Tag: Goodwill

  • Difference between Average and Super profit

    Difference between Average and Super profit

    Average and Super Profits; The valuation of goodwill depends upon assumptions made by the valuer. Meaning; The average profit is the average of the profits in the past few years; Or, super profit is an excess of average profit over normal profit. This article explains the difference between Average and Super profit; Methods to adopt in the valuation of goodwill would depend on the circumstances of each case and are often based on the customs of the trade.

    The distinction/difference between Average profit and Super profit.

    Methods of Goodwill Valuation; Goodwill is the value of the reputation of a firm built over time concerning the expected future profits over and above the normal profits. Also, Goodwill is an intangible real asset which cannot see or felt but exists in reality and can buy and sell. In partnership, goodwill valuation is very important. Thus, we will here discuss the various methods of Goodwill Valuation.

    The various methods that can adapt to the valuation of goodwill are the following:

    • Average Profit Method.
    • Super Profit Method.

    Now, explain each one;

    Average Profit:

    Average profit is the average of all the agreed profits of past years. It calculates by dividing the total profits by the number of years. This is the most common method of calculating goodwill.

    Average Profits = Total Profits/Number of years

    A buyer always wants to estimate the future profits of the business. Also, Future profits always depend upon the performance of the business in the past. Past profits indicate what profits are likely to accrue in the future. Therefore, past profits are averaged.

    The first step under this method is the calculation of average profit based on the past few years’ profits. As well as, Past profit adjust in respect of any abnormal items of profit or loss which may affect future profit. Also, Average profit may be based on a simple average or weighted average.

    If profits are constant, equal weight-age may give in calculating the average profits i.e., the simple average may calculate. However, if the trend shows increasing or decreasing profit, it is necessary to give more weight-age to the profits of recent years.

    Types of Average Profits Method:
    1. Simple Average: Under this method, the goodwill values at the agreed number of years of the purchase of the average profits of the past years.
    2. Simple Average: Under this method, the goodwill values at the agreed number of years of the purchase of the average profits of the past years.

    Super Profit:

    This Profit is the excess of average profit over the normal profit. It shows the exceptional ability of the firm to earn more profits in comparison to other firms in the industry.

    Super Profits = Actual Profits – Normal Profits

    It calculates by deducting the normal profits from average profits. Super profit is the excess of estimated future maintainable profits over normal profits. Super profit represents the difference between the average profit earned by the business and the normal profit i.e., the firm’s anticipated excess earnings. As such, if there is no anticipated excess earning over normal earnings, there will be no goodwill.

    An enterprise may possess some advantages which enable it to earn extra profits over and above the normal profit that would earn if the capital of the business was invested in some other business with similar risks. Also, the goodwill under this method ascertains by multiplying the super-profits by a certain number of year’s purchases.

    Types of Super Profits Method:
    • The Number of Years Purchase Method: Under this method, the goodwill values at the agreed number of years’ purchase of the super-profits of the firm.
    • Annuity Method: This method considers the time value of money. Here, we consider the discounted value of the super profit.
    Difference between Average and Super profit table
    Difference between Average and Super profit table.

    References:

    1. commerceiets.com/average-profit-vs-super-profit/
    2. www.toppr.com/guides/principles-and-practice-of-accounting/treatment-of-goodwill/methods-of-goodwill-valuation/
    3. www.yourarticlelibrary.com/accounting/goodwill/accounting-procedure-for-valuation-of-goodwill-4-methods/57243
  • Goodwill Meaning, Definition, Classification, Features, Types

    Goodwill Meaning, Definition, Classification, Features, Types

    Goodwill – Meaning, Definition, Classification, Features, Types, and Accounting Concept (In Hindi). In other words, goodwill shows that a business has value beyond its actual physical assets and liabilities. Discover the meaning and significance of goodwill in business. Learn how it adds value beyond physical, identifiable assets and liabilities. Goodwill is a company’s value that exceeds its assets minus its liabilities. This value can create from the excellence of management, customer loyalty, brand recognition, favorable location, or even the quality of employees. The number of goods is the purchase price the business minus the fair market value of the tangible assets, the intangible assets that can identify, and the liabilities obtained in the purchase.

