Annuity Method Of Goodwill

What is Meant by Goodwill? 

Goodwill is a type of intangible asset owned by the company. It represents the value of a company’s brand, existing customer base, and consumer and stakeholder relationships.

The same arises in the books of accounts when another entity purchases an entity. In the process of acquiring, the assets and corresponding liabilities are taken up by the purchaser. However, at times the net fair value of the assets purchased and liabilities taken tend to exceed the Book value. This excess is referred to as goodwill.      

Two types of goodwill are: 

• Inherent goodwill: The goodwill that is internally generated and arises over a period when the fair value of the assets tends to be higher than the book value. 

• Purchased goodwill: It is the difference between the value paid by the purchaser and the value of assets minus the liabilities acquired. 

Various methods to calculate goodwill are: 

• Average Profit Method

• Super Profit Method

• Capitalization Method

• Annuity Method 

What is the Annuity Method of Goodwill? 

The annuity method of goodwill values goodwill as per the formula given below:

Value of Goodwill = Average Super Profit * Present Value of annuity for Rupee at a given rate of Interest(A)

where, 

A = [1-(1+r/100)-n]/[r/100]

Here,

A = Present Value of annuity of Rupee 1

r = Normal rate of return

n= number of years

How is super profit calculated? 

Super Profit is the profit earned over and above the normal profit. It is calculated using the formula – 

Super profit = Actual or average profit – Normal Profit. 

Where, 

Normal profit is calculated by multiplying the capital employed with the normal rate of return. Capital employed is the total of the Shareholders Fund and Long-term debts or the aggregate of fixed assets and net current assets. 

For instance: 

Further,

• The capital Employed is Rs. 1,00,000/-

• The normal rate of interest is 10%. 

The average profit = [12,200 + 15,000 + 21,000 + 2,000]/4 = 12,550/-

Calculation of Super Profit: 

Illustration for calculation by annuity method 

For Example: 

The Net profit of a company after tax for the last Five Years is 

Further, 

• The net tangible asset amount to Rs. 5,00,000/-. 

• The normal rate of return is expected to be 10%. 

• The company will be able to maintain its profits for the next five years

• Present value of an annuity of Rs. 1 for 5 years at 10% interest is Rs. 3.78

The goodwill shall be calculated as under: 

Calculation of Super Profit: 

Value of Goodwill = Super Profit * Value of Annuity = 8,000/- * 3.78 = 30,240/-. 

In Conclusion

The valuation of goodwill is often required for various reasons such as sale, purchase of the concern, and the likes. Although different methods have been prescribed to calculate goodwill, the annuity method gives accurate results. It considers all the factors that can impact goodwill. 

This method is quick, easy to comprehend, and justified. Since it keeps in view your future expectations, the method is considered viable by big corporates worldwide.

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