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.
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 $