Valuation of Goodwill
Meaning of Goodwill Goodwill means the 'good-name' or the reputation earned by a firm through the hard-work and honesty of its owners. Goodwill is the value of the reputation of a firm which enables it to earn higher profits in comparison to the normal profits earned by other firms in the same trade.
Characteristics or Features of Goodwill:
1. It is an intangible asset
2. It is a valuable asset.
3. It is helpful in earning excess profits
4. It is valuable only when entire business is sold
5. It is difficult to estimate the exact value of goodwill
Nature of Goodwill:
⇒ Goodwill is an intangible asset since it has no physical existence and cannot be seen or touched.
⇒ But it is not a fictitious asset because fictitious assets do not have a value whereas goodwill has a value in case of profit making concerns
Origin of Goodwill Or Factors Affecting the Value of Goodwill:
1. Favorable Location of the Business
2. If the business is run by experienced and efficient management, its profits will go on increasing, which results in increase in the value of goodwill.
3. The Longevity of the Business- An older business is better known to its customers, therefore it is likely to have more goodwill
4. Possession of License :- If a firm holds an import license, the goodwill of the firm will be more as it will be very difficult for other firms to enter this business
5. Risk Involved :- If there is more risk involved in the business, the value of the goodwill will be less.
6. Future Competition :- The likelihood or possibility of increased competition in future would definitely reduce the value of Goodwill.
Classification of Goodwill :
Goodwill can be classified into two categories:
(1) Purchased Goodwill, and
(2) Self-Generated Goodwill or Inherent Goodwill
(1) Purchased Goodwill: Purchased goodwill is the goodwill which is acquired by making a payment. For example, when a business is purchased, the excess of purchase consideration over its net assets (i.e., Assets - Liabilities) is referred to as purchased goodwill.
(2) Self-Generated Goodwill or Inherent Goodwill: It is internally generated goodwill which arises from a number of characteristics or attributes which an ongoing business possesses.
√ It is internally generated over a long period of time.
√ As per Accounting Standard 26 (Intangible Assets), it is not recorded in the books of accounts
Need for the Valuation of Goodwill
The need for valuing the goodwill in partnership arises in the following circumstances :
1. When there is a change in the profit sharing ratio among the existing partners;
2. When a new partner is admitted;
3. When a partner retires or dies;
4. When the firm is sold; and
5. When the firm is amalgamated with another firm.
Methods of Valuation of Goodwill
1. Average profit method
Step 1- calculate total profits
Step 2- calculate average profits= total profit / number of years
Step 3- calculate goodwill= average profit X no. of years purchase.