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Nature and Valuation of GoodwillNature and Valuation of Goodwill

Prepared by:- Navdeep kaurPrepared by:- Navdeep kaurPGT_COMMERCEPGT_COMMERCE

K.V. 2 PATHANKOTK.V. 2 PATHANKOT

GOODWILL CONSISTS OF THE ADVANTAGES A GOODWILL CONSISTS OF THE ADVANTAGES A BUSINESS HAS IN CONNECTION WITH ITS BUSINESS HAS IN CONNECTION WITH ITS CUSTOMERS, EMPLOYEES AND OUTSIDE PARTIES CUSTOMERS, EMPLOYEES AND OUTSIDE PARTIES WITH WHOM IT HAS TO CONTACT. THAT IS WHY IT WITH WHOM IT HAS TO CONTACT. THAT IS WHY IT WAS DEFINED AS THE PROBABILITY THAT THE OLD WAS DEFINED AS THE PROBABILITY THAT THE OLD CUSTOMERS WILL RESORT TO THE OLD PLACE.CUSTOMERS WILL RESORT TO THE OLD PLACE.

THUS, TO DETERMINE THE NATURE OF GOODWILL IN THUS, TO DETERMINE THE NATURE OF GOODWILL IN A PARTICULAR CASE, IT IS NECESSARY TO CONSIDER A PARTICULAR CASE, IT IS NECESSARY TO CONSIDER THE TYPE OF BUSINESS AND THE TYPE OF THE TYPE OF BUSINESS AND THE TYPE OF CUSTOMERS WHICH SUCH A BUSINESS IS CUSTOMERS WHICH SUCH A BUSINESS IS INHERENTLY LIKELY TO ATTRACT AS WELL AS INHERENTLY LIKELY TO ATTRACT AS WELL AS SURROUNDING CIRCUMSTANCES OF EACH CASE.SURROUNDING CIRCUMSTANCES OF EACH CASE.

Goodwill is sometimes described as a Goodwill is sometimes described as a ‘momentum or a push’ that keeps the business ‘momentum or a push’ that keeps the business going without further effort like the momentum going without further effort like the momentum of a body that continues its motion against a of a body that continues its motion against a retarding force till it comes to rest gradually.retarding force till it comes to rest gradually.

When a man pays for goodwill, he pays for When a man pays for goodwill, he pays for something which places him in the position of something which places him in the position of being able to earn more than he would be able being able to earn more than he would be able to do by his own unaided efforts.to do by his own unaided efforts.

Goodwill is thus present value of a firm’s Goodwill is thus present value of a firm’s anticipated super normal earnings.anticipated super normal earnings. The term The term ‘super normal earnings’, means the excess of ‘super normal earnings’, means the excess of earnings attributable to operating tangible and earnings attributable to operating tangible and intangible assets over the normal rate of intangible assets over the normal rate of return.return.

ACCORDING TO KOHLER: “Goodwill is ACCORDING TO KOHLER: “Goodwill is the current value of expected future the current value of expected future income in excess of a normal return on income in excess of a normal return on investment in net tangible assets.”investment in net tangible assets.”

Whatever be the nature of Whatever be the nature of goodwill, one thing is definite about it. goodwill, one thing is definite about it. It is treated as an intangible asset in It is treated as an intangible asset in accounts. One of the basic accounts. One of the basic characteristic features of assets is that characteristic features of assets is that they help in earning profit for the they help in earning profit for the business. As a result, every asset is business. As a result, every asset is said to have productivity. Thus, said to have productivity. Thus, goodwill is, like any other asset, a goodwill is, like any other asset, a store of prospective revenue.store of prospective revenue.

FEATURES OF GOODWILLFEATURES OF GOODWILLA.A. Goodwill can be sold only with the entire businessGoodwill can be sold only with the entire business or it or it

cannot be sold in part or in isolation except on cannot be sold in part or in isolation except on admission or retirement of a partner when new partner admission or retirement of a partner when new partner compensate the old partners or the retiring partner compensate the old partners or the retiring partner gives up his rights in favour of remaining partners.gives up his rights in favour of remaining partners.

