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-
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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-
- A new person is admitted in the firm
- At the time of reconstitution of the firm
- Retirement or death of the partner
- All of the above
Answer- All of the above
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.
6. Past performace,quality,advantages of patents,copyrights, contracts, inherent risks of business.
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
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Calculation of Adjusted profits-
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Particular
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Amount
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Given Profits
Add- Abnormal losses
Add capital loss on sale of asset
Add: over valuation over value of opening stock or undervaluation of closing stock
Add- non-recurring expenses
Add: Capital Expenditure Charged to Revenue
Less: Abnormal Gain
Less : over valuation over value of closing stock or undervaluation of opening stock
Less- non-recurring income
Less: Interest on Non trade investments
Less: Unprovided Depreciation
Less: Management costs, insurance costs
Less: Partners remuneration ( if not charged)
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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.
Q 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
Q2. Calculate value of goodwill on the basis of three years' purchase of average profit of the preceding five years which were as follows:
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Year
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2018-19
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2017-18
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2016-17
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2015-16
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2014-15
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Profits
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8,00,000
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15,00,000
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18,00,000
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4,00,000
Loss
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13,00,000
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Q. Geet and Meet are partners in a firm. They admit Jeet into partnership for equal share. It was agreed that goodwill will be valued at three years' purchase of average profit of last five years. Profits for the last five years were:
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Year ended
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31st march,2015
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31st march,2016
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31st march,2017
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31st march,2018
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31st march,2019
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Profits
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90,000 loss
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1,60,000
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1,50,000
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65,000
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1,77,000
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Books of Account of the firm revealed that:
i) The firm had gain profit of 50,000 from sale of machinery sold in the year ended 31st March, 2016. The gain profit was credited in Profit and Loss Account.
ii) There was an abnormal loss of 20,000 incurred in the year ended 31st March, 2017 because of a machine becoming obsolete in accident.
iii) Overhauling cost of second hand machinery purchased on 1st July, 2017 amounting to 1,00,000 was debited to Repairs Account. Depreciation is charged @ 20% p.a. on Written Down Value Method.
Calculate the value of goodwill.
Solution:
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Particulars
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Year
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31st Mar., 2015
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31st Mar., 2016
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31st Mar., 2017
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31st Mar., 2018
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31st Mar., 2019
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Profit/Loss
Less: Gain on Sale of Machinery
Add: Abnormal Loss
Add: Overhaul of existing machinery
Debited to Repairs A/c
Less: Depreciation @20% p.a.
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90, 000
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1,60,000
50,000
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1,50,000
20,000
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65,000
1,00,000
15000
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1,77,000
17,000
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Normal Profit/Loss
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90,000
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1,10,000
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1,70,000
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1,50,000
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1,60,000
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Average profits = Total profits = 90000+1,10,000+1,70,000+1,50,000+1,60,000 = 5,00,000
Number of years 5 5
= Rs. 1,00,000
Goodwill = 1,00,000 x3 =Rs. 3,00,000
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
Q. A and B are partners sharing profits and losses in the ratio of 5 : 3. On 1st April, 2019, C is admitted to the partnership for 1/4th share of profits. For this purpose, goodwill is to be valued at two years' purchase of last three years' profits after allowing partners′ remuneration
. Profits to be weighted 1 : 2 : 3, the greatest weight being given to last year. Net profit before partners' remuneration were:
2016-17 : 2,00,000;
2017-18 : 2,30,000;
2018-19 : 2,50,000.
The remuneration of the partners is estimated to be 90,000 p.a. Calculate amount of goodwill.
Solution:
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Year
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Profit before Partners’ Remuneration
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-
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Partner’s Remuneration
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=
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Profit after Partners’ Remuneration
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Weight
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Product
Profit after Partner’s remuneration x Weight
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2016-17
2017-18
2018-19
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2,00,000
2,30,000
2,50,000
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|
90,000
90,000
90,000
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1,10,000
1,40,000
1,60,000
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1
2
3
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1,10,000
2,80,000
4,80,000
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|
|
|
|
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|
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6
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8,70,000
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Weighted Average profit = Total product of profits = 8,70,000 = Rs. 1,45,000
Total of weights 6
Goodwill =Weighted average profit x number of years = 1,45,000 x 2 =Rs. 2,90,000
Q. Calculate the goodwill of a firm on the basis of three years' purchase of the weighted average profit of the last four years. The appropriate weights to be used and profits are:
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Year
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2014-15
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2015-16
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2016-17
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2017-18
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Profit (?)
