What is Goodwill in Accounting?
Goodwill in accounting is something which places an organisation at an advantageous position due to which enables the organisation to earn profit without putting extra efforts. These efforts are made in the past but the benefit is either reaped today or in the upcoming future. For example, if organisation is providing quality services to its customers, the customers will be satisfied from the service quality. This brings them back to the organisation. This will result in higher sales and ultimately it leads to higher profits.
“Goodwill is the present value of the expected future income that the company going to earn due to some advantageous position.”
According to Dicksee “When a man pays for goodwill, he pays for something which places him in the position of being able to earn more than he would be able to do by his own unaided efforts.”
Characteristics of Goodwill
The characteristics of goodwill are as follows –
- An intangible asset which is not a fictitious asset.
- It does not have any separate existence without that of an organisation.
- The value depends upon the judgement of the valuer.
- Helps in earning higher profits.
- It persuades customers and bring them back to the organisation.
- Its existence depends upon location, market reputation, etc of the organisation.
Methods of Valuation of Goodwill
The method for valuation of goodwill in accounting are as follows –
- Average Profits Method
- Super Profit Method
- Capitalization Method
1. Average profits Method
Under this method, the normal profit earned by business is useful in calculating the Goodwill. There is calculation of profits for the specific years and then calculation of average profit takes place.
Steps to calculate Goodwill under this method –
- Calculate the normal profits of a business for each year. For calculating profit, subtract losses from gains and incomes.
- Now calculate average profits.
- Calculate goodwill using this formula – Average Profit × Number of years purchase
Weighted Average Profit Method
This is another method for doing the valuation of goodwill in accounting.Under this method, calculate the product of each years’s profit and number of assigned weights.
Weighted Average Profits = Total Products of Profits/ Total of Weights
Goodwill = Weighted Average Profits × Number of years purchase
2. Super Profit Method
The excess of actual profits over normal profit is known as super natural profits. Capital employed in a business brings profits. The only difference is some brings more profits and some less.
For calculating goodwill under this method, follow the below steps –
- Calculate average profits for the years.
- Compute Capital Employed which is (Opening Capital Employed + Closing Capital Employed)/2
- Calculate normal profits on average capital employed as follows –
Average Capital Employed × (Normal Rate of Return/100)
- Now calculate super profits which is, actual average profits – normal profits
- Now Compute Goodwill with the help of below given formula –
Goodwill = Super Profits × no. of years purchase
3. Capitalization Method
This is the method to calculate Goodwill in accounting. It consists of two ways for goodwill valuation.
Case 1 – Capitalization of Average Profits
Under this method, the total value of the business is ascertain by capitalizing the profits earned at the rate of profit normally earned.
Steps for calculation Goodwill are as follows –
- Calculate the average profits.
- Compute Capitalization of average profits as follows –
(Average Profits × 100)/ Rate of Normal Profit
- Determine the value of net tangible assets
- Now calculate goodwill.
Goodwill = Capitalized Value – Net Tangible Assets
Case 2 – Capitalization of Super Profits
For calculation of goodwill in accounting in this method are as follows –
- Calculate employed capital in the business
- Now calculate normal profits on employed capital.
- Find out the average profits of the past years.
- Subtract normal profits from Actual Average Profits to calculate super profits.
- Now compute goodwill in accounting as follows –
Goodwill = Super Profits × (100/normal rate of return)