An account that can be found in the assets portion of a company’s balance sheet. Goodwill can often arise when one company is purchased by another company. In an acquisition, the amount paid for the company over book value usually accounts for the target firm’s intangible assets. 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.
Method:
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.
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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 $ 4,500,250.
Solution:
Total profits earned in the past five years= 10,000,000 + 12,250,000 + 7,450,000 – 2,450,000 + 12,400,000 = $ 39,650,000 Total Profits after adjustments = $ 39,650,000 + $ 1,000,500 – $ 4,500,250=$ 36,150,250 Average Profits= $ 36,150,250÷5=$ 7,230,050
Goodwill = $ 7,230,050×3=$ 21,690,150
Thus A Ltd would pay $ 21,690,150 as the price of Goodwill earned by B Ltd.
2. Super profits method:
Super profit refers to a situation where in the actual profit is higher than what is expected. Under this method,
Goodwill = super profit x number of years’ purchase
Steps for calculating Goodwill under this method are given below:
i) Normal Profits = Capital Invested X normal rate of return/100
ii) Super Profits = Actual Profits – Normal Profits
iii) Goodwill = Super Profits x No. of years purchased
For example, the capital employed as shown by the books of ABC Ltd is $ 50,000,000. And the normal rate of return is 10 %. Goodwill is to be calculated on the basis of 3 years purchase of super profits of the last four years.
Profits for the last four years are:
Year| Profit/Loss ($)|
2005 | 10,000,000|
2006| 12,250,000|
2007| 7,450,000|
2008| 5,400,000|
Total profits for the last four years = 10,000,000 + 12,250,000 + 7,450,000 +
5,400,000 = $35,100,000 Average Profits = 35,100,000 / 4 = $ 8,775,000
Normal Profits = 50,000,000 X 10/100 = $ 5,000,000
Super Profits = Average/ Actual Profits − Normal Profits = 8,775,000 − 5,000,000 = $ 3,775,000 Goodwill = 3,775,000 × 3 = $ 11,325,000
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3. Capitalisation Method:
There are two ways of calculating Goodwill under this method:
(i) Capitalisation of Average Profits Method
(ii) Capitalisation of Super Profits Method
(i) Capitalisation of Average Profits Method:
As per this method,
Goodwill = Capitalized Value the firm – Net Assets Capitalized
Value of the firm = Average Profit x 100/ Normal Rate of Return
Net Assets = Total Assets – External Liabilities
For example a firm earns $40,000 as its average profits. The normal rate of rteturn is 10%. Total assets of the firm are $1,000,000 and its total external liabilities are $ 500,000. To calculate the amount of goodwill: Total capitalized value of the firm = 40,000 × 100/10 = 400,000 Capital Employed = 1,000,000 − 500,000 = 500,000
Goodwill = 500,000 − 400,000 = 100,000
(ii)Capitalisation of Super Profits:
Under this method, goodwill is calculated as:
Goodwill = Super Profit x 100/Normal Rate of Return
For example ABC Ltd earns a profit of $ 50,000 by employing a capital of $ 200,000, The normal rate of return of a firm is 20%. To calculate Goodwill: Normal Profits = 200,000 × 20/100 =$ 40,000
Super profits = 50,000 − 40,000 = $10,000
Goodwill = 10,000 × 100 / 20 = $50,000
Partial Goodwill Method
In the partial goodwill method, goodwill is calculated as the difference between the purchase consideration paid and the acquirer’s share of the fair value of the net identifiable assets. In partial goodwill method, only the acquirer’s share of the goodwill is recognized. Goodwill under full goodwill method exceeds goodwill under partial goodwill method by the non-controlling interest share of the goodwill. Partial goodwill method is not allowed under US GAAP but it is allowed as an option under IFRS (besides the full goodwill method).
Goodwill under partial goodwill method differs from goodwill under full goodwill method only in situations in which investment by the acquirer is less than 100%.
Example
Let’s follow the same example that we discussed in full goodwill method. Company A acquired 75% shareholding in Company B for $20 million. Book value of net identifiable assets of Company B is $14 million. The fair value of Company B’s asset is the same as their book value except accounts receivables which are impaired by $1 million. Book value of assets is $54 million while book value of liabilities is $40 million.
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The purchase consideration is the cash paid to acquire 75% ownership and it equals $20 million. Fair value of net identifiable assets is $13 million ($54 million book value minus $1 million on account if impairment in accounts receivable minus liabilities of $40 million).
The acquirer’s share of the net identifiable assets equals 75% of $13 million which equals $9.75 million. Goodwill is hence $20 million minus $9.75 which equals $10.25 million. Company A will pass the following journal entry to record the business combination.
Goodwill| $10.25 M| |
Assets| $53 M| |
Liabilities| | $40 M|
Cash| | $20 M|
Non-Controlling Interest| | $3.25 M|
Non-controlling interest is calculated as 25% of fair value of net identifiable assets. It equals $3.25 ($13 million multiplied by 0.25).
It can also be arrived at the balancing figure: (goodwill under full goodwill method + assets acquired − liabilities assumed − cash paid).
Total goodwill under full goodwill method was $13.67 and non-controlling interest was $6.67 million. The difference is non-controlling interest in case of partial goodwill is only because in partial goodwill method the non-controlling interest share of goodwill is not recorded which equals $3.42 million (0.25 of ($26.67 minus $13 million)).
Weighted average profit method
This method of goodwill evaluation can be explained as a modified side of the he average profit method. This method involves the relevant number of weights, i.e. 1, 2, 3, 4 multiples profit of each year so as to find out value product. The total of products is thereafter divided by the total of weights so as to calculate the weighted average profits.
Goodwill = Weighted Average Profits x No. of years Purchase
Weighted Average Profit = Total of Products of Profits/ Total of Weights
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EXAMPLE
The profit of X Ltd. for the last five years and the corresponding weights are as follows.
Calculate the value of goodwill on the basis of 3 years’ purchase of the weighted average profit.
Solution:
Weighted Average Profit = Rs. 21, 30,000 ÷ 15 = Rs. 1, 42,000. Value of Goodwill = 3 years’ purchase of weighted average profit: Rs. 1, 42,000 x 3 = Rs. 4, 26,000
