Evaluating Goodwill of a Business: 4 Methods | Accounting

The following are the methods of evaluating goodwill:- 1. Average Profit Method  2. Super Profit Method  3. Capitalisation Method  4. Annuity Method.

Method # 1. Average Profit Method:

Under this method goodwill is valued on the basis of an agreed number of years’ purchase of the average maintainable profits. The maintainable profit indicates the adjusted profit. To get the adjusted profit, the profit for the year has to be adjusted for the abnormal items— exceptional opportunities or exceptional expenses.

When the maintainable free average profit is calculated, the following factors are to be considered:

1. Non-operating profit or loss to be excluded.

2. The loss, if any, in any year to be deducted.

3. Deduct such incomes or special incomes which may not be continued in future.

4. Past special type of expenses, which will not incur in future, are added.

5. Provision may be made for managerial remuneration.

6. Depreciation on fixed assets should be provided.

By making the above additions and deductions in the profit, the average profit is found out. The average profit is multiplied by certain number of years in order to get the value of goodwill. Generally the actual trading profits of the immediately preceding three or four years are accounted for after the adjustment of abnormal items, if any. A simple average is used where the profits are almost uniform but weighted average is employed otherwise.

 

Method # 2. Super Profit Method:

Super profit refers to that average profit which is earned by a business in excess of normal earnings. Really speaking the super profit is the difference between actual average profit and normal profit. That is, the term super profit means the profit over and above the normal profit.

Or

SUPER PROFIT = AVERAGE PROFIT (ADJUSTED) – NORMAL PROFIT

VALUE OF GOODWILL = SUPER PROFIT x YEARS’ PURCHASE

An assumption is made regarding the percentage of profit earned on a certain investment of capital in similar industries. This is considered as the normal expected profit in similar concerns. This normal profit is compared with the actual profit. When the actual profit is more, there will be goodwill. To arrive at the value of goodwill, the super profit is multiplied by the number of years.

Sliding-Scale Valuation of Super Profit:

This method of valuation of goodwill is a slight variation of the purchase of super profit, method. It has been advocated by AE. Cutforth. It is based on the logic that the greater is the amount of super profits, the more difficult it is to maintain it.

Higher profit will naturally attract competition and soon the firm’s ability to make super profits is curtailed. Hence, instead of multiplying the whole super profit by a certain number of years, a grading scale is adopted. According to Cutforth, super profit is divided into two or three divisions. Each of these be multiplied by a different number of year’s purchase, in decreasing order from the first division.

Thus, for example, if super profit is estimated at Rs. 15,000, the goodwill will be calculated as under:

Method # 3. Capitalisation of Profit Method:

There are two methods under this:

(a) Capitalisation of Super Profit:

Under this method, it is estimated as to how much capital will be required to earn super profit at normal rate of profit. This capitalised value of super profit is treated as goodwill.

(b) Capitalisation of Average Profit:

Under this method, the average annual profit is to be ascertained after providing for reasonable management remuneration. This profit should be capitalised at the rate of reasonable return to find out the total value of the business. Now the value of goodwill will be the total value of the business minus its net assets. If, however, the net asset is greater, there will be no goodwill but bad will.

 Method # 4. Annuity Method:

When a business is purchased, goodwill is paid by the purchaser at the time of purchase of business for the super profits of the business, but these super profits are made in future years. Let us take a clear example. Suppose the super profit of a business has been calculated at Rs. 50,000 and it has been considered reasonable that 5 years’ purchase of the super profit approximates the value of goodwill.

The contention behind this is that the purchaser of the business can expect to enjoy super profit of Rs. 50,000 per year for next five years. If this is the contention it is not reasonable that he should pay Rs. 50,000 x 5 = 2, 50,000. He should pay an amount which will give him an annuity of Rs. 50,000 over the next 5 years at the current rate of interest.

In other words, the value of goodwill is the present value of an annuity of the annual super profit payable over an expected number of years at the current rate of interest. This is what is known as the annuity method of valuation of goodwill.

The amount of goodwill under this method can be found out by:

(i) Annuity table or

(ii) Formula.