ACCOUNTANCY

Valuation of Goodwill

Part 1: Meaning, Nature, Factors, and the Average Profit Method (Comprehensive Study)

1. Concept and Meaning of Goodwill

In simple terms, Goodwill is the benefit and advantage of the good name, reputation, and connection of a business. It is the attractive force which brings in customers. From an accounting perspective, it is an intangible asset that enables a firm to earn higher profits (Super Profits) than the normal profits earned by other firms in the same industry.

Key Definition: Goodwill is the present value of expected future profits that are in excess of the normal return on the investment in the relevant assets of the business. It is recorded in the books only when consideration in money is paid for it (Purchased Goodwill).

2. Nature of Goodwill

Understanding the nature of goodwill is essential for proper valuation. It possesses the following characteristics:

• It is an Intangible Asset: It cannot be seen or felt, yet it is not a fictitious asset because it has a saleable value.
• Valuation Subjectivity: Its value depends on the subjective judgment of the valuer, though various mathematical methods are used to bring consistency.
• Fluctuating Value: The value of goodwill is never constant; it changes with the change in the profitability and reputation of the business.
• Realization: It can generally only be realized (sold) when the entire business is sold as a going concern.

3. Factors Affecting the Valuation of Goodwill

The value of goodwill is influenced by several critical factors that determine the "profit-earning capacity" of the firm:

1. Nature of Business: A business producing high-demand, stable products will have higher goodwill.
2. Location: A centrally located shop attracts more customers, leading to higher turnover and goodwill value.
3. Efficiency of Management: Competent management reduces costs and increases productivity, thereby boosting profits.
4. Market Condition: Monopoly rights or limited competition allow for higher profit margins, increasing goodwill.
5. Access to Supplies: If a firm has a steady and cheap source of raw materials, its profit potential is higher.
6. Quality: Consistent quality builds brand loyalty, which is the backbone of goodwill.

4. Need for Valuation

In partnership accounting, the valuation of goodwill becomes mandatory during structural changes:

• Change in Profit Sharing Ratio (PSR) among existing partners.
• Admission of a new partner.
• Retirement or death of a partner.
• Dissolution or Sale of the business.

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5. Method 1: Average Profit Method

This is the simplest and most commonly used method of valuing goodwill. It is based on the assumption that a new business will take some time to settle down and, during that period, it will enjoy the profits earned by the previous owner. Therefore, goodwill is calculated by multiplying the average past profits by a certain number of "years' purchase."

The Formulas

Average Profit = Total Profits of Past Years / Number of Years (Note: Exclude abnormal losses and gains before calculating average)

Value of Goodwill = Average Profit × Number of Years' Purchase (Years' Purchase refers to the number of years for which the firm is likely to earn the same amount of profit)

Steps to Calculate Adjusted Profits

Before applying the formula, the past profits must be adjusted for "Abnormal" items to reflect the true operating capacity of the business:

• Add: Abnormal losses (like loss by fire, theft), non-recurring expenses, and capital expenditure wrongly treated as revenue.
• Less: Abnormal gains (like profit on sale of fixed assets), non-recurring income, and income from non-trade investments.

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Numerical Demonstrations

Numerical 1: Simple Average Profit (Easy)

Question: The profits of a firm for the last 4 years were: 2020: ₹ 40,000; 2021: ₹ 50,000; 2022: ₹ 60,000; 2023: ₹ 50,000. Calculate the value of goodwill on the basis of 3 years' purchase of the average profit.

Solution:

1. Total Profit = 40,000 + 50,000 + 60,000 + 50,000 = ₹ 2,00,000
2. Average Profit = 2,00,000 / 4 = ₹ 50,000
3. Value of Goodwill = Average Profit × No. of Years' Purchase
    Goodwill = 50,000 × 3 = ₹ 1,50,000

Numerical 2: Adjusted Average Profit (Difficult)

Question: Calculate goodwill of a firm on the basis of 2 years' purchase of average profit of last 3 years. The profits were:
• 2021: ₹ 1,00,000 (including an abnormal gain of ₹ 10,000)
• 2022: ₹ 80,000 (after charging an abnormal loss of ₹ 20,000)
• 2023: ₹ 1,10,000 (excluding ₹ 10,000 as insurance premium on firm's property now to be insured).

