Presentation

On
Nature and Valuation of Goodwill

Prepared by:- Navdeep kaur

PGT_COMMERCE
K.V. 2 PATHANKOT

GOODWILL CONSISTS OF THE ADVANTAGES A

BUSINESS HAS IN CONNECTION WITH ITS
CUSTOMERS, EMPLOYEES AND OUTSIDE PARTIES
WITH WHOM IT HAS TO CONTACT. THAT IS WHY IT
WAS DEFINED AS THE PROBABILITY THAT THE OLD
CUSTOMERS WILL RESORT TO THE OLD PLACE.

THUS, TO DETERMINE THE NATURE OF GOODWILL IN

A PARTICULAR CASE, IT IS NECESSARY TO CONSIDER
THE TYPE OF BUSINESS AND THE TYPE OF
CUSTOMERS WHICH SUCH A BUSINESS IS
INHERENTLY LIKELY TO ATTRACT AS WELL AS
SURROUNDING CIRCUMSTANCES OF EACH CASE.

 Goodwill

is sometimes described as a
momentum or a push that keeps the business
going without further effort like the momentum
of a body that continues its motion against a
retarding force till it comes to rest gradually.
When a man pays for goodwill, he pays for
something which places him in the position of
being able to earn more than he would be able
to do by his own unaided efforts.
Goodwill is thus present value of a firms
anticipated super normal earnings. The term
super normal earnings, means the excess of
earnings attributable to operating tangible and
intangible assets over the normal rate of
return.

 ACCORDING

TO KOHLER: Goodwill is
the current value of expected future
income in excess of a normal return on
investment in net tangible assets.
Whatever be the nature of
goodwill, one thing is definite about it.
It is treated as an intangible asset in
accounts. One of the basic
characteristic features of assets is that
they help in earning profit for the
business. As a result, every asset is
said to have productivity. Thus,
goodwill is, like any other asset, a store
of prospective revenue.

FEATURES OF GOODWILL
A.

B.

C.
D.

E.

Goodwill can be sold only with the entire business or it

cannot be sold in part or in isolation except on
admission or retirement of a partner when new partner
compensate the old partners or the retiring partner
gives up his rights in favour of remaining partners.
Goodwill is valuable only if it is capable of being
transferred from one person to another. If it cannot be
transferred then there will be no value of goodwill.
Goodwill represents a non-physical value over and
above the physical assets.
Goodwill cannot have an exact cost as its value
fluctuates from time to time due to internal or external
factors which ultimately affect the fortune of the
company.
The value of goodwill is based on subjective judgement
of the valuer.

TYPES OF GOODWILL
PURCHASED

GOODWILL: It arises only

when a business enterprise is acquired by

another business enterprise and the price
paid is more than the net assets acquired.

THE MAIN FEATURES OF SUCH GOODWILL

ARE:
It arises only on purchase of business.
It is reflected by purchase transaction.
Its cost could depend upon the future
maintainable profits.
It can be shown in the balance sheet.

 NON-PURCHASED

GOODWILL: It arises

only when a business generates its own

goodwill over a period of time due to various
factors such as location,good
management,sales policies etc.
THE MAIN FEATURES OF SUCH GOODWILL
ARE:
It is internally generated.
No cost can be placed on it.
Value of goodwill is based on the subjective
judgement of the valuer.
It is not reflected by purchase consideration.
It is not shown in the balance sheet.

CLASSES OF GOODWILL
According to rowland, there are four principal
classes of goodwill,viz.,

Local, arising from the situation of traders premises

e.g., a retail shopkeeper in a busy market centre ;

The personal reputation, of the individual, arising

through his skill,influence and personality, as in the
case of professional man.

The reputation of the goods sold, arising from

the high standard of quality of the goods sold
themselves.

The absence of competition, or the existence of

an absolute or partial monoply.

RECORDING OF GOODWILL
The following are the circumstances
when goodwill is valued and recorded:
i.

ii.

a)

In case of partnership where there is a

change in the profit sharing ratio on
admission, death and retirement of a partner
or when two firms are amalgamated, the
value of goodwill is to be calculated.
In case of a joint stock company, the need for
valuation of goodwill may arise in the
following cases:
When the business of the company is to be
sold to another company or when the
company is to be amalgamated with another
company.

RECORDING OF GOODWILL
b)

c)

d)
e)
f)

When the stock exchange quotations not

being available, shares have to be valued for
taxation purposes-gift tax, etc.
When a large block of shares has to be
bought and sold as to enable the buyer to
exercise control over the company concerned.
When the company has previously written off
goodwill and wants to write it back.
When the company is being taken over by
another company.
Goodwill is frequently to be brought into
account upon consolidation of the assets and
liabilities of a holding company and its
subsidiaries.

FACTORS TO BE CONSIDERED IN THE

VALUATION OF GOODWILL

The most important consideration is earning

capacity of the business. Earning capacity of the
business depends upon the following factors :

Nature of goods.
Monopolised business.
Trade name.
Risk involved.
Favourable location and site.
Possession of trademarks, patents and copyrights.
Skill to management.
Future competition.
Profit trends.
Money market conditions.
Capital required.

Goodwill can be said to have value only when it

can be transferred for valuable considerations .
Thus, personal knowledge and skill as possessed
by a doctor cannot be transferred and sold and
goodwill of such a person made up wholly of
such a factor will have no commercial value.
A prospective buyer of a business will be very
much concerned with the possible future
taxation liability. Buyer of the goodwill expects to
recoup what he has paid for goodwill out of the
future profits. The future profits are likely to be
reduced materially by taxation and the buyer will
not be ready to pay any large amount for
goodwill, other things being equal.

