AccountancyGoodwill: nature and methods of valuation
An old, trusted shop earns more than a new one with the same stock and furniture. The value of that extra earning power is goodwill.
Meaning
Goodwill is the value of the reputation and connections of a business, which enable it to earn more profit than a similar new business could. It is an intangible asset: it cannot be seen or touched, but it is real, because a buyer will pay for it. It cannot be sold separately from the business.
Factors affecting goodwill
- Location: a shop on a busy road draws more customers.
- Time: an older business has more loyal customers.
- Nature of business: steady demand, few competitors or a licence adds value.
- Efficient management and skilled staff.
- Quality of goods and service.
- Market situation: a monopoly or a strong brand.
- Special advantages: long-term contracts, patents, assured supply of materials.
Kinds of goodwill
Purchased goodwill arises when a business is bought for more than the value of its net assets. It is recorded in the books because a price was paid for it. Self-generated goodwill is built up by the business over time. Accounting Standard 26 (Intangible Assets) does not allow self-generated goodwill to be recorded as an asset, since its cost cannot be measured reliably. This is why, on changes in a firm, goodwill is adjusted through the partners' capital accounts and not kept in the books.
When goodwill is valued in a partnership
- Change in the profit sharing ratio.
- Admission of a partner.
- Retirement or death of a partner.
- Sale or amalgamation of the firm.
Method 1: average profit
Goodwill = Average profit × Number of years' purchase
Before averaging, make the profits normal: remove abnormal gains (add back abnormal losses), and deduct a fair salary for the owners if none was charged.
Example. Profits of a firm for the last four years: ₹80,000, ₹90,000, ₹1,00,000 and ₹1,10,000. Goodwill is valued at two years' purchase of the average profit.
Average profit = (80,000 + 90,000 + 1,00,000 + 1,10,000) ÷ 4 = ₹95,000. Goodwill = ₹95,000 × 2 = ₹1,90,000.
Weighted average profit
When profits show a clear rising or falling trend, recent years are given more weight.
| Year | Profit | Weight | Product |
|---|---|---|---|
| 1 | 80,000 | 1 | 80,000 |
| 2 | 90,000 | 2 | 1,80,000 |
| 3 | 1,00,000 | 3 | 3,00,000 |
| 4 | 1,10,000 | 4 | 4,40,000 |
| Total | 10 | 10,00,000 |
Weighted average profit = ₹10,00,000 ÷ 10 = ₹1,00,000. Goodwill at two years' purchase = ₹2,00,000.
Method 2: super profit
Any business earns some return on the money invested in it. Goodwill exists only if the firm earns more than the normal return.
- Capital employed = Total assets (excluding goodwill and fictitious assets) − Outside liabilities.
- Normal profit = Capital employed × Normal rate of return ÷ 100.
- Super profit = Average profit − Normal profit.
- Goodwill = Super profit × Number of years' purchase.
Example. Average profit ₹95,000; capital employed ₹6,00,000; normal rate of return 10%. Goodwill at three years' purchase of super profit.
Normal profit = 10% of ₹6,00,000 = ₹60,000. Super profit = ₹95,000 − ₹60,000 = ₹35,000. Goodwill = ₹35,000 × 3 = ₹1,05,000.
Method 3: capitalisation
(a) Capitalisation of average profit
- Capitalised value of the business = Average profit × 100 ÷ Normal rate of return.
- Goodwill = Capitalised value − Capital employed (net assets).
With the same figures: capitalised value = ₹95,000 × 100 ÷ 10 = ₹9,50,000. Goodwill = ₹9,50,000 − ₹6,00,000 = ₹3,50,000.
(b) Capitalisation of super profit
Goodwill = Super profit × 100 ÷ Normal rate of return = ₹35,000 × 100 ÷ 10 = ₹3,50,000. Both capitalisation routes give the same answer, which is a useful check.
The methods side by side
| Method | Goodwill in the example |
|---|---|
| Average profit, 2 years' purchase | ₹1,90,000 |
| Weighted average profit, 2 years' purchase | ₹2,00,000 |
| Super profit, 3 years' purchase | ₹1,05,000 |
| Capitalisation (either route) | ₹3,50,000 |
The answers differ because the methods and the years of purchase differ. In practice the partners agree on a method in the deed; in an examination the question states it.
Normalising profits: a short example
Profit of the year was ₹1,20,000 after a loss by fire of ₹15,000 (abnormal) and including a gain of ₹10,000 on sale of an old machine (not from trading). The partners work full time and a fair salary would be ₹30,000; none was charged. Normal profit for valuing goodwill = 1,20,000 + 15,000 − 10,000 − 30,000 = ₹95,000.
How goodwill is adjusted between partners is shown on the pages on change in ratio, admission and retirement.
Questions students ask
What is super profit?
The excess of a firm's average profit over the normal profit, where normal profit is the normal rate of return applied to the capital employed.
Why is self-generated goodwill not shown in the books?
Because its cost cannot be measured reliably. Accounting Standard 26 allows only purchased goodwill, for which a price was paid, to be recorded.
What does "years' purchase" mean?
The number of years for which the buyer expects to enjoy the past level of profit or super profit. Goodwill is that profit multiplied by this number.
More Class 12 topics
For study, and independent. These pages explain accountancy as it is generally taught in Class 11, Class 12 and B.Com courses in India, in our own words with our own examples, reviewed in November 2026. This site is not connected with NCERT, CBSE, ICAI or any board or university. Syllabuses change: follow your own board's or university's current syllabus and textbook. Nothing here is professional accounting, tax or legal advice.