Valuing Goodwill — Super Profit and Capitalization Methods, and Treatment in the Books

Super Profit Method

The Average Profit and Weighted Average Profit methods value goodwill on the whole of the firm's average earnings. But some of those earnings are simply the normal return any firm of that size and risk would earn on the capital invested — that portion has nothing to do with goodwill. The Super Profit Method isolates only the extra earnings that come from the firm's reputation:

Normal Profit = Capital Employed × Normal Rate of Return

Super Profit = Average Profit − Normal Profit

Goodwill = Super Profit × Number of Years' Purchase

Here, Capital Employed is the net amount of capital actually invested in the business (broadly, total assets used in the business, excluding goodwill and fictitious assets, minus outside liabilities), and the Normal Rate of Return is the rate of return that similar firms in the same industry, carrying a similar level of risk, normally earn on their capital. If the firm's Average Profit exceeds this normal return, the excess (the super profit) is what goodwill is valued on.

Capitalization Method

This method works the relationship between profit, capital, and rate of return the other way around, and comes in two variants.

1. Capitalization of Average Profit — first find what total capital ought to support the firm's average profit at the normal rate of return, then compare it with the capital actually employed: Capitalized Value of the Business = Average Profit × (100 ÷ Normal Rate of Return) Goodwill = Capitalized Value of the Business − Actual (Net) Capital Employed
2. Capitalization of Super Profit — capitalize only the super profit directly, which gives goodwill in a single step: Goodwill = Super Profit × (100 ÷ Normal Rate of Return) Both capitalization variants and the Super Profit method are closely related — all three start from the same idea that goodwill exists only because of profit earned above the normal return on capital; they simply arrive at the rupee figure through slightly different arithmetic routes.

Treatment of Goodwill in the Books

However goodwill is valued — by any of the four methods above — the figure is only useful once it is actually recorded and adjusted in the partners' capital accounts. The standard practice, most commonly seen on admission of a new partner, is:

• The new partner's share of goodwill (the "premium for goodwill") is calculated using their new profit share and the goodwill value agreed for the firm.
• If the new partner brings this premium in cash (or otherwise), it is credited to the sacrificing partners in their sacrificing ratio — the old partners who are giving up a share of future profits are the ones entitled to be compensated for the goodwill they helped build. …