B.B. Goodwill is valuable only if it is capable of being Goodwill is valuable only if it is capable of being transferred from one person to another. transferred from one person to another. If it cannot beIf it cannot be transferred then there will be no value of goodwill.transferred then there will be no value of goodwill.

C.C. Goodwill represents a non-physical value Goodwill represents a non-physical value over and over and above the physical assets.above the physical assets.

D.D. Goodwill cannot have an exact costGoodwill cannot have an exact cost as its value as its value fluctuates from time to time due to internal or external fluctuates from time to time due to internal or external factors which ultimately affect the fortune of the factors which ultimately affect the fortune of the company.company.

E.E. The value of goodwill is based on subjective judgementThe value of goodwill is based on subjective judgement of the valuer.of the valuer.

TYPES OF GOODWILLTYPES OF GOODWILL PURCHASED GOODWILL: PURCHASED GOODWILL: It arises only It arises only

when a business enterprise is acquired by when a business enterprise is acquired by another business enterprise and the price another business enterprise and the price paid is more than the net assets acquired.paid is more than the net assets acquired.

THE MAIN FEATURES OF SUCH GOODWILL THE MAIN FEATURES OF SUCH GOODWILL ARE:ARE:

It arises only on purchase of business.It arises only on purchase of business. It is reflected by purchase transaction.It is reflected by purchase transaction. Its cost could depend upon the future Its cost could depend upon the future

maintainable profits.maintainable profits. It can be shown in the balance sheet.It can be shown in the balance sheet.

NON-PURCHASED GOODWILL: NON-PURCHASED GOODWILL: It arises It arises only when a business generates its own only when a business generates its own goodwill over a period of time due to various goodwill over a period of time due to various factors such as location,good factors such as location,good management,sales policies etc.management,sales policies etc.

THE MAIN FEATURES OF SUCH GOODWILL THE MAIN FEATURES OF SUCH GOODWILL ARE:ARE:

It is internally generated.It is internally generated. No cost can be placed on it.No cost can be placed on it. Value of goodwill is based on the subjective Value of goodwill is based on the subjective

judgement of the valuer.judgement of the valuer. It is not reflected by purchase consideration.It is not reflected by purchase consideration. It is not shown in the balance sheet.It is not shown in the balance sheet.

CLASSES OF GOODWILLCLASSES OF GOODWILL According to rowland, there are four principal According to rowland, there are four principal

classes of goodwill,classes of goodwill,vizviz.,., Local,Local, arising from the situation of trader’s premises arising from the situation of trader’s premises

e.g., a retail shopkeeper in a busy market centree.g., a retail shopkeeper in a busy market centre;; The personal reputationThe personal reputation, , of the individual, arising of the individual, arising

through his skill,influence and personality, as in the through his skill,influence and personality, as in the case of professional man.case of professional man.

The reputation of the goods soldThe reputation of the goods sold, arising from , arising from the high standard of quality of the goods sold the high standard of quality of the goods sold themselves.themselves.

The absence of competitionThe absence of competition, or the existence of , or the existence of an absolute or partial monoply.an absolute or partial monoply.

RECORDING OF GOODWILLRECORDING OF GOODWILL The following are the circumstances The following are the circumstances

when goodwill is valued and recorded:when goodwill is valued and recorded:i.i. In case of In case of partnershippartnership where there is a where there is a

change in the profit sharing ratio on change in the profit sharing ratio on admission, death and retirement of a partner admission, death and retirement of a partner or when two firms are amalgamated, the or when two firms are amalgamated, the value of goodwill is to be calculated.value of goodwill is to be calculated.

ii.ii. In case of a In case of a joint stock companyjoint stock company, the need for , the need for valuation of goodwill may arise in the valuation of goodwill may arise in the following cases:following cases:

a)a) When the business of the company is to be When the business of the company is to be sold to another company or when the sold to another company or when the company is to be amalgamated with another company is to be amalgamated with another company.company.

