Valuation of Goodwill Lecture Notes

Introduction

• This chapter is from Corporate Accounts.
• Valuation of Goodwill:
  • A simple chapter with no debit/credit or account preparation.
  • Focus on valuation using calculations and working notes.

Concept of Goodwill

• Goodwill is an intangible asset helping businesses earn extra profit.
  • It is not physical, but increases earning capacity.

Example of Goodwill

• Scenario:
  • Four shops: three old (10 years), one new (1 year).
  • Profits:
    • Shop 1: 5 Lakhs
    • Shop 2: 4 Lakhs
    • Shop 3: 3 Lakhs
    • New Shop: 2 Lakhs (normal profit)
• Extra Profit:
  • Old shops earn above normal profit due to goodwill.
  • Goodwill is derived from reputation, customer loyalty, market position.
  • Extra profits over normal profits are termed 'Super Profits'.

Another Goodwill Example

• A shop with loyal customers, good reputation, and quality service attracts more business compared to others.
• Word-of-mouth enhances goodwill.

Types of Goodwill

• Self-Generated Goodwill:
  • Developed over time with loyal customers and reputation.
  • Not recognized in accounting or shown on the balance sheet.
• Purchased Goodwill:
  • Arises when acquiring a business, reflected in balance sheet as per Accounting Standard 26.

Example of Purchased Goodwill

• Buying a profitable business in a prime location at higher than net asset value due to future profit potential.
• Owner compensated for future profits they will not receive post-sale.

Methods of Valuation of Goodwill

• Average Profit Method:
  • Simple Average and Weighted Average (when profits are trending).
• Super Profit Method
• Capitalization Method:
  • Involves capitalizing average profit or super profit.
• Annuity Method

Summary

• Methods and formulas for calculating goodwill will be discussed in future sessions with practical problems.
• Understanding the base method makes it easier to derive others.

Upcoming Sessions

• Detailed analysis and problem-solving on:
  • Average Profit Method
  • Super Profit Method
  • Capitalization Method
  • Annuity Method