Goodwill is an intangible asset that represents the value of the reputation of a business earned by a firm over time through the quality of its products, efficient management, loyal customers, and favourable location. It is the premium that an incoming buyer is willing to pay over and above the value of the tangible net assets because the business is expected to earn higher profits in the future. In accounting, goodwill is recognized only when a firm is purchased, a new partner is admitted, a partner retires or dies, or the firm is dissolved.
The nature of goodwill can be explained by comparing it to tangible assets: goodwill has no physical existence, it cannot be seen or touched, yet it has a definite value and can be bought and sold. Goodwill is not an independent asset; it cannot be sold separately from the business as a whole. The value of goodwill fluctuates with the earning capacity of the firm, so it must be revalued whenever there is a change in the profit sharing ratio of the partners.
Since goodwill represents the excess earning power of a business, its valuation is usually based on the profits that the firm has earned or is expected to earn. Different methods are available for valuing goodwill, and the choice of method depends on the facts of the case and the agreement of the partners. The most common methods are the Average Profit Method, the Super Profit Method, and the Capitalization Method.
The value of goodwill is influenced by several factors which may be internal or external to the business. Key factors include:
Under this method, goodwill is valued on the basis of the average of past profits multiplied by a certain number of years' purchase. The number of years is chosen with reference to the expected future profits. While computing the average profit, abnormal items must be adjusted.
$$\text{Goodwill} = \text{Average Profit} \times \text{Years of Purchase}$$
If the past profits show an increasing or decreasing trend, a weighted average is preferred. Under the weighted average method, weights are assigned to profits of recent years, with the latest year given the highest weight:
$$\text{Weighted Average Profit} = \frac{\sum (\text{Profit} \times \text{Weight})}{\sum \text{Weight}}$$
Super profit is the excess of actual profit over normal profit. Normal profit is the profit that a firm of similar size in the same industry would normally earn on the capital employed.
$$\text{Normal Profit} = \text{Capital Employed} \times \frac{\text{Normal Rate of Return}}{100}$$
$$\text{Super Profit} = \text{Average Actual Profit} - \text{Normal Profit}$$
$$\text{Goodwill} = \text{Super Profit} \times \text{Number of Years of Purchase}$$
Capital employed is usually computed as:
$$\text{Capital Employed} = \text{Total Assets} - \text{Outside Liabilities}$$
Alternatively, Capital Employed = Partners' Capital + Reserves + Accumulated Profits - Fictitious Assets - Goodwill already in the books.
Under this method, goodwill is computed in two ways: capitalization of average profit and capitalization of super profit.
$$\text{Capitalized Value of Business} = \frac{\text{Average Profit}}{\text{Normal Rate of Return}} \times 100$$
$$\text{Goodwill} = \text{Capitalized Value of Business} - \text{Net Assets}$$
$$\text{Goodwill} = \frac{\text{Super Profit}}{\text{Normal Rate of Return}} \times 100$$
Certain items must be adjusted while computing average profit so that the profit figure reflects the true earning capacity:
If an asset has been purchased from the profits, the capital employed must be adjusted accordingly, and if a liability or a charge exists, it is treated suitably while computing normal profit and capital employed.
When the firm already shows goodwill in its books and the partners change, the existing goodwill is written off among the old partners in their old profit sharing ratio before a new value is brought in. If a partner brings in premium for goodwill, the amount is credited to the old partners' capital accounts in the sacrificing ratio.
| Method | Formula |
|---|---|
| Average Profit Method | Average Profit x Years of Purchase |
| Weighted Average Profit | Sum(Profit x Weight) / Sum(Weight) |
| Super Profit Method | Super Profit x Years of Purchase |
| Normal Profit | Capital Employed x Normal Rate / 100 |
| Capitalization of Average Profit | (Average Profit / Normal Rate) x 100 - Net Assets |
| Capitalization of Super Profit | (Super Profit / Normal Rate) x 100 |
| Factor that Increases Goodwill | Factor that Decreases Goodwill |
|---|---|
| Favourable location | Poor location |
| Efficient management | Inefficient management |
| Customer loyalty and brand image | High competition |
| Consistent high profits | Fluctuating profits |
| Low business risk | High business risk |
| Item | Treatment |
|---|---|
| Abnormal income (e.g. profit on sale of asset) | Deduct |
| Abnormal loss (e.g. loss by fire) | Add back |
| Non-operating income (e.g. interest on investments) | Deduct |
| Non-recurring expense | Add back |
| Expected future liability | Deduct if likely |
Goodwill is a crucial intangible asset that captures the excess earning capacity of a business. Its valuation is essential whenever there is a change in the ownership structure of a partnership firm. The average profit method values goodwill on the basis of past performance, the super profit method on the basis of excess profits over the normal rate of return, and the capitalization method capitalizes expected earnings. Careful adjustment of abnormal items and correct computation of capital employed are necessary for an accurate valuation. These concepts form the foundation for the admission, retirement, and death of partners, where the incoming or outgoing partner's share of goodwill must be valued and adjusted.