RECORDING OF GOODWILLRECORDING OF GOODWILLb)b) When the stock exchange quotations not When the stock exchange quotations not

being available, shares have to be valued for being available, shares have to be valued for taxation purposes-gift tax, etc.taxation purposes-gift tax, etc.

c)c) When a large block of shares has to be bought When a large block of shares has to be bought and sold as to enable the buyer to exercise and sold as to enable the buyer to exercise control over the company concerned.control over the company concerned.

d)d) When the company has previously written off When the company has previously written off goodwill and wants to write it back.goodwill and wants to write it back.

e)e) When the company is being taken over by When the company is being taken over by another company.another company.

f)f) Goodwill is frequently to be brought into Goodwill is frequently to be brought into account upon consolidation of the assets and account upon consolidation of the assets and liabilities of a holding company and its liabilities of a holding company and its subsidiaries.subsidiaries.

FACTORS TO BE CONSIDERED IN THE FACTORS TO BE CONSIDERED IN THE VALUATION OF GOODWILLVALUATION OF GOODWILL

The most important consideration is The most important consideration is earning earning capacitycapacity of the business. Earning capacity of the of the business. Earning capacity of the business depends upon the following factorsbusiness depends upon the following factors::

Nature of goods.Nature of goods. Monopolised business.Monopolised business. Trade name.Trade name. Risk involved.Risk involved. Favourable location and site.Favourable location and site. Possession of trademarks, patents and copyrights.Possession of trademarks, patents and copyrights. Skill to management.Skill to management. Future competition.Future competition. Profit trends.Profit trends. Money market conditions.Money market conditions. Capital required.Capital required.

Goodwill can be said to have value only when it Goodwill can be said to have value only when it can be can be transferred for valuable considerationstransferred for valuable considerations. . Thus, personal knowledge and skill as possessed Thus, personal knowledge and skill as possessed by a doctor cannot be transferred and sold and by a doctor cannot be transferred and sold and goodwill of such a person made up wholly of such goodwill of such a person made up wholly of such a factor will have no commercial value.a factor will have no commercial value.

A prospective buyer of a business will be very A prospective buyer of a business will be very much concerned much concerned with the possible future taxation with the possible future taxation liabilityliability. Buyer of the goodwill expects to recoup . Buyer of the goodwill expects to recoup what he has paid for goodwill out of the future what he has paid for goodwill out of the future profits. The future profits are likely to be reduced profits. The future profits are likely to be reduced materially by taxation and the buyer will not be materially by taxation and the buyer will not be ready to pay any large amount for goodwill, other ready to pay any large amount for goodwill, other things being equal.things being equal.

METHODS OF VALUING GOODWILLMETHODS OF VALUING GOODWILL By an arbitrary assessment.By an arbitrary assessment. By capitalisation of expected net profits By capitalisation of expected net profits

or earnings (or capitalisation method).or earnings (or capitalisation method). By certain number of years’ purchase of By certain number of years’ purchase of

past average profits or earnings.past average profits or earnings. By super profits or earnings. By super profits or earnings. This This

includesincludes:: purchase of super profit.purchase of super profit. Annuity method.Annuity method. Capitalisation of super profit method.Capitalisation of super profit method.

Arbitrary assessmentArbitrary assessment: : This method can be This method can be used only when information relating to earning used only when information relating to earning capacity is availablecapacity is available. . If this information is not If this information is not available because of non-availability of the profit available because of non-availability of the profit immediately prior to sale or if the profits are immediately prior to sale or if the profits are abnormal or unreliable then such profits cannot abnormal or unreliable then such profits cannot be used as a guide to super profits.be used as a guide to super profits.

Capitalisation method: Capitalisation method: The following are the The following are the main steps to be taken in computing goodwill by main steps to be taken in computing goodwill by this method:-this method:-

a)a) Ascertain the average net profit which it is Ascertain the average net profit which it is expected will be earned in future;expected will be earned in future;

b)b) Capitalise this net profit at the rate which is Capitalise this net profit at the rate which is considered a suitable return on capital invested considered a suitable return on capital invested in a business of the type under consideration;in a business of the type under consideration;

c)c) Find the value of the net tangible assets used in Find the value of the net tangible assets used in the business, the business, i.e., i.e., assets less outside liabilities. assets less outside liabilities. (here outside liabilities will also include (here outside liabilities will also include preference capital) andpreference capital) and

d) d) Deduct the net tangible assets as per (c) from the Deduct the net tangible assets as per (c) from the capitalised profit obtained in (b) and the difference is capitalised profit obtained in (b) and the difference is goodwill.goodwill.