Solution:

Year	Profit (₹)	Adjustments	Adjusted Profit (₹)
2021	1,00,000	(-) 10,000 (Abnormal Gain)	90,000
2022	80,000	(+) 20,000 (Abnormal Loss)	1,00,000
2023	1,10,000	(-) 10,000 (Recurring Expense)	1,00,000
Total Adjusted Profit			2,90,000

1. Average Adjusted Profit = 2,90,000 / 3 = ₹ 96,667 (approx)
2. Value of Goodwill = 96,667 × 2 = ₹ 1,93,334

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Advanced Technical Demonstration: Adjusted Average Profit

In high-level professional examinations, "Profit" is rarely given in its pure form. We must find the Future Maintainable Profit (FMP) using the logic below:

Adjusted Profit = Reported Profit + Abnormal Losses + Capital Exp. treated as Revenue - Abnormal Gains - Revenue Exp. treated as Capital - Non-Trade Income

Numerical 3: The "Master Problem" (Difficulty: Very High)

The profits of M/s High-Tech Solutions for the last four years ending 31st March were: 2021: ₹1,80,000; 2022: ₹1,60,000; 2023: ₹2,50,000; 2024: ₹2,20,000.

Additional Adjustments:

1. Stock Valuation: Closing Stock for 2022 was overvalued by ₹ 20,000.
2. Capital Error: On 1st April 2022, a Computer costing ₹ 50,000 was debited to Office Expenses. Dep. @ 20% p.a. (WDV).
3. Machinery Sale Error: On 1st Oct 2023, Machinery (BV ₹ 40,000) was sold for ₹ 55,000. Proceeds wrongly credited to Sales Account. Dep. on Mach. is 10% p.a.
4. Non-Trade Item: 2021 profits included ₹ 10,000 income from Non-Trade Investments.
5. Abnormal Item: 2023 profits reduced by a Loss by Fire of ₹ 30,000.
6. Management Cost: Annual charge of ₹ 20,000 to be made.

Calculate Goodwill on the basis of 3 years' purchase of the Average Profit.

Detailed Solution & Adjustment Table:

Particulars	2021 (₹)	2022 (₹)	2023 (₹)	2024 (₹)
Reported Profits	1,80,000	1,60,000	2,50,000	2,20,000
(-) Non-Trade Income (2021)	(10,000)	-	-	-
(-) Overvaluation of Closing Stock (2022)	-	(20,000)	-	-
(+) Overvaluation of Opening Stock (2023 impact)	-	-	+20,000	-
(+) Computer purchased treated as Expense	-	+50,000	-	-
(-) Dep. on Computer (20% WDV)	-	(10,000)	(8,000)	(6,400)
(+) Loss by Fire (Abnormal Loss)	-	-	+30,000	-
(-) Sale of Machinery wrongly in Sales	-	-	(55,000)	-
(+) Profit on sale of Mach. (Abnormal Gain)	-	-	(15,000)	-
(+) Dep. not charged on Mach. sold (6 months)	-	-	+2,000	-
Adjusted Business Profit	1,70,000	1,80,000	2,24,000	2,13,600

Critical Concept Check:

• Stock Adjustment: Overvalued Closing Stock (2022) is subtracted. Since it becomes 2023's Opening Stock, it must be added back to 2023.
• The Machinery Sale: We remove the ₹55,000 from sales and also remove the actual profit (₹15,000) from the machine sale. We add back the 6-month depreciation (₹2,000) to rectify the operating profit.
• WDV Depreciation: Computer depreciation reduces annually: 1st yr (50k * 20% = 10k), 2nd yr (40k * 20% = 8k), 3rd yr (32k * 20% = 6.4k).

Final Calculation:

1. Total Adjusted Profit: ₹ 7,87,600
2. Average Annual Profit: ₹ 1,96,900
3. Avg Profit after Management Cost: 1,96,900 - 20,000 = ₹ 1,76,900
4. Goodwill (3 Yrs Purchase): 1,76,900 × 3 = ₹ 5,30,700

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