily called goodwill.

Goodwill arises only part of a purchase transaction. In most cases, this is a transaction in which one company acquires all the assets of another company for some consideration other than an exchange of common stock. The buying company is willing to pay more than the fair value of the identifiable assets because the acquired company has a strong management team, a favourable reputation in the marketplace, superior production methods, or other unidentifiable intangibles.

The acquisition cost of the identifiable assets acquired is their fair market value at the time of acquisition. Usually, these values are determined by appraisal, but in some cases, the net book value of these assets is accepted as being their fair value. If there is evidence that the fair market value differs from net book value, either higher or lower, the market value governs.

Illustration 1

Company X acquires all the assets of company Y, giving Company Y Rs 15 lakh cash. Company Y has cash Rs 50,000 accounts receivable that are believed to have a realisable value of Rs 60,000, and other identifiable assets that are estimated to have a current market value of Rs 11 lakhs.

This extra amount of Rs 2,90,000 paid over an above, Net worth Rs 12,10,000 is goodwill, which is a capital loss far purchasing company and to be shown on assets side of Balance Sheet. This entire amount will be written off against revenue profit, i.e., Profit and Loss Account over period of time.

Types of Valuing Goodwill

There are basically two types of valuing goodwill: (a) Simple profit method and (b) Super profit method.

(a) Simple Profit Method: Goodwill is generally valued on the basis of a certain number of years’ purchase of the average business profits of the past few years. While calculating average profits for the purposes of valuation of goodwill, certain adjustments are made. Some of the adjustments are as follows:

Trading Profit/Business Profit/Recurring Profit/Normal Profit (of Past Year)​

Calculation of Average profit:

(a) Simple Average Profit  

(b) Weighted Average profit:

Weighted Average Profit = 

Notes: If past profits are in increasing trend, then calculate Average Profit by weighted average method or otherwise simple average method.

Calculation of F.M.P. (Future Maintainable Profit):

(i) All actual expenses and losses not likely to occur in the future are added back to profits.
(ii) All actual expenses and losses not likely to occur in the future are added back to profits.
(iii) All profits likely to come in the future are added.

After adjusting profit in the light of future possibilities, average profit are estimated and then the value of goodwill is estimated. If goodwill is to be valued at 3 years’ purchase of the average profits which come to Rs 50,000, the goodwill will be Rs 1,50,000, i.e., 3 × Rs. 50,000.

This method is a simple one and has nothing to recommend since goodwill is attached to profits over and above what one can earn by starting a new business and not to total profits.

It ignores the amount of capital employed for earning the profit. However, it is usual to adopt this method for valuing the goodwill of the practice of a professional person such as a chartered accountant or a doctor.

Calculation of Capital Employed and Average Capital Employed

∴ Average Capital Employed = 

= Closing Capital Employed – ½ of Current Years’ Profit + Current Years’ Dividend

(b) Super Profit Method: The future maintainable profits of the firm are compared with the normal profits for the firm. Normal earnings of a business can be judged only in the light of normal rate of earning and the capital employed in the business. Hence, this method of valuing goodwill would require the following information:

(i) A normal rate of return for representative firms in the industry.
(ii) The fair value of capital employed.

The normal rate of earning is that rate of return which investors in general expect on their investments in the particular type of industry. Normal rate of return depends upon the risk attached to the investment, bank rate, market, need, inflation and the period of investment.