what is the need for the valuation of goodwill?

The valuation of the Goodwill of a sole proprietorship is done when the business is being sold, but in case of a partnership firm and a joint stock company goodwill can be sold to some another business entity without selling the whole business. Hence when you are going to sell the goodwill of your business, you should be assured of the value of your goodwill at that particular time.

In case of a Partnership firm, there is a need for the valuation of Goodwill of the Firm in the following cases:

1) In the case of a change in the profit sharing ratio of the firm;

2) In case of admission of a new partner;

3) In case of retirement or death of an old partner;

4) In case of Sale / amalgamation of the firm.

In case of a Joint Stock Company, Goodwill is valued in the following circumstances:

1) In case of amalgamation of two or more companies;

2) In case of taking over of business of a company by another company;

3) In case of taking over the business of the company by Government;

4) In case of conversion of shares of one class into another;

5) If a company wants to acquire conrol of another company;

6) In case of valuation of shares of the company for taxation purposes, if stock exchange quotations are not available.

Methods of Valuation of Goodwill – Weighted Average Profit Method

Weighted Average Profit Method

The Weighted Average Profit Method is an improvement over Simple average Profit Method. Under this method Weights are assigned to each year’s profit.For calculating Goodwill, the Profits of each year are multiplied with the respective weight assigned to that particular year. Usually more weightage is assigned to recent years. The product of the profits with weights is added. This sum of products is then divided by the total number of weights. This method is suitable in case of a rising trend of profits.

Formula: Weighted Average Profit = Sum of Weighted profits / Sum of weights

Value of Goodwill = Weighted Average Profits × No. of Years’ Purchase

Number of Years’ Purchase

What is number of years’ purchase?

Quite frequently, when we are going to evaluate the Goodwill of a company, we come across the term , ‘ Number of years purchase’.

What is this ‘ number of years purchase’ and why do we take this into account while calculating Goodwill of an enterprise?

The answer to this question is very simple.

As we all know, establishing a new business and purchasing an established business are quite different phenomenons. When we start a new business, a lot of hard work is required to bring this business at par with other competitors in the industry. In the initial years, sometimes, many losses are suffered and many priliminary expenses are incurred. The business does not start reaping profits in the beginning itself. A lot of extra efforts and patience is required for a business to start showing results.

When somebody purchases the Goodwill of an established enterprise, he is going to get the benefits of the hardwork of the seller of the Goodwill that he has done to establish the business and bring it to the level where it now stands. Hence he compensates the seller for his hard work and efforts that he has put in the business to establish it. For this he pays an amount equal to a few years of the future profits he would be getting because of the existing reputation of the business largely due to seller’s past effrots.

The number of year’s purchase indicates the time required by the new business to come at a level equal to the old settled business. And the selection of the number of years is based purely on an estimate or the trend of the industry concerned. For example, A purchases B’s business and he estimates that had he started a new business it would have taken him around 3 years to start earning a profit of $ 10 million p.a. But since he has purchased B’s business he will be able to earn this profit right from the beginning and that is due to B’s past hard work. Hence in order to compensate B for this he pay a lumpsum of $ 30 millions(i.e. the equivalent profits of the 3 years) to B at the time of purchase as the price for Goodwill.

Method of Valuation of Goodwill By Simple Average Profits Method

Simple Average Profit method is the simplest method for the calculation of the Goodwill of a concern.

The formula:

Goodwill = Average Future Maintainable Profits X No. of years’ purchase

Steps:

1. Calculate Average Future Maintainable Profits of the given number of past years.

2. Multiply the Average Future Maintainable Profits with the number of years’ purchase.

Example:

Alpha Ltd. acquire the business of Beta Ltd. Goodwill for this purpose is to valued on 4 years’ purchase of average of previous 5 years’ adjusted profits. The profits for the last 5 years from 2006 to 2010 were as follow: $ 4 million; $ 3.7 million; $ 5.2 million; $ 4.64 million; $ 5.8 million subject to the follwing adjustments.

a) The closing stock for the year 2006 was overvalued by $ 15000.

b) In 2007, expenditure on a major repair work to plant and machinery for $ 250000 was charged to revenue

Solution:

Calculation of Adjusted Profits

Total profits for the last five years ( 4+3.7+5.2+4.64+5.8 ) 23,340,000

Add: overvaluing of opening stock for 2007 15,000

Add: Expenditure on plant wrongly debited to Profit and Loss Account in 2007 250,000

____________

23,605,000

Less: overvaluing of closing stock for 2006 15,000

____________

Total adjusted Profits for five years 23,590,000

Average Adjusted Profits =23,590,000 / 5 = 4,718,000

Goodwill = Number of years’ purchase X Adjusted Profits

= 4 X 4,718,000 = $ 1,887,2000

Impairment of Goodwill

What is impairment Loss?

Some times it is realised that some assets do not have as mush recoverable value in the market as they are shown in the balance sheet of an enterprise. e.g. goodwill of an enterprise may be shown in the balancesheet worth 10 million dollors, but you actually sell it in the market its recoverable value is only 7 million dollars. The value at which the asset is shown in the balance sheet is called its carrying amount and the price at which it can be sold in the market is called its recoverable value. The excess of the carrying amount of the asset over its recoverable value is called impairment loss. Thus in the example above 3 millin dollars is the impairment loss .

Provision for Impairment loss …

Its a matter of prudence not to show an asset above its recoverable amount in the balancesheet. At the time of acquistion of Goodwill the acquirer makes a payment for purchasing the Goodwill in anticipation of its future benefits. But the recoverable amount of goodwill in the market is difficult to determine as Goodwill does not generate cash flows on its own, independently of other assets. This gives rise to impairment loss and if there is any indication of this loss a provision has to be made for this.