Valuation of Goodwill Class 12th
Introduction
Goodwill represents a significant intangible asset, capturing the value from a company’s established brand, loyal customer base, and potential for higher-than-average future earnings. Putting a price on goodwill is especially important when a business is being transferred, there are structural changes among partners, a merger takes place, or other major transitions occur. While goodwill cannot be physically touched, it plays a large role in assessing a company’s total value.
Methods of Valuation of Goodwill
There are three widely accepted techniques to estimate the monetary value of goodwill:
- Method Based on Average Profits
- Method Based on Surplus Earnings
- Method Based on Capitalisation
Let’s look at each approach:
1. Method Based on Average Profits
This technique calculates goodwill by averaging the business’s profits over several accounting periods. It is most suitable when profits are steady and future earnings are expected to follow historical trends.
Variations:
- Simple Average: The profits from the chosen previous years are summed and divided by the number of years, then this mean figure is multiplied by an agreed number of years.
- Weighted Average: More recent profits are assigned greater value (weighting) if recent performance is thought to be more indicative of the future.
Calculation Formula
Goodwill = Typical (or Weighted Typical) Profit × Agreed Years
Steps:
- Collect annual profits for the relevant period.
- Adjust these figures for unusual or exceptional items, such as one-off gains/losses or errors.
- Calculate either the simple or weighted average.
- Multiply the average profit by the selected number of years (usually decided by industry standards or negotiation).
Weighted Average Example:
| Year Ended | Profit (₹) | Weight | Weighted Profit (₹) |
|---|---|---|---|
| 31st March, 2018 | 40,000 | 1 | 40,000 |
| 31st March, 2019 | 48,000 | 2 | 96,000 |
| 31st March, 2020 | 60,000 | 3 | 180,000 |
| 31st March, 2021 | 50,000 | 4 | 200,000 |
| 31st March, 2022 | 36,000 | 5 | 180,000 |
| Total | 15 | 696,000 |
Weighted Average Profit = ₹696,000 ÷ 15 = ₹46,400
2. Method Based on Surplus Earnings
In this method, one determines the amount by which the business’s actual or average earnings surpass the normal or expected return for that amount of capital in a comparable enterprise.
Surplus Earnings = Usual Profit – Expected Profit
Goodwill = Surplus Earnings × Number of Years (for goodwill calculation)
Where:
- Usual Profit: The average annual profit calculated as described above.
- Expected Profit: The profit that would ordinarily be earned by investing the same amount of capital at the standard industry rate of return.
This approach highlights the business’s capability to generate profits above what is typical for its industry and invested resources.
3. Method Based on Capitalisation
This strategy works by calculating what the total worth of the business should be based on its ability to generate recurring profits, then comparing that value to the net value of its tangible assets.
Two Approaches:
- Capitalisation of Normal Earnings
- Capitalisation of Surplus Earnings
(i) Capitalisation of Normal Earnings
Overall Value of the Firm = (Normal Profit × 100) / Typical Rate of Return
Goodwill = Overall Firm Value – Net Tangible Worth
Here, Net Tangible Worth is determined by taking all company assets (excluding goodwill and any fictitious or non-real assets) and subtracting all external obligations.
(ii) Capitalisation of Surplus Earnings
Goodwill = (Surplus Earnings × 100) / Usual Rate of Return
This technique is particularly appropriate when profits are volatile or when unusually high profits occur.
Key Concepts and Adjustments
- Expected Profit: The level of income a similar business would earn from the same capital investment.
- Net Tangible Worth (Capital Employed): The collective value of assets (excluding non-substantial or illusory items and goodwill itself) after deducting external debts and obligations.
- Years of Purchase: The period over which the extra profits are anticipated to last, usually set by industry practice or mutual agreement among the parties involved.
- Profit Adjustments: It is essential to amend profit numbers by eliminating exceptional, non-recurring, or incorrectly treated income and expenses to reflect a realistic periodic earning.
Difference Between Average Profit and Surplus Earnings Methods
| Point of Comparison | Average Profits Method | Surplus Earnings Method |
|---|---|---|
| Definition | Uses ordinary profits from several past periods | Focuses on income in excess of regular return |
| Industry Return Rate | No consideration of standard return rates | Standard/benchmark return rate is included |
| Capital Invested | Not part of the calculation process | Amount of capital invested is essential |
| Usefulness | For straightforward profit-based calculations | For scenarios with above-average performance |
Valuation of Goodwill Class 12th
Conclusion
Assessing goodwill is vital for ensuring fair outcomes when organizations change ownership, welcome or lose partners, or undergo major restructuring. The selection of the most appropriate valuation method—based on average earnings, surplus earnings, or capitalisation—depends on the financial patterns of the business and the mutual consent of interested parties. Accurate estimation calls for careful adjustment of profits and thoughtful selection of the relevant calculation period for surplus returns.