Question

Briefly describe each of the above three approaches to accounting for goodwill

Identify and briefly comment on some of the criticisms of the existing impairment model.

State support for a hybrid alternative where goodwill is amortized over 10 years as well as tested for impairment periodically

Answer 1

The valuation of goodwill depends upon assumptions made by the valuer. Methods to be adopted in valuation of goodwill would depend on circumstances of each case and is often based on the customs of the trade.

The various methods that can be adopted for valuation of goodwill are follows:

1. Average Profit Method

2. Super Profit Method

3. Capitalization Method

4. Annuity Method.

1. Average Profit Method:

Under this method the value of Goodwill is calculated by multiplying the Average Future profit by a certain number of year’s purchase.

Goodwill = Future maintainable profit after tax x No. of years purchase

The first step under this method is the calculation of average profit based on past few years’ profit. Past profit are adjusted in respect of any abnormal items of profit or loss which may affect future profit. Average profit may be based on simple average or weighted average.

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

Number of year’s purchase:

After calculating future maintainable average profits, the next step is to determine the number of years’ purchase. The number of years of purchase is determined with reference to the probability of new business to catch up with an existing business. It will differ from industry to industry and from firm to firm. Normally the number of years ranges between 3 to 5.

Steps Involved under Average Profits Method:

(i) Calculate past profits before tax.

(ii) Calculate future-maintainable profit before tax after making past adjustments.

(iii) Calculate Average Past adjusted Profits (taking simple average or weighted average as applicable).

(iv) Multiply Future Maintainable Profits by number of years’ purchase.

Value of Goodwill = Future Maintainable Profits x No. of years’ purchase.

2. Super Profit Method:

Super profit is the excess of estimated future maintainable profits over normal profits. An enterprise may possess some advantages which enable it to earn extra profits over and above the normal profit that would be earned if the capital of the business was invested in some other business with similar risks. The goodwill under this method is ascertained by multiplying the super profits by certain number of year’s purchase.

Steps Involved in Calculating Goodwill under Super Profit Method:

Step 1: Calculate capital employed (it is the aggregate of Shareholders’ equity and long term debt or fixed assets and net current assets).

Step 2: Calculate Normal Profits by multiplying capital employed with normal rate of return.

Step 3: Calculate average maintainable profit.

Step 4: Calculate Super Profit as follows:

Super Profit = Average maintainable profits – Normal Profits.

Step 5: Calculate goodwill by multiplying super profit by number of year’s purchase.

3. Capitalization Method:

Goodwill under this method can be calculated by capitalizing average normal profit or capitalizing super profits.

(i) Capitalisation of Average Profit Method:

Under this method goodwill is ascertained by deducting Actual Capital Employed (i.e., Net Assets as on the valuation date) from the capitalised value of the average profits on the basis of normal rate of Return (also known as value of the firm or capitalised value of business)

Goodwill = Capitalised Value – Net Assets of Business

Steps involved in calculating goodwill as per capitalisation of Average Profits Method:

Step 1: Calculate Average future maintainable profits

Step 2: Calculate Capitalised value of business on the basis of Average Profits

Step 3: Calculate the value of Net Assets on the valuation date

Net Assets = All Assets (other than goodwill, fictitious assets and non-trade investments) at their current values – Outsider’s Liabilities

Step 4: Calculate Goodwill

Goodwill = Capitalised Value – Net assets of business.

(ii) Capitalisation of Super Profit Method:

The goodwill under this method is ascertained by capitalizing the super profits on the basis of normal rate of return. This method assesses the capital needed for earning the super profit.

The value of goodwill is computed as follows:

4. Annuity Method:

Under this method, goodwill is calculated by taking average super profit as the value of an annuity over a certain number of years. The present value of this annuity is computed by discounting at the given rate of interest (normal rate of return). This discounted present value of the annuity is the value of goodwill. The value of annuity for Rupee 1 can be known by reference to the annuity tables.

If the value of annuity is not given, it can be calculated with the help of following formula: