Goodwill

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Good will definition:
An account that can be found in the assets portion of a company's balance sheet. Goodwill can often arise when one company is purchased by another company. In an acquisition, the amount paid for the company over book value usually accounts for the target firm's intangible assets. Goodwill is seen as an intangible asset on the balance sheet because it is not a physical asset like buildings or equipment. Goodwill typically reflects the value of intangible assets such as a strong brand name, good customer relations, good employee relations and any patents or proprietary technology. Method:

There are three methods of valuation of goodwill of the firm; 1. Average Profits Method
2. Super Profits Method
3. Capitalisation Method
1. Average Profits Method:
This method of goodwill valuation takes the average profit of previous years as its basis. This average profit is multiplied by the number of purchases made in that year.

Goodwill = Average Profit x Number of Purchases in the year

Before calculating the average profits the following adjustments should be made in the profits of the firm: a. Any abnormal profits should be deducted from the net profits of that year. b. Any abnormal loss should be added back to the net profits of that year. c. Non-operating incomes eg. Income from investments etc should be deducted from the net profits of that year. Example:

An Ltd agreed to buy the business of B Ltd.  For that purpose Goodwill is to be valued at three years purchase of Average Profits of last five years. The profits of B Ltd. for the last five years are: Year|  Profit/Loss ($)|

2005          | 10,000,000|
2006| 12,250,000|
2007| 7,450,000|
2008| 2,450,000 (Loss)|
2009| 12,400,000|
Following additional information is available:
1. In the year 2008 the company suffered a loss of $1,000,500 due to fire in the factory. 2. In the year 2009 the company earned an income from investments outside the business $ 4,500,250. Solution:

Total profits earned in the past five years= 10,000,000 + 12,250,000 + 7,450,000 - 2,450,000 + 12,400,000 = $ 39,650,000 Total Profits after adjustments = $ 39,650,000 + $ 1,000,500 - $ 4,500,250=$ 36,150,250 Average Profits= $ 36,150,250÷5=$ 7,230,050

Goodwill = $ 7,230,050×3=$ 21,690,150
Thus A Ltd would pay $ 21,690,150 as the price of Goodwill  earned by B Ltd.

2. Super profits method:
Super profit refers to a situation where in the actual profit is higher than what is expected. Under this method,

Goodwill = super profit x number of years’ purchase
Steps for calculating Goodwill under this method are given below: i) Normal Profits = Capital Invested X Normal rate of return/100 ii) Super Profits = Actual Profits - Normal Profits
iii) Goodwill = Super Profits x No. of years purchased
For example, the capital employed as shown by the books of ABC Ltd is $ 50,000,000. And the normal rate of return is 10 %.  Goodwill is to be calculated on the basis of 3 years purchase of super profits of the last four years. Profits for the last four years are:

Year|  Profit/Loss ($)|
2005          | 10,000,000|
2006| 12,250,000|
2007| 7,450,000|
2008| 5,400,000|
Total profits for the last four years = 10,000,000 + 12,250,000 + 7,450,000 + 5,400,000 = $35,100,000 Average Profits = 35,100,000 / 4 = $ 8,775,000
Normal Profits = 50,000,000 X 10/100 = $ 5,000,000
Super Profits = Average/ Actual Profits − Normal Profits = 8,775,000 − 5,000,000 = $ 3,775,000 Goodwill = 3,775,000 × 3 = $ 11,325,000

3. Capitalisation Method:
There are two ways of calculating Goodwill under this method: (i) Capitalisation of Average Profits Method
(ii) Capitalisation of Super Profits Method
(i) Capitalisation of Average Profits Method:
As per this method,

Goodwill = Capitalized Value the firm - Net Assets Capitalized

Value of the firm = Average Profit x 100/ Normal Rate of Return

Net Assets = Total Assets - External Liabilities
For example...
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