Goodwill

 Goodwill is also one of the special aspects of partnership accounts which requires adjustment (also valuation if not specified) at the time of reconstitution of a firm viz., a change in the profit sharing ratio, the admission of a partner or the retirement or death of a partner. Goodwill is of two types-

• Purchased goodwill
• Self generated Goodwill

As per Accounting Standard 26, goodwill is an intangible asset and is valued as per the accounting standard. Self generated goodwill is not shown in the books of accounts while purchased goodwill is shown.

Goodwill is shown after valuation when-

1. A new person is admitted in the firm
2. At the time of reconstitution of the firm
3. Retirement or death of the partner
4. All of the above

Answer- All of the above

Explanation-

Goodwill is also one of the special aspects of partnership accounts which requires adjustment (also valuation if not specified) at the time of reconstitution of a firm viz., a change in the profit sharing ratio, the admission of a partner or the retirement or death of a partner.

Meaning of Goodwill

Over a period of time, a business firm develops a good name and reputation among the customers. This help the business earn some extra profits as compared to a newly set up business. In accounting capitalised value of this extra profit is known as goodwill. For example, your firm earns say Rs 1200 and the normal profit was expected from your firm Rs 700. The rate of return is @ 10%. In this case goodwill is ascertained as under :

Step 1 : Excess profit = Actual profit – Desired normal profit  1200 – 700 = 500

Step 2 : Goodwill = 500

100 10 × = Rs 5000

In other words, goodwill is the value of the reputation of a firm in respect of the profit earned in future over and above the normal profit

Factors Affecting the Value of Goodwill

The main factors affecting the value of goodwill are as follows:

 1. Nature of business: A firm that produces high value added products or having a stable demand is able to earn more profits and therefore has more goodwill.

2. Location: If the business is centrally located or is at a place having heavy customer traffic, the goodwill tends to be high.

 3. Efficiency of management: A well-managed concern usually enjoys the advantage of high productivity and cost efficiency. This leads to higher profits and so the value of goodwill will also be high.

 4. Market situation: The monopoly condition or limited competition enables the concern to earn high profits which leads to higher value of goodwill.

 5. Special advantages: The firm that enjoys special advantages like import licences, low rate and assured supply of electricity, long-term contracts for supply of materials, well-known collaborators, patents, trademarks, etc. enjoy higher value of goodwill.

Need for Valuation of Goodwill

Normally, the need for valuation of goodwill arises at the time of sale of a business. But, in the context of a partnership firm it may also arise in the following circumstances:

 1. Change in the profit sharing ratio amongst the existing partners;

 2. Admission of new partner;

3. Retirement of a partner;

 4. Death of a partner; and

5. Dissolution of a firm involving sale of business as a going concern.

 6. Amalgamation of partnership firms.

Methods of Valuation of Goodwill

The important methods of valuation of goodwill are as follows:

 1. Average Profits Method

2. Super Profits Method

3. Capitalisation Method

1. Average Profits Method

Under this method, the goodwill is valued at agreed number of ‘years’ purchase of the average profits of the past few years. It is based on the assumption that a new business will not be able to earn any profits during the first few years of its operations. Hence, the person who purchases a running business must pay in the form of goodwill a sum which is equal to the profits he is likely to receive for the first few years. The goodwill, therefore, should be calculated by multiplying the past average profits by the number of years during which the anticipated profits are expected to accrue.

1. The profit for the five years of a firm are as follows – year 2010 Rs. 4,00,000; year 2011 Rs. 3,98,000; year 2012 Rs. 4,50,000; year 2013 Rs. 4,45,000 and year 2014 Rs. 5,00,000. Calculate goodwill of the firm on the basis of 4 years purchase of 5 years average profits

Year Profit (Rs.)

2010 4,00,000

2011 3,98,000

2012 4,50,000

2013 4,45,000

2014 5,00,000

Total 21,93,000.