    Here are explains; What is Goodwill? First Meaning, Definition, Classification, Features, Types, and finally their Accounting Concept.

    The amount in the Goodwill account will adjust to a smaller amount if there is an impairment in the value of the acquired company as of a balance sheet date or accounting treatment. Goodwill in the world of business refers to the established reputation of a company as a quantifiable asset and calculate as part of its total value when it takes over or sale. It is the vague and somewhat subjective excess value of a commercial enterprise or asset over its net worth. It is a vital component for increasing a company’s customer base and retaining existing clients.

    Meaning of Goodwill:

    Meaning; that may describe as the aggregate of those intangible attributes of a business that contributes to its superior earning capacity over a normal return on investment. It may arise from such attributes as favorable locations, the ability, and skill of its employees and management, quality of its products and services, customer satisfaction, etc.

    Definition of Goodwill:

    Definition; it is an asset that has countless definitions. Accountants, Economists, Engineers, and the Courts have to define Goodwill in several ways from their respective angles. As such, they have suggested different methods for their nature and valuation. No doubt it is an intangible real asset and not a fictitious one. “It is perhaps the most intangible of intangibles.” It is a valuable asset if the concern is profitable; on the other hand, it is valueless if the concern is a losing one. Therefore, it can state that Goodwills the value of the representative firm, judged in respect of its earning capacity.

    Some definitions of goodwill are:

    UK Accounting Standard on Accounting for Goodwill,

    “Goodwill is the difference between the value of a business as a whole and the aggregate of the fair values of its separable net assets.”

    Lord Eldon by,

    “Goodwill is nothing more than the profitability that the old customers will resort to the old place.”

    Dr. Canning by,

    “Goodwill is the present value of a firm’s anticipated excess earnings.”

    Prof. Dicksee by,

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

    Here, the word excess indicates some special hints as to its valuation which, perhaps, is equal to earnings attributable to the rate of return on tangible and intangible assets over the normal rate of return earns by the representative firms in the same industry. In short, the excess reveals the difference between the actual profits earns minus the normal rate of return on the capital employed.

    Classification of Goodwill:

    The following classification by P. D. Leake as:

    1. Dog-Goodwills: Dogs are attaching to the persons and, hence, such customers lead to personal they which is not transferable,
    2. Cat-Goodwills: Since cats prefer the person of the old home, similarly, such customers give rise to locality goodwills.
    3. Rat-Goodwills: The other variety of customers has an attachment neither to the person nor to the place, which, in other words, is known as fugitive goodwills.

    Other Classifications:

    The following classifications below are:

    1] Purchased/Acquired Goodwill:

    Purchased goodwills arise when a firm purchases another firm and when payment makes more than net assets acquired for that purpose; such excess payment know as Purchase Goodwills. The same has also been corroborating by AS 10 (Accounting for Fixed-Assets).

    2] Treatment of Purchased Goodwills as per AS 10 (Accounting for Fixed-Assets):

    In general records in the books only when some consideration in money or money’s worth has been paying for it. Whenever a business is acquired for a price (payable either in cash or in shares) that is more than the value of the net assets of the business taken over the excess is termed Goodwill. It arises from business’s reputation, connections, trade name or reputation of an enterprise, or other intangible benefits enjoyed by an enterprise. As a matter of financial prudence, goodwill written off over a period. However, many enterprises do not write off goodwill and retain it as an asset.

    3] Treatment of Purchased Goodwills as per AS 14 (Accounting for Amalgamation):

    They arising on amalgamation represent a payment made in anticipation of future income and it is appropriate to treat it as an asset to amortize to income on a systematic basis over its useful life. Due to the nature of goodwill, it is frequently difficult to estimate its useful life with reasonable certainty. Such estimation is, however, made on a prudent basis. Accordingly, it is considered appropriate to amortize goodwill over a period not exceeding 5 years unless a somewhat longer period can justify.

