Financial Accounting

Methods of Valuation of Goodwill

The following are the methods of valuation of goodwill:-

  • Average maintainable profits method
  • Super profit method
  • Capitalisation method
  • Annuity method
  • Hidden method

Average Maintainable Profit Method

Under this method, average profit means average profits of actual profits of the past three to five years depending upon the nature of business.

The average of actual profits must be adjusted in the light of future events that may affect the future profits so this method is also known as” future maintainable profits”.

Under this method, we can calculate the value of goodwill by multiplying the average future maintainable profits by a certain number of years. The following formula used for calculating the value of goodwill:

1 Steps:- In the first step we have to calculate average maintainable profits of the past few years are as follow-

Average maintainable profits= Total adjusted profits / No. Of years

  1. Step:- Calculate the Value of goodwill by using the following formula-

Goodwill= Average maintainable profits* Number of years purchased.

To calculate the total adjusted profits, the following adjustments should be made in the profits.

  • Any abnormal losses such as strikes, floods, and accidents etc. added back to the past profits.
  • Any abnormal profits should be deducted from past profits.
  • Interest, remuneration, commission etc should be adjusted.
  • The past average profits should be calculated after deducting tax at current rates.

Super Profits Method

Under the super-profits method, the value of goodwill on the basis of super-profits. Super profits are the profits that earned above the normal profits i.e.  Excess the actual profits over the normal profits. For calculating the value of goodwill, the following formula should be followed:-

Super Profits = Actual Profits – Normal Profits

Normal Profits = Capital Invested X Normal rate of return/100

Goodwill = Super Profits x No. of years purchased

Capitalisation Method

under this method, the value of goodwill is calculated by two ways such as-

  • The Capitalisation of Average Profits Method
  • Capitalisation Super Profits Method

The Capitalisation of Average Profit Method

The formula for calculating the value of goodwill under the capitalization of average profits method is as follow-

·         Capitalised Value of Average Profits = Average Profits X (100 / Normal Rate of Return)

  ·         Capital Employed = Assets – Liabilities ·         Goodwill = Capitalised Value of Average Profits – Capital Employed

The Capitalisation of Super Profits

For calculating the value of goodwill, the formula is such as follow-

Goodwill = Super Profits X (100/ Normal Rate of Return)

Example: The adjusted forecast maintainable profit is $40,000, capital employed is $200,000, the normal rate of return is 15%, and the capitalisation rate is 20%.

Here the value of goodwill shall be = [40,000 – (200,000 x 15%)] / 20%

= [40000-30000]/0.20

= $50,000

Annuity Method

Under this method, goodwill is calculated by taking the average of the super profit as the value of an annuity over a certain number of years. The present value of the above annuity discounted at the given rate of interest (normal rate of return is the value of the goodwill. Following is the formula to calculate goodwill under the annuity method:

Goodwill = Super profits per annum x Relevant annuity value

Hidden Goodwill

Under hidden goodwill method, the value of goodwill is calculated on the basis of capital contributed by the partners and their respective share in the firm.

Hidden goodwill method is used in such a case when no particular method of valuation of goodwill or information is provided in the question. The following steps are followed to calculate the value of hidden goodwill:-

First of all, find out the total capital of the firm by using the formula:-

  1. Total capital= New partner capital * Reverse of new partner’s share
  2. Deduct from the total capital, the combined capital of all the partners
  3. Balance is the value of goodwill

In other words, Hidden Goodwill = Sundry Debtors – Outsiders Liabilities

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