While making an estimate of future maintainable While making an estimate of future maintainable profit on the basis of past profits, the following points profit on the basis of past profits, the following points are kept in mind:are kept in mind:

Interest on debentures and depreciation on all fixed Interest on debentures and depreciation on all fixed assets and non-trading investments should be assets and non-trading investments should be excluded.excluded.

Provision for taxation should be made.Provision for taxation should be made. Preference dividend should be deducted.Preference dividend should be deducted. If the profits of the past 4 or 5 years have been If the profits of the past 4 or 5 years have been

increasing or decreasing in a significant manner, it increasing or decreasing in a significant manner, it will be better to give more importance to the profits will be better to give more importance to the profits of the last year and least importance to the profits of of the last year and least importance to the profits of the first year. This can be taken care of by taking the first year. This can be taken care of by taking weighted average profit by assigning weights as weighted average profit by assigning weights as 1,2,3,4 and 5 to the profits of 11,2,3,4 and 5 to the profits of 1stst year, 2 year, 2ndnd year, 3 year, 3rdrd year, 4year, 4thth year and 5 year and 5thth year respectively. This practice year respectively. This practice is not to be followed if there is consistent decline of is not to be followed if there is consistent decline of profits.profits.

ILLUSTRATION 1ILLUSTRATION 1

A company desirous of selling its business to another company A company desirous of selling its business to another company has earned an average profit in the past of Rs.1,50,000 per has earned an average profit in the past of Rs.1,50,000 per annum. It is considered that such average profit fairly annum. It is considered that such average profit fairly represents the profit likely to be earned, in the future, except represents the profit likely to be earned, in the future, except that:that:

a)a) Directors’ fees Rs.10,000 charged against such profit will not Directors’ fees Rs.10,000 charged against such profit will not be payable by the purchasing company whose existing board be payable by the purchasing company whose existing board can easily cope with the additional administrative work at can easily cope with the additional administrative work at present fees payable to the directors.present fees payable to the directors.

b)b) Rent at Rs.20,000 p.a. which had been paid by the vendor Rent at Rs.20,000 p.a. which had been paid by the vendor company will not be charge in the future, since the purchasing company will not be charge in the future, since the purchasing company owns its own premises and can supply the company owns its own premises and can supply the accommodation necessary for the staff and the equipment of accommodation necessary for the staff and the equipment of the vendor company.the vendor company.

The value of the net tangible assets of the vendor The value of the net tangible assets of the vendor company at the proposed date of the sale was Rs.15,00,000 company at the proposed date of the sale was Rs.15,00,000 and it was considered that a reasonable return on capital and it was considered that a reasonable return on capital invested, for this type of commodity, was 10%.invested, for this type of commodity, was 10%.

ILLUSTRATION 1ILLUSTRATION 1 The profit of the vendor company would in no way be affected by The profit of the vendor company would in no way be affected by

the sale of its business to the purchasing company and goodwill the sale of its business to the purchasing company and goodwill existed and was to be paid for on the basis that the vendor existed and was to be paid for on the basis that the vendor company was a continuing enterprise. Calculate the value of company was a continuing enterprise. Calculate the value of goodwill by capitalisation of expected future net profits.goodwill by capitalisation of expected future net profits.