    4] Inherent/Latent Goodwill:

    It is practically the reputation of a firm that has been acquiring by the business over some time. It is not purchased for cash consideration. That is why; it is not recording in the books of accounts like Purchase Goodwills. This types of goodwill depends on several factors, viz, supplying goods and services at a reasonable price to the society, etc. Accountants are not concerning about it.

    5] Inherent/Internally Generated Tangible Assets — As per AS 26:

    Internally generated goodwill should not recognize as an asset. In some cases, expenditure is incurring to generate future economic benefits, but it does not result in the creation of an intangible asset that meets the recognition criteria in this statement.

    Such expenditure is often describing as contributing to internally generated them. Internally generated and factors affecting goodwill not recognizing as an asset because it is not an identifiable resource control by the enterprise that can measure reliably at cost.

    The difference between the market value of an enterprise and the carrying amount of its identifiable net assets at any point in time may be due to a range of factors that affect the value of the enterprise. However, such a difference cannot consider representing the cost of intangible assets controlled by the enterprise.

    The Features of Goodwill:

    The following features below are:

    • It is an intangible asset, it is non-visible, but it is not a fictitious asset.
    • It cannot separate from the business and therefore cannot sell like other identifiable and separable assets, without disposing of the business as a whole.
    • The value of goodwill has no relation to the amount invested or the cost incurred to build it.
    • Valuation of goodwill is subjective and is highly dependent on the judgment of the valuer.
    • It is subject to fluctuations. The value of goodwill is an intangible may fluctuate widely according to internal and external factors of the business.

    Types of Goodwill:

    It is generally of two types:

    • Purchased, and.
    • Non-Purchased or Inherent.

    1] Purchased Goodwill:

    Purchased goodwills arise when a business concern is purchased and the purchase consideration paid exceeds the fair value of the separable net assets acquired. The purchased goodwills show on the assets side of the Balance sheet. Para 36 of AS-10 “Accounting for fixed assets” states that only purchased goodwill should recognize in the books of accounts.

    2] Non-Purchased Goodwill/Inherent Goodwill:

    Inherent goodwills the value of the business over the fair value of its separable net assets. It is referred to as internally generated them and it arises over some time due to the good reputation of a business. The value of goodwill may be positive or negative. Positive goodwill arises when the value of the business as a whole is more than the fair value of its net assets. It is negative when the value of the business is less than the value of its net assets.

    Goodwills for Accounting:

    Accounting for goodwill, the various ways in which they can account for are as follows:

    • Carry it as an asset and write it off over years through the profit and loss account.
    • Write it off against profits or accumulated reserves immediately.
    • Retain it as an asset with no write-off unless a permanent diminution in value becomes evident.
    • Show it as a deduction from shareholders funds which may authorize carry forward indefinitely.

    In this connection, it is important to state that they should recognize and recorded in business only when some consideration in money or money’s worth has been paying for it.

    How Goodwill entry in the Accounting Book?

    It is always paying for the future. A record of Goodwill in accounting makes only when it has a value. When a business is purchasing and an additional amount is paid more than the number of assets, then the additional amount calls goodwill. It treats as an asset and the payment made for it is a capital expenditure. It treats as an intangible asset and thus depreciation is not charging. The value of goodwill decreases and increases but the fluctuations are not recording in the books.

    The presence of goodwill in the books is not necessarily a sign of prosperity. A prospective purchaser would agree to make any payment for the goodwill only when he is convinced that the profit likely to accrue to him from the acquired business would be more than the normal return expects in a business of a similar nature. This means that any such payment refers to the future differential earnings and is a premium to the vendor for relinquishing his right thereto in favor of the vendee.

