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Valuation of Goodwill

Goodwill is the value of the reputation of a firm in respect of profits expected in the future over and above the normal rate of profits. From an accounting point of view, goodwill is an intangible asset and it is necessary that it has some monetary or saleable value. Here, we will try to explain various methods of valuation of goodwill.

Need for Valuation of Goodwill in Different Scenarios

In Partnership Firm, the necessity for goodwill valuation arises in the following cases:-

a) When the profit sharing ratio amongst the partners is changed;

b) When a new partner is admitted;

c) When a partner retires or dies; and

d) When the business is dissolved or sold. 

In a Company, valuation of goodwill is required in the case of amalgamation of the company or acquiring a controlling interest.

In Sole Proprietorship, valuation of goodwill is required in certain instances while computing purchase considerations of selling off business. 

Factors affecting the Value of Goodwill

The major factors which affect value of goodwill are as follows:

  • The quality of the goods sold.
  • The personal reputation of the owners.
  • The location of the business premises.
  • The possession of trademarks and patents.
    The presence of managerial skill.
  • The cost of research and development which enables the production at low cost and of good quality.
  • The possession of special contracts for the availability of materials.

Methods for Goodwill Valuation

There are the three methods for valuation of goodwill.

i) Average profit method

  • Simple average profits
  • Weighted average profits

ii) Super profit method

iii) Capitalization method

  • Of average profits
  • Of super profits

Average Profit Method

In this method, the average profits of past years are adjusted for any expected change in the future. There are two ways in which goodwill can be valued.

  • Simple Average Profits

Goodwill = Average Profits X Number of years purchase

(Average Profits = Total Profits/ Number of years)

  • Weighted Average Profits

Goodwill = Weighted Average Profits X Number of years purchase

(Weighted Average Profits = Total of Weighted Profits/ Total of Weights)

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TaxGyata Team

TaxGyata Team