SOLUTION:SOLUTION: CALCULATION OF VALUE OF GOODWILLCALCULATION OF VALUE OF GOODWILLAverage net profitAverage net profitAdd: Non-recurring charges for: Add: Non-recurring charges for: Rs.Rs. Directors’ fees Directors’ fees 10,00010,000 Rent Rent 20,00020,000Estimated future maintainable profitEstimated future maintainable profitFuture profit capitalised at 10% i.e., Future profit capitalised at 10% i.e., Rs.1,80,000*100Rs.1,80,000*100 1010 Capitalised profitCapitalised profitLessLess: Net tangible assets: Net tangible assetsGoodwillGoodwill

1,50,0001,50,000

30,00030,000 1,80,0001,80,000

18,00,00018,00,00018,00,00018,00,00015,00,00015,00,000 3,00,0003,00,000

ILLUSTRATION 2ILLUSTRATION 2 Ascertain the value of goodwill of P.Co. Ltd. Carrying Ascertain the value of goodwill of P.Co. Ltd. Carrying

on business as retail traders from the following on business as retail traders from the following information according to capitalisation method:information according to capitalisation method:

BALANCE SHEETBALANCE SHEET as on 31as on 31stst December, 2007 December, 2007 LiabilitiesLiabilities Rs.Rs. AssetsAssets Rs.Rs.Paid-up capital:Paid-up capital:2,500 Shares of 2,500 Shares of Rs.100 eachRs.100 eachProfit and loss Profit and loss accountaccountBank OverdraftBank OverdraftSundry CreditorsSundry CreditorsProvision for TaxationProvision for Taxation

2,50,002,50,0000

56,65056,65058,350 58,350 90,500 90,500 19,50019,5004,75,004,75,0000

GoodwillGoodwillLand and Building at costLand and Building at costPlant and Machinery at Plant and Machinery at cost less Depreciationcost less DepreciationStock at costStock at costBook Debts less Provision Book Debts less Provision for Doubtful Debtsfor Doubtful Debts

25,00025,0001,10,001,10,0000

1,00,001,00,00001,50,001,50,0000

90,00090,0004,75,004,75,0000

The company commenced operations in 2003 The company commenced operations in 2003 with a paid up capital as aforesaid of with a paid up capital as aforesaid of Rs.2,50,000. The profits earned, before Rs.2,50,000. The profits earned, before providing for taxation, have been as:providing for taxation, have been as:

2003 Rs.61,000 ; 2004 Rs.64,000 ; 2005 2003 Rs.61,000 ; 2004 Rs.64,000 ; 2005 Rs.71,500 ; 2006 Rs.78,000 and 2007 Rs.71,500 ; 2006 Rs.78,000 and 2007 Rs.85,000.Rs.85,000.

You may assume that income-tax at the You may assume that income-tax at the rate of 50% has been payable on these profits.rate of 50% has been payable on these profits.

The average dividend paid by the The average dividend paid by the company for the four years is 10% which is company for the four years is 10% which is taken as reasonable return expected on the taken as reasonable return expected on the capital invested in the business.capital invested in the business.

SOLUTIONSOLUTIONProfit for 5 years(Rs.61,000+Rs.64,000+Rs.71,500+Rs.78,000+Profit for 5 years(Rs.61,000+Rs.64,000+Rs.71,500+Rs.78,000+ Rs.85,000) = Rs.85,000) =

3,59,5003,59,500LessLess: 50% income-tax : 50% income-tax

1,79,7501,79,750

1,79,7501,79,750 Average profit (Rs. 1,79,750 /5) Average profit (Rs. 1,79,750 /5)

35,95035,950Future profits capitalised at 10%= Future profits capitalised at 10%= Rs.35,950*100Rs.35,950*100 10 10

3,59,500 3,59,500 Total Assets = Rs. 4,75,000Total Assets = Rs. 4,75,000LessLess: Goodwill Rs. 25,000: Goodwill Rs. 25,000LessLess: Liabilities : Liabilities (Rs.58,350+ Rs.90,500+(Rs.58,350+ Rs.90,500+ Rs.19,500) Rs. Rs.19,500) Rs. 1,68,350 1,68,350 Rs. Rs. 1,93,3501,93,350Net Tangible Assets Rs. Net Tangible Assets Rs. 2,81,6502,81,650 Capitalised Profit Capitalised Profit

3,59,5003,59,500LessLess: Net Tangible Assets : Net Tangible Assets

2,81,650 2,81,650 Goodwill Goodwill

77,85077,850