Annuity Method Of Goodwill

The annuity method of goodwill is a popular tool used for the valuation of goodwill. Under this method, the goodwill is computed using the super-profits as the annuity value over several years. The present value of annuity is then calculated by discounting at the normal rate of interest. This discounted present value calculated is the value of goodwill. The formula uses the annuity tables to arrive at the value of an annuity for Rupee 1.

Read more

Secure Your Retirement with

100% Guaranteed

Pension For Life

Best Pension Options
  • Invest 20 Lacs Get ₹ 1.6 Lacs pension for Life

  • Guaranteed Return For Life

  • Multiple Annuity Options

*All savings are provided by the insurer as per the IRDAI approved insurance plan. Standard T&C Apply

Buy Online and Get ₹ 1.4 Lacs extra#
Guaranteed Pension For Life For You And Your Spouse
Invested amount returned to your nominee
+91
View Plans
Please wait. We Are Processing..
Plans available only for people of Indian origin By clicking on "View Plans" you agree to our Privacy Policy and Terms of use #For a 55 year on investment of 20Lacs #Discount offered by insurance company
Get Updates on WhatsApp

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

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: 

Year Profit after Tax
2021 12,200/-
2020 15,000/-
2019 21,000/-
2018 (2,000/-)

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 = 11, 550/-

Calculation of Super Profit: 

Particulars Amount
Average Profit  11,550/-
Less Normal Profit  10,000/-
Super Profit  1,150/-

Illustration for calculation by annuity method 

For Example: 

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

Year Profit after Tax
2021 70,000/-
2020 40,000/-
2019 50,000/-
2018 30,000/-
2017 80,000/-

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: 

Year Profit after Tax
2021 70,000/-
2020 40,000/-
2019 60,000/-
2018 40,000/-
2017 80,000/-
Total  2,90,000/-
Average  2,90,000/5=58,000/-

Calculation of Super Profit: 

Particulars  Amount
Average Profit  58,000/-
Less Normal Profit  50,000/-
Super Profit  8,000/-

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.

FAQ's

  • What are the limitations of using goodwill? 

    Calculation of goodwill is challenging. At times the purchaser may purchase the entity at a price lower than the fair market value, which results in negative goodwill. The situation arises in the case of distressed sales.
  • Why is the calculation of goodwill different from other intangible assets? 

    Goodwill cannot be sold or bought independent of a purchase transaction. On the other hand, other intangible assets can be easily sold. Secondly, goodwill has an indefinite life while others have a predetermined definite life. 
  • What is impairment of goodwill? 

    Impairment is a concept that recognizes the fall in the historical cost of an asset in comparison to its market value. This usually occurs on account of a decline in cash flows, an increase in competition, and the like. 
  • What is the need for the valuation of goodwill? 

    Goodwill is usually calculated on account of the following reasons:
    • Death of a Partner
    • Retirement or admission of a partner
    • Change in Profit sharing ratio of the partners
    • Consolidation of two or more entities
    • Sale of an entity
  • What are the factors that affect goodwill? 

    The factors listed out hereunder affect goodwill:
    • Presence of Favorable contracts: If the firm has favorable contracts for business or sale, the value of goodwill increases. 
    • Location of the entity: A business that works in a suitable location has higher goodwill than the one that is set up in a remote location. 
    • Quality of Services Provided: The business that provides good quality services to its clientele will have higher goodwill in comparison to its competitors. 
    • Management Efficiency: Efficient management can generate greater profits and higher goodwill. 
    • Trade Marks and Patents: Since trademarks and patents can help create a monopoly, they create excess goodwill.
Disclaimer: Policybazaar does not endorse, rate or recommend any particular insurer or insurance product offered by an insurer.
top
Close
Download the Policybazaar app
to manage all your insurance needs.
INSTALL