Types of Goodwill

The category into which the goodwill of a company will fall depends upon the fact that how
that company got its goodwill. Did it purchase the goodwill like any other asset or did it earn
the goodwill on account of its standing in the business. Hence goodwill of a business concern
can be divided into two categories from accounting point of view.
1) Purchased Goodwill
2) Non purchased Goodwill.
We will explain the concept of purchased and non purchased goodwill with the help of
examples. Let us assume that You purchased the business of a company XYZ ltd. The
purchase consideration that you paid is $20 million. But the value of net assets acquired by
you against the purchase consideration is only 19 million. This extra one million $ that you
are paying as a part of purchase consideration represents the amount of goodwill that you
purchased from XYZ Ltd along with other assets. So if the purchase consideration exceeds
the value of net assets taken over by you, the difference is called purchased goodwill.
Purchased Goodwill arises on the acquisition of an existing business concern. It can be
calculated with the help of purchase consideration and the value of net assets acquired. You
can show the value of this Goodwill in your Balance Sheet like any other asset. The cost of
the purchased Goodwill is determined by the future maintainability of profits.
Let us again assume that while working in the same business due to some positive factors you
have earned a value for your business which the other business concerns on the same level of
activity do not possess. This value, athough not exhibited by your financial statements, yet it
makes you stand apart form your rivals. It can fetch a good market standing to you. It has
given a loyal customer base to you. This positive image of your business reflects in the trust
of your creditors and bankers which they have on you. This value for your business that you
have earned yourself is called Non Purchased Goodwill. Non purchased goodwill, as it is
clear from the name itself is not purchased from any other entity. It is the goodwill that has
been earned by you over a period of years on account of many favorable factors that increase
the value of your business. Non purchased goodwill is the goodwill which the business has
generated on its own due to its location, managerial efficiency, credit worthiness, brand
value, product quality, public image and many more other factors. It is also called Raised
Goodwill or Inherent Goodwill. It has been generated by the company itself so no
consideration is paid for it and hence no cost can be placed on it. It is not shown in the
Balance Sheet of the business.
There are three methods of valuation of goodwill of the firm;

1. Average Profits Method

2. Super Profits Method
3. Capitalisation Method

1. Average Profits Method:

Under this metod goodwill is calculated on the basis of the average of some agreed number of
past years. The average is then multiplied by the agreed number of years. This is the simplest
and the most commonly used method of the valuation of goodwill.
Goodwill = Average Profits X Number of years of Puchase
Before calculating the average profits the following adjustments should be made in the profits
of the firm:
a. Any abnormal profits shoulld be deducted from the net profits of that year.
b. Any abnormal loss should be added back to the nat profits of that year.
c. Non operating incomes eg. income from investments etc should be deducted from the net
profits of that year.
Now we will explain this method with the help of a simple example.
A Ltd agreed to buy the business of B Ltd. For that purpose Goodwill is to be valued at three
years purchase of Average Profits of last five years. The profits of B Ltd. for the last five
years are:
Year
2005
2006
2007
2008
2009

Profit/Loss ($)
10,000,000
12,250,000
7,450,000
2,450,000 (Loss)
12,400,000

Following additional information is available:

1. In the year 2008 the company suffered a loss of $1,000,500 due to fire in the factory.
2. In the year 2009 the company earned an income from investments outside the business $
4,500,250.
Solution:
Total profits earned in the past five years= 10,000,000 + 12,250,000 + 7,450,000 - 2,450,000
+ 12,400,000 = $ 39,650,000
Total Profits after adjustments = $ 39,650,000 + $ 1,000,500 - $ 4,500,250=$ 36,150,250
Average Profits= $ 36,150,2505=$ 7,230,050
Goodwill = $ 7,230,0503=$ 21,690,150
Thus A Ltd would pay $21,690,150 as the price of Goodwill earned by B Ltd.

2. Super profits method:

Super Profits are the profits earned above the normal profits. Under this method Goodwill is
calculated on the basis of Super Profits i.e. the excess of actual profits over the average
profits. For examplle if the normal rate of return in a particular type of business is 20% and
your investment in the business is $1,000,000 then your normal profits should be $ 200,000.
But if you earned a net profit of $ 230,000 then this excess of profits earned over the normal
profits i.e. $ 230,000 - $ 200,000= Rs.30,000 are your super profits. For calculating
Goodwill, Super Profits are multiplied by the agreed number of years of purchase.
Steps for calculating Goodwill under this method are given below:
i) Normal Profits = Capital Invested X Normal rate of return/100
ii) Super Profits = Actual Profits - Normal Profits
iii) Goodwill = Super Profits x No. of years purchased
For example, the capital employed as shown by the books of ABC Ltd is $ 50,000,000. And
the normal rate of return is 10 %. Goodwill is to be calculated on the basis of 3 years puchase
of super profits of the last four years. Profits for the last four years are:
Year
2005
2006
2007
2008

Profit/Loss ($)
10,000,000
12,250,000
7,450,000
5,400,000

Total profits for the last four years = 10,000,000 + 12,250,000 + 7,450,000 + 5,400,000 = $35,100,000
Average Profits = 35,100,000 / 4 = $ 8,775,000
Normal Profits = 50,000,000 X 10/100 = $ 5,000,000
Super Profits = Average/ Actual Profits Normal Profits = 8,775,000 5,000,000 = $ 3,775,000
Goodwill = 3,775,000 3 = $ 11,325,000

3. Capitalisation Method:

There are two ways of calculating Goodwill under this method:

(i) Capitalisation of Average Profits Method
(ii) Capitalisation of Super Profits Method

(i) Capitalisation of Average Profits Method:

Under this method we calculate the average profits and then assess the capital needed for
earning such average profits on the basis of normal rate of return. Such capital is called
capitalised value of average profits. The formula is:Capitalised Value of Average Profits = Average Profits X (100 / Normal Rate of Return)
Capital Employed = Assets - Liabilities
Goodwill = Capitalised Value of Average Profits - Capital Employed
For example a firm earns $40,000 as its average profits. The normal rate of rteturn is 10%.
Total assets of the firm are $1,000,000 and its total external liabilities are $ 500,000. To
calculate the amount of goodwill:
Total capitalized value of the firm = 40,000 100/10 = 400,000
Capital Employed = 1,000,000 500,000 = 500,000
Goodwill = 500,000 400,000 = 100,000

(ii)Capitalisation of Super Profits:

Under this method first of all we calculate the Super Profits and then calculate the capital
needed for earning such super profits on the basis of normal rate of return. This Capital is the
value of our Goodwill . The formula is:Goddwill = Super Profits X (100/ Normal Rate of Return)
For example ABC Ltd earns a profit of $ 50,000 by employing a capital of $ 200,000, The
normal rate of return of a firm is 20%. To calculate Goodwill:
Normal Profits = 200,000 20/100 =$ 40,000
Super profits = 50,000 40,000 = $10,000
Goodwill = 10,000 100 / 20 = $50,000