Definition of Goodwill Valuation
Goodwill is the reputation earned bya business over time and it is considered to be an intangible asset. Goodwill valuation refers to the process ofassigning value to this reputation in monetary terms. Goodwill is recognized and valued when a company acquires another company at a consideration in excess of the fair value of its net assets.
Explanation
Goodwill valuation is done at the time of business combination i.e. when a company is merged with or acquires another company. Companies do not recognize the goodwill it generates overtime due to its quality products and services, customer satisfaction, trust,and other similar factors in their books of accounts. The goodwill is recognized on the balance sheet under non-current assets as intangible assets.
There are various methods through which goodwill is valued at the time of business combination. As per US GAAP (Generally accepted accounting principles) and IFRS (International financial reporting standards), the goodwill needs not to be amortized as it is assumed to have an indefinite useful life. But companies are required to test goodwill for impairment once in a year. However, in the US private companies are allowed to amortize goodwill over a period of ten years, if they opt for it, based on the straight-line method to avoid the cost and complexity of the impairment test.
Methods of Goodwill Valuation
There are several methods of goodwill valuation which are discussed below:
1. Average Profit Method
Under the average profit method, an average profit usually for the last 3-4 years is calculated ignoring any abnormal profit or loss. The average profit figure thus calculated will be multiplied by the agreed number of years say 4 or 5. The resultant figure gives the value of the goodwill.
The weighted profit method is a modified version of the average profit method wherein an agreed weightage is multiplied to each year’s profit and divided by the aggregate number of weights to calculate the average weighted profit which is then multiplied to the no. of years of purchase as agreed.
2. Super Profit Method
Under the super profit method, super profit is multiplied by the number of years as agreed. Super profit is defined as an excess of profit over normal profit. It is calculated by deducting normal return (which is calculated by multiplying capital employed by the rate of normal return) from future maintainable profit. Further to calculate the goodwill amount super profit is multiplied with the number of years of purchase as agreed.
3. Annuity Method
Under this method, goodwill is calculated as a present value of future super-profits to be earned by the company. Therefore, super profits are multiplied by the annuity factor to get the present value of the goodwill.
4. Capitalization Method
Under this method, goodwill is calculated by deducting the actual capital employed from the capitalized average profit based on a normal rate of return or by dividing super profit with agreed capitalization rate respectively. Thus, the following are the two options for calculating goodwill under this method.
- Average Profit Capitalization Method: Goodwill = [Average profit/ normal rate of return* 100]- capital employed.
- Super Profit Capitalization Method: Goodwill – Super profit/ capitalization rate* 100.
Factors Affecting Goodwill Valuation
Below are the factors that affect goodwill valuation at the time of business combination:
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- The nature of business and its location affect the value of goodwill. If the business is located in a favorable location, goodwill will be more.
- Longevity i.e. the time-period since the business is existing also affects how much goodwill will be valued. Older the business, the stronger the market existence, brand name, and the higher the goodwill valuation.
- Quality of products and services, customer trust, and customer base also play a deciding role in the valuation of goodwill.
- License, technical know-how, customer services, after-sales services, the business risk involved also affects goodwill valuation.
- Profitability, capital employed, market competitors, management strategies for meeting up the investors’ expectations, etc. are some other factors affecting goodwill.
Need for Goodwill Valuation
There can be many circumstances in the business wherein the need for valuation of goodwill arises. Some of them in respect of the company are as follows:
- When an existing company amalgamates with another existing company.
- When goodwill was written off in the past but the value of goodwill is now further to be recorded in the books of accounts.
- If a company is interested in acquiring a controlling interest in another company.
- If a company wants to merge with another company i.e. business combination.
- In the case where the valuation of shares is required for taxation purposes but the stock quotation is not available.
Advantages of Goodwill Valuation
- It helps to establish the value of the business in the eyes of stakeholders, customers, and investors.
- It helps in setting the business image above from its competitors in customers’ minds when they are confused between choosing two different companies.
- Goodwill based on brand name built over definitely helps in improving the current value of the business.
- It helps encouraging brand loyalty also it serves as a test for the solvency of the business.
Conclusion
Valuation of goodwill is an important phenomenon at the time of business combination, amalgamation, etc. The value of goodwill is recognized only when business is sold or transferred, irrespective of the fact that goodwill was built over the years.
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