Valuation/Computation Of Goodwill

July 27th, 2007 Comments off
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Refer to the Category on Goodwill Valuation, you will see many methods of computing goodwill.

This article deals with one of the normal way of computing or valuing goodwill particularly in a partnership whether at the time of a new partner, or the retiring or death of an old partner.

Goodwill Valuation:
  1. Average annual net profit x an agreed figure

In this case, the goodwill valuation is based on the following steps:
  • the profits for an agreed number of years preceding the valuation are averaged to arrive at an average annual profit earned and
  • then goodwill is estimated to be worth so many years’ purchase of such average profit

Illustration No 1:

Say Partnership A registered the following annual profits:

Year 1 : Profits $10,000 Year 2: Profits $20,000 Year 3: Profits $30,000

If goodwill is agreed to be valued as:(a) two years’ purchase of average profit for the last three years

Solution:

Goodwill computation:

(a) Average profit = $10,000+$20,000+$30,000 / 3 = $20,000

(b) Goodwill = $20,000 x 2 agreed years = $40,000 Illustration No 2

:In the Partnership, the three partners A B C has the profit/loss sharing ratio of 2/5 ,2/5 and 1/5 respectively.In the partnership agreement, it states that in the event of death or retirement of a partner, goodwill should be valued on the basis of two years’ purchase of the average net profits for the preceding three years. Eventually Mr A retires on 31 /12 /xx.

Compute the goodwill due to Mr A.

Solution:

Following net profits registered:

Year 1 : $10,000 Year 2 : $20,000 Year 3 : $30,000

Total profits for preceding 3 years = $10,000+$20,000+$30,000=$60,000

Average profit = $60,000/3 = $20,000

Total goodwill = $20,000 x 2 = $40,000

Mr A’s share of goodwill = $40,000 x 2/5 = $16,000

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