Meaning, Circumstances, Factors of Valuation of Goodwill

11/07/2020 2 By indiafreenotes

The name and fame of an organization can be termed as goodwill. Goodwill is the benefit and merit of good name and reputation. Goodwill refers to a measure of the capacity of a business to earn excess profit. Therefore, goodwill can be defined as an intangible asset of the business.

Thus, goodwill may also be defined as “value of the reputation of business“. It is a valuable asset if the concern is profitable. It is useless if the concern is a loosing concern. Goodwill can be described as the extra sale able value attached to a prosperous business beyond the intrinsic value of net assets. Thus the existence of goodwill can be felt through extra earning power. Because of such a nature, it seems like a real assets. But since it is invisible such as patents, trademark, copyrights etc. goodwill is termed as intangible assets.

Need For Valuation of Goodwill

The need for valuation of goodwill arises in various circumstances. Some of the circumstances are as follow:

  1. In the case of sole trading concern, valuation of goodwill is needed at the time of selling of business, to take any person as a partner, to convert sole trading concern into a company.
  2. In the case of partnership, when there is an admission, retirement and death of partner, amalgamation, conversion into a company and change in profit sharing ratio.
  3. In the case of company, goodwill is valued at the time of amalgamation of two or more companies, absorption of company, reconstruction and holding company. The valuation of goodwill also becomes necessary, if the shares have to be valued on the basis of intrinsic value, market value or fair value and if the stock exchange quotation of the value of shares of a company is not available.
  4. For taxation purpose such as wealth tax also, the valuation of goodwill is necessary.

Factors determining the value of Goodwill:

Since goodwill of a business represents its capacity to earn above normal profits, all factors which contribute to such profits influence the goodwill of the firm. Some of those factors may be:

(1) Location factors:

Favourable location influences the earning capacity of the business and enhances its goodwill.

(2) Time factor:

An older, more established, business enjoys better goodwill than a new business.

(3) Nature of business:

The nature of goods dealt with, the risk attached the competition involved, certain special privileges enjoyed by the firm such as special licenses, franchise, etc., determine the value of goodwill.

(4) Efficiency of management:

Planned production, distribution and highly successful mar­keting of a business leads to better profits and higher value of goodwill.

Factors determining the value of Goodwill:

(1) Goodwill is always paid for the future.The buyer of a business is always interested in knowing whether the business will maintain its profits in the future also. If the advantage is not likely to come to the buyer, the buyer will not be ready to pay anything for goodwill. Therefore, when evaluating the amount of the future maintainable profits.

(2) The ability to earn future profits is measured by the profits made by the business in the recent past. Hence, analysis of the past profits becomes necessary to determine the average maintainable profit in the future.

For the purpose of finding out the average profits likely to be earned in the future:

(a) all actual expense and losses not likely to occur in the future are added back to the profits, (b) all expenses and losses not incurred in the past, but likely to arises in the future are to be deducted,

(c) All profits likely to be earned in the future only are to be add and

(d) Profit earned in the past, but not likely to be earned in the future are to be deducted.

After having adjusted profit in the light of the future possibilities, the average maintainable profit is ascertained which forms the basis for the valuation of goodwill.

(3) The future profits are likely to be reduced materially by taxation and hence it is also taken into account for determining the value of goodwill.