    The goodwill of a business is the intangible value to it, independent of its visible assets because the business is a well-established one having a good reputation. But at the same time, it is obvious that goodwill is inseparable from the business to which it adds value. The value of the goodwill of the business will, therefore, be the value that a reasonable and prudent buyer would give for the business as a going concern minus the value of the tangible assets.

    Why Need for Valuation of Goodwill?

    Valuation of goodwill may make due to any one of the following reasons:

    1. In the case of a Sole-Proprietorship Firm:
    • If the firm is selling to another person.
    • It takes any person as a partner, and.
    • It is converting into a company.

    2. In the case of a Partnership Firm:

    • If any new partner takes.
    • Any old partner retires from the firm.
    • There is no change in the profit-sharing ratio among the partners.
    • If any partner dies.
    • Different partnership firms are amalgamating.
    • If any firm is selling, and.
    • If any firm converts into a company.

    3. In the case of a Company:

    • If the goodwill has already been written-off in the past but the value of the same is to record further in the books of accounts.
    • If an existing company is taking with or amalgamate with another existing company.
    • The Stock Exchange Quotation of the value of shares of the company is not available to compute gift tax, wealth tax, etc., and.
    • If the shares are valued based on intrinsic values, market value, or fair value methods.

  • Valuation of Goodwill: Meaning, Need, Factors, and Methods

    Valuation of Goodwill: Meaning, Need, Factors, and Methods

    Valuation of Goodwill: What is Goodwill? Meaning of Goodwill; Goodwill is the value of the reputation of a firm built over time concerning the expected future profits over and above the normal profits. So, what is the topic we are going to study; Valuation of Goodwill – Meaning, Need, Factors, and Methods (In Hindi). A well-established firm earns a good name in the market, builds trust with the customers, and also has more business connections as compared to a newly set up business. Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business.

    Here are explained how to Valuation of Goodwill? Meaning, Need, Factors, and Methods.

    Goodwill represents assets that are not separately identifiable. Goodwill does not include identifiable assets that are capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability regardless of whether the entity intends to do so.

    Valuation of Goodwill Meaning:

    There are various circumstances when it may be necessary to value goodwill. Some of the circumstances are;

    First, In the case of a partnership, when there is an admission, retirement, death or amalgamation, or a change in the profit-sharing ratio take place, the valuation of goodwill becomes necessary.

    Secondly, In the case of a company, when two or more companies amalgamate, or one company absorbs another company, or one company wants to acquire controlling interest in another company or when the Government takes over the business, valuation of goodwill becomes necessary.

    Third, In the case of a sole trader concern, goodwill is valued at the time of selling die business, to decide the purchase consideration.

    Finally, In the case of individuals, goodwill is valued for Estate Duty, Death Duty, etc. On the death of a person.

    Need for Valuation of Goodwill:

    Valuation of goodwill may make due to any one of the following reasons:

    A Sole-Proprietorship Firm:

    • If the firm sells to another person.
    • It takes any person as a partner, and.
    • It converts into a company.

    A Partnership Firm:

    • If any new partner takes.
    • Any old partner retires from the firm.
    • There is any change in the profit-sharing ratio among the partners.
    • Any partner dies.
    • Different partnership firms amalgamate.
    • Any firm sale, and.
    • Any firm converts into a company.

    A Company or Firm:

    • If the goodwill has already been written-off in the past but the value of the same is to records further in the books of accounts.
    • An existing company taking with or amalgamated with another existing company.
    • The Stock Exchange Quotation of the value of shares of the company is not available to compute gift tax, wealth tax, etc., and.
    • The shares are valued based on intrinsic values, market value, or fair value methods.

    Factors Affecting the Value of Goodwill:

    The following factors affect the value of goodwill:

    Location:

    A business which locates in the main market or at a place where there is more customer traffic tends to earn more profit and also more goodwill. If the firm centrally locates or locate in a very prominent place, it can attract more customers, increasing turnover. Therefore, the locational factor should always consider while ascertaining the value of goodwill.

