Key Points - Goodwill : Nature and Valuation

Meaning of Goodwill:
Goodwill places the organization at a good position due to which the organization is able to earn higher profits without any extra efforts. Goodwill cannot be seen but felt.
Therefore goodwill is called an Intangible asset.

Factors affecting the value of Goodwill :

1. Efficient management

2. Quality of products

3. Location of business

4. Availability of raw material

5. Favorable contracts

Need for valuing goodwill : Whenever the mutual rights of the partners changes then party which makes a sacrifice must be compensated. This basis of compensation is goodwill so we need to calculate goodwill.
Mutual rights change under following circumstances

1. When profit sharing ratio changes

2. On admission of a partner

3. On Retirement or death of a partner

4. When amalganation of two firms taken place.

5. When partnership firm is sold.

Methods of valuation of goodwill :

1.  Average profit method

2. Super profit method

3. Capitalization method

Average Profit Method
The profit earned by a Firm during previous accounting periods on an average basis is called average profit. Goodwill is calculated on the basis of average profit due to future expectations of earning capacity of the firm.
Illustration 1. (Average Profit Method)
Akanksha,Chetna and Dipanshu are partners in a firm sharing profits and losses in the ratio of 3:2:1. They decide to take Jatin into partnership from January 1,2012 for 1/5 share in the future profits. For this purpose , goodwill is to be valued at 2 times the average annual profits of the previous four years. The average profits for the past four years were:

Formula
Average Profit = Total Profits/No. of Years
Goodwill = Average Profit x Number of years of purchase.

Super Profit Method
If a firm earns higher profit in comparison to normal profit (generally earned by other firms of same industry) then the difference is called Super Profit. Goodwill is calculated on the basis of Super profit due to future expectations of learning capacity of the firm.
Super profit = Average profit ­ Normal profit
Normal Profit = Investment (Capital Employed) x Normal Rate of Return/100

Capitalisation Method
In this method capitalized value of the firm is calculated on the basis of normal rate of return. Difference between teh capitalized value and actual capital employed is called goodwill.