Goodwill: nature and valuation

The essentials

Goodwill is the value of a firm's reputation, which enables it to earn more profit than a normal business with the same capital. It is an intangible asset, though not a fictitious one, because it has value and can be sold with the business. Goodwill must be valued at reconstitution because old partners are compensated for the share of future excess profits they give up.

Key points

• Factors: nature of business, location, efficiency of management, market situation, special advantages (licences, patents), and quality of products and service.
• Average profit method: Goodwill = Average profit × Number of years' purchase.
• Super profit method: Super profit = Average profit − Normal profit; Normal profit = Capital employed × Normal rate ÷ 100; Goodwill = Super profit × Number of years' purchase.
• Capitalisation of super profit: Goodwill = Super profit × 100 ÷ Normal rate.
• Capitalisation of average profit: Goodwill = (Average profit × 100 ÷ Normal rate) − Capital employed (net assets).
• Weighted average profit gives more weight to recent years.

Exam tips

Adjust past profits for abnormal items (such as a one-time gain or loss) before averaging. Write formulae before substituting values.

Common mistakes

• Using total profit instead of average profit.
• Forgetting to subtract normal profit in the super profit method.
• Treating goodwill as a fictitious asset.