    Time:

    The time dimension is another factor that influences the value of goodwill. The comparatively old firm will enjoy a more commercial reputation than the other one since the old one is better known to its customers, although both of them may have the same locational advantages.

    Nature of Business:

    A firm that deals with good quality products or has stable demand for its product can earn more profits and therefore has more value. This is another factor which also influences the value of goodwill which includes:

    • The nature of goods.
    • Risk involved.
    • Monopolistic nature of the business.
    • Benefits of Patents and Trade-marks, and.
    • Easy access to raw materials, etc.

    Capital Required:

    More buyers may interest to purchase a business that requires a comparatively small amount of capital but the rate of earning a profit is high and, consequently, raise the value of goodwill. On the contrary, for a business that required a large amount of capital but the rate of earning a profit is comparatively less, no buyer will interest to have the business and, hence, the goodwill of the said firm pull down.

    Owner’s Reputation:

    An owner, who has a good personal reputation in the market, is honest and trustworthy attracts more customers to the business, and makes more profits and also goodwill.

    Market Situation:

    The organization has a monopoly right or condition in the market or having limited competition, enables it to earn high profits which in turn leads to a higher value of goodwill.

    The trend of Profit:

    The value of goodwill may also be affected due to the fluctuation in the amount of profit (i.e., based on the rate of return). If the trend of profit is always rising, no doubt the value of goodwill will be high, and vice versa.

    The efficiency of Management:

    Efficient management may also help to increase the value of goodwill by increasing profits through properly planned production, distribution, and services. An organization with efficient management has high productivity and cost-efficiency. This gives it increased profits and also high goodwill. Therefore, to ascertain the value of goodwill, it must note that such efficiency in management must not be curtailed.

    Special Advantages:

    A firm that has special advantages like import licenses, patents, trademarks, copyrights, assured supply of electricity at low rates, subsidies for being situated in a special economic zone’s (SEZs), etc. possess a higher value of goodwill.

    Other Factors:

    • The condition of the money market.
    • The possibility of competition.
    • Government policy, and.
    • Peace and security in the country.

    Precaution to Take in Valuing Goodwill: We know that the amount of goodwill always pays for in the future. The buyer will pay a little more than the intrinsic value of assets only when he expects that he will enjoy some extra benefits from such goodwill shortly. On the other hand, if the buyer thinks that there is no possibility of having such advantages in the future, he will not be ready to pay anything for goodwill—even if the value of goodwill is very high.

    Methods of Valuing Goodwill:

    There are two methods of valuing goodwill:

    1. Simple profit method, and.
    2. Super-profit method.

    Simple Profit Method:

    There are two methods based on simple profit:

    • Purchase of Past Profit Method, and.
    • The capitalization of the Average Profit Method.
    A. Purchase of Past Profit Method:

    Under this method, goodwill is expressed as a purchase of a certain number of years’ profit based on the adjusted average profit of a given number of years.

    This method involves two steps:

    • The profits for an agreed number of years preceding the valuation average to ar­rive at the average annual profit earned during that period. This will have to adjust in the light of future possibilities and the average future maintainable profit determined. If the profits have been fluctuating, a simple average use. If profits show a steadily increasing or decreasing trend, appropriate weights are used giving greater weightage for profits of the later year.
    • The average future maintainable profit is multiplied by a certain number of years to find out the value of goodwill. The number of years selected for this purpose base on the expectation of the number of years’ benefit to derive in the future from the past association.

    For example, if the average future maintainable profit is Rs.25, 000 and it expects that this profit would earn for at least another 3 years, then the goodwill will be:

    Goodwill,

    = Rs. 75,000 (25,000 x 3).
    = Average of profit x number of years.

    The number of years over which the profits are averaged and the number of years’ purchase applied may vary considerably in practice but generally falls between one and five years. Estimating future profit beyond a period of say, 5 years would be quite difficult and unrealistic.