Average Profit = Total Profit of Last 5Years

No.of years = Rs. 21,93,000 5 = Rs. 4,38,600

Goodwill = Average Profits × No. of years purchased = Rs. 4,38,600 × 4 = Rs. 17,54,400

Weighted average Profit Method-

In this method each year profit is assigned a weight i.e. 1, 2, 3, 4 etc. The goodwill is calculated as follows

Weighted average profit = Total product of profit

Total of weights

Super Profits Method

The basic assumption in the average profits (simple or weighted) method of calculating goodwill is that if a new business is set up, it will not be able to earn any profits during the first few years of its operations. it is limited to such amounts of profits which are in excess of the normal return on capital employed in similar business. Therefore, it is desirable to value, goodwill on the basis of the excess profits and not the actual profits. The excess of actual profits over the normal profits is termed as super profits.

Normal Profit=Capital Employed × Normal Rate of Return

100

the steps involved under the method are:

1. Calculate the average profit,

2. Calculate the normal profit on the capital employed on the basis of the normal rate of return, 3. Calculate the super profits by deducting normal profit from the average profits, and

4. Calculate goodwill by multiplying the super profits by the given number of years’ purchase.

The books of a business showed that the capital employed on December 31, 2014, Rs. 5,00,000 and the profits for the last five years were:

2010– Rs. 40,000:

2011-Rs. 50,000;

2012-Rs. 55,000;

2013-Rs.70,000

2014-Rs. 85,000.

You are required to find out the value of goodwill based on 3 years purchase of the super profits of the business, given that the normal rate of return is 10%.

Solution-

Normal Profits=Capital Employed  X Normal Rate of Return

100

=Rs. 5,00,000 X 10

100

=Rs. 50,000

Average Profits-

YearProfit (Rs.)

201040,000

201150,000

201255,000

201370,000

201485,000

Total3,00,000

AverageProfits =Rs. 3,00,000/5= Rs. 60,000

Super Profit =Rs. 60,000 – Rs. 50,000=Rs. 10,000

Goodwill =Rs. 10,000× 3 = Rs. 30,000

Capitalisation Methods

Under this method the goodwill can be calculated in two ways:

(a) by capitalizing the average profits, or

(b) by capitalizing the super profits.

(a) Capitalisation of Average Profits:

Under this method, the value of goodwill is ascertained by deducting the actual capital employed (net assets) in the business from the capitalized value of the average profits on the basis of normal rate of return.This involves the following steps:

1. Ascertain the average profits based on the past few years’ performance.
2. Capitalize the average profits on the basis of the normal rate of return to ascertain the capitalised value of average profits as follows:

                              Average Profits × 100/Normal Rate of Return

(iii) Ascertain the actual capital employed (net assets) by deducting outside liabilities from the total assets (excluding goodwill).

Capital Employed = Total Assets (excluding goodwill) – Outside Liabilities

(iv) Compute the value of goodwill by deducting net assets from the capitalised value of average profits, i.e. (ii) – (iii).

A business has earned average profits of Rs. 2,00,000 during the last few years and the normal rate of return in a similar business is 10%. Ascertain the value of goodwill by capitalisation average profits method, given that the value of net assets of the business is Rs. 16,20,000.

 

 

Capitalised Value of Average Profits

Rs.2,00,000 X 100

10

= Rs. 10,00,000

Goodwill = Capitalised value – Net Assets = Rs. 20,00,000 – Rs. 16,20,000 = Rs.3,80,000

 

(b) Capitalisation of Super Profits:

Goodwill can also be ascertained by capitalising the super profit directly. Under this method there is no need to work out the capitalised value of average profits. It involves the following steps.

(i) Calculate capital employed of the firm, which is equal to total assets minus outside liabilities. (ii) Calculate normal profits on capital employed.

(iii) Calculate average profit for past years, as specified.

(iv) Calculate super profits by deducting normal profits from average profits.

(v) Multiply the super profits by the required rate of return multiplier, that is

 

Goodwill = Super Profits × 100 Normal Rate of Return

In other words, goodwill is the capitalised value of super profits. The amount of goodwill worked out by this method will be exactly the same as calculated by capitalising the average profits.

For example, using the data given in Previous where the average profits are Rs. 2,00,000 and the normal profits are Rs. 162,000 (10% of Rs. 16,20,000), the super profits worked out as Rs. 38,000 (Rs. 2,00,000 – Rs. 1,62,000),

the goodwill will be Rs. 38,000 ×100

10

 = Rs. 3,80,000.