METHODS OF VALUING GOODWILL

By

an arbitrary assessment.
By capitalisation of expected net profits
or earnings (or capitalisation method).
By certain number of years purchase of
past average profits or earnings.
By super profits or earnings. This
includes:
purchase of super profit.
Annuity method.
Capitalisation of super profit method.

a)
b)

c)

Arbitrary assessment: This method can be

used only when information relating to earning

capacity is available. If this information is not
available because of non-availability of the profit
immediately prior to sale or if the profits are
abnormal or unreliable then such profits cannot
be used as a guide to super profits.
Capitalisation method: The following are the
main steps to be taken in computing goodwill by
this method:Ascertain the average net profit which it is
expected will be earned in future;
Capitalise this net profit at the rate which is
considered a suitable return on capital invested
in a business of the type under consideration;
Find the value of the net tangible assets used in
the business, i.e., assets less outside liabilities.
(here outside liabilities will also include
preference capital) and

d) Deduct the net tangible assets as per (c) from the

capitalised profit obtained in (b) and the difference is

goodwill.
While making an estimate of future maintainable
profit on the basis of past profits, the following points
are kept in mind:
Interest on debentures and depreciation on all fixed
assets and non-trading investments should be
excluded.
Provision for taxation should be made.
Preference dividend should be deducted.
If the profits of the past 4 or 5 years have been
increasing or decreasing in a significant manner, it
will be better to give more importance to the profits
of the last year and least importance to the profits of
the first year. This can be taken care of by taking
weighted average profit by assigning weights as
1,2,3,4 and 5 to the profits of 1st year, 2nd year, 3rd
year, 4th year and 5th year respectively. This practice
is not to be followed if there is consistent decline of
profits.

ILLUSTRATION 1

a)

b)

A company desirous of selling its business to another company

has earned an average profit in the past of Rs.1,50,000 per
annum. It is considered that such average profit fairly
represents the profit likely to be earned, in the future, except
that:
Directors fees Rs.10,000 charged against such profit will not
be payable by the purchasing company whose existing board
can easily cope with the additional administrative work at
present fees payable to the directors.
Rent at Rs.20,000 p.a. which had been paid by the vendor
company will not be charge in the future, since the purchasing
company owns its own premises and can supply the
accommodation necessary for the staff and the equipment of
the vendor company.
The value of the net tangible assets of the vendor
company at the proposed date of the sale was Rs.15,00,000
and it was considered that a reasonable return on capital
invested, for this type of commodity, was 10%.

ILLUSTRATION 1
The profit of the vendor company would in no way be affected by
the sale of its business to the purchasing company and goodwill
existed and was to be paid for on the basis that the vendor
company was a continuing enterprise. Calculate the value of
goodwill by capitalisation of expected future net profits.
SOLUTION:
CALCULATION OF VALUE OF GOODWILL
Average net profit
Add: Non-recurring charges for:
Directors fees
10,000
Rent
20,000
Estimated future maintainable profit
Future profit capitalised at 10% i.e., Rs.1,80,000*100
10
Capitalised profit
Less: Net tangible assets

1,50,000
Rs.
30,000
1,80,000
18,00,000
18,00,000
15,00,000
3,00,000

ILLUSTRATION 2
Ascertain the value of goodwill of P.Co. Ltd. Carrying
on business as retail traders from the following
information according to capitalisation method:
BALANCE SHEET
as on 31st December, 2007
Liabilities
Paid-up capital:
2,500 Shares of
Rs.100 each
Profit and loss
account
Bank Overdraft
Sundry Creditors
Provision for Taxation

Rs.

Assets

Goodwill
2,50,00 Land and Building at cost
0
Plant and Machinery at
cost less Depreciation
56,650 Stock at cost
58,350 Book Debts less Provision
for Doubtful Debts
90,500
19,500
4,75,00

Rs.
25,000
1,10,00
0
1,00,00
0
1,50,00
0

The company commenced operations in 2003

with a paid up capital as aforesaid of
Rs.2,50,000. The profits earned, before
providing for taxation, have been as:
2003 Rs.61,000 ; 2004 Rs.64,000 ; 2005
Rs.71,500 ; 2006 Rs.78,000 and 2007
Rs.85,000.
You may assume that income-tax at the
rate of 50% has been payable on these profits.
The average dividend paid by the
company for the four years is 10% which is
taken as reasonable return expected on the
capital invested in the business.

SOLUTION

Profit for 5 years(Rs.61,000+Rs.64,000+Rs.71,500+Rs.78,000+

Rs.85,000) =
3,59,500
Less: 50% income-tax
1,79,750
1,79,750
Average profit (Rs. 1,79,750 /5)
35,950
Future profits capitalised at 10%= Rs.35,950*100
10
3,59,500
Total Assets
= Rs. 4,75,000
Less: Goodwill
Rs. 25,000
Less: Liabilities
(Rs.58,350+ Rs.90,500+
Rs.19,500)
Rs. 1,68,350
Rs. 1,93,350
Net Tangible Assets
Rs. 2,81,650
Capitalised Profit
3,59,500
Less: Net Tangible Assets
2,81,650
Goodwill
77,850