    The method suffers from two defects:

    • The difficulty of finding out the right number of years’ purchase of profits as it depends on so many factors and
    • Ignoring capital to employ in the business.
    B. The capitalization of the Average Profit Method:

    The following steps are to take in ascertaining the value of goodwill under this method:

    • Ascertain the average future maintainable profit, as explained already.
    • Capitalize this average profit at the normal rate of return on investment on the type

    Of business under consideration:

    This will give the net worth of the business.

    • Find out the value of net tangible assets (i.e., net assets other than goodwill) of the business.
    • Deduct the net tangible assets from the capitalized net worth of the business and the difference is goodwill.

    Super-Profit Method:

    Strictly speaking, goodwill can attach only to a business that is earning above-normal profits of super-profits. If there is no anticipated excess earning over normal earnings, there can be no goodwill.

    Such excess profits know as super-profits and it is the difference between the average profit earned by the business and the normal profit based on the normal rate of return.

    Hence for find­ing to the super-profits, the following information will require:

    • The estimated average future profits of the firm (ascertained as already explained),
    • The normal rate of return on investment and
    • The fair value of the average capital employed in the business.

    The normal rate of return:

    The normal rate of return refers to the rate of earnings that inves­tor, in general, expect on their investments in a particular type of industry. It varies depending upon general factors like the bank rate, general economic conditions, political stability, etc., and specific factors like period of investment, risk attached to the investment, etc.

    Normal profit and Super-profit:

    If the average capital employed and the normal rates of return know, the normal profit can ascertain. For example, if the average capital employed is Rs. 1, 00,000 and the normal rate of return is 10%, the normal profit is 1, 00, 000 x 10/100 = 10, 000.

    Super-profit is the simple difference between the actual average profit earned and the normal profit. If in the above example, the average profit is Rs. 25,000, then the super-profits will be Rs. 25,000 – Rs. 10,000 = Rs. 15,000

    Goodwill based on Super-Profit:

    There are four methods of calculating goodwill based on the super-profit.

    They are:

    • Purchase of super-profits Method,
    • Sliding-scale Valuation of Super-profit Method,
    • Annuity of Super-Profit Method and
    • The Capitalization of Super-Profit Method.
    1. Purchase of Super-profit Method:

    Goodwill as per this method = Super profit * Number of years. If, for example, the super-profit is Rs. 15,000 and goodwill agree to be 3 years’ purchase of super-profits, then the goodwill will be s.45,000 (15,000 * 3)

    2. Sliding-scale Valuation of super-profits Method:

    This is the only variation of the first method. It is based on the logic that the greater the number of super-profits, the more difficult it would be to maintain. Higher profit will naturally attract competition and soon the firm’s ability to make super-profits is curtailed.

    3. Annuity super-profit Method:

    Under this method, goodwill calculates by finding the present worth of an annuity paying the super profit per year, over the estimated period discounted at the given rate of interest. Usually, the reference to the Annuity Table will give the present value of an annuity for the given number of years and at the given rate of interest.

    Goodwill = super-profit * annuity.

    For example, if the super-profits are Ts. 15,000 and the annuity of re. 1 at 10% for 3 years is 2.48,685, then the goodwill is = Rs. 15,000 * 2.48,685 = Rs. 37,302.75. This method takes into consideration the interest loss involved in paying a lump sum as goodwill in anticipation of the future of profit.

    4. The Capitalization of Super-Profit Method:

    This is similar to the capitalization of the average profit method as already explained. Under this method, the super-profits when capitalized at the normal rate of return will give the value of goodwill.

    Goodwill,

    = Rs. 1, 50, 000 (Rs. 15, 000/10 x 100).
    = Super Profit/Normal rate of return x 100.

    This method gives the maximum value for goodwill. Since the contention that super-profits will continue for long is unreasonable, this method is not safe for one to follow.