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1,01,000
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1,24,000
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1,00,000
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1,40,000
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Weight
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1
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2
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3
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4
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On a scrutiny of the accounts, the following matters are revealed:
(i) On 1st December, 2016, a major repair was made in respect of the plant incurring ? 30,000 which was charged to revenue. The said sum is agreed to be capitalised for goodwill calculation subject to adjustment of depreciation of 10% p.a. on reducing balance method.
(ii) The closing stock for the year 2015-16 was overvalued by ? 12,000.
(iii) To cover management cost, an annual charge of ? 24,000 should be made for the purpose of goodwill valuation.
(iv) In 2015-16, a machine having a book value of ? 10,000 was sold for ? 11,000 but the proceeds were wrongly credited to Profit and Loss Account. No effect has been given to rectify the same. Depreciation is charged on machine @ 10% p.a. on reducing balance method.
ANSWER:
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Particulars
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2014-15
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2015-16
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2016-17
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2017-18
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Profits
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1,01,000
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1,24,000
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1,00,000
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1,40,000
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Repair Capitalised
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|
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+30,000
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|
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Depreciation
|
|
|
(1,000)
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(2,900)
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|
Overvaluation of Closing Stock
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(12,000)
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12,000
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|
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Management Cost
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(24,000)
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(24,000)
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(24,000)
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(24,000)
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Sale Proceeds
Wrong Depreciation
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(10,000)
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900
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810
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Adjusted Profits
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77,000
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78,000
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1,17,900
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1,13,910
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Weights
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1
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2
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3
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4
|
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Product
|
77,000
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1,56,0000
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3,53,700
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4,55,640
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Working Notes:
Goodwill=Weighted Average Profits×Number of Years' Purchase
Weighted Average Profits=Total of ProductTotal of Weights
77,000+1,56,000+3,53,700+4,55,64010=Rs 1,04,234
Goodwill=1,04,234×3=Rs 3,12,702
Goodwill=Weighted Average Profits×Number of Years' Purchase
Weighted Average Profits=Total of Product/Total of Weights
=77,000+1,56,000+3,53,700+4,55,64010
=Rs 1,04,234
Goodwill=1,04,234×3=Rs 3,12,702
Note 1: Depreciation on Rs 30,000 machinery is charged for only 4 months in the year 2016-17.
Note 2: Sale proceeds wrongly credited in 2015-16 have been deducted after adjusting for profit of Rs 1,000. No depreciation is charged, since date of sale is not given (assumed that the machinery is sold at the end of the year)
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%.
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Q. Average net profit expected in future by XYZ firm is ? 36,000 per year. Average capital employed in the business by the firm is ? 2,00,000. The normal rate of return from capital invested in this class of business is 10%. Remuneration of the partners is estimated to be ? 6,000 p.a. Calculate the value of goodwill on the basis of two years' purchase of super profit.
Answer-
Normal Profits=Capital Employed X Normal Rate of Return
100
?
Average Profits-
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Average profits = 300000/5 = 60,000
Super Profit =Rs. 60,000 – Rs. 50,000=Rs. 10,000
Goodwill =Rs. 10,000× 3 = Rs. 30,000
Q. Average net profit expected in future by XYZ firm is ? 36,000 per year. Average capital employed in the business by the firm is ? 2,00,000. The normal rate of return from capital invested in this class of business is 10%. Remuneration of the partners is estimated to be ? 6,000 p.a. Calculate the value of goodwill on the basis of two years' purchase of super profit.
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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:
- Ascertain the average profits based on the past few years’ performance.
- 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).
Q. 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? = 200000 X100
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.
Q . From the following information, calculate value of goodwill of the firm by applying Capitalisation Method: Total Capital of the firm ? 16,00,000.
Normal rate of return 10%. Profit for the year ? 2,00,000.
ANSWER:
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A firm earns profit of ? 5,00,000. Normal Rate of Return in a similar type of business is 10%. The value of total assets (excluding goodwill) and total outsiders' liabilities as on the date of goodwill are ? 55,00,000 and ? 14,00,000 respectively. Calculate value of goodwill according to Capitalisation of Super Profit Method as well as Capitalisation of Average Profit Method.
ANSWER:
(i) Calculation of Goodwill by Capitalisation of Super Profit Method
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(ii) Calculation of Goodwill by Capitalisation of Average Profit Method
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Q. From the following information, calculate value of goodwill of the firm:
(i) At three years' purchase of Average Profit.
(ii) At three years' purchase of Super Profit.
(iii) On the basis of Capitalisation of Super Profit.
(iv) On the basis of Capitalisation of Average profit.
Information:
(a) Average Capital Employed is ? 6,00,000.
(b) Net Profit/(Loss) of the firm for the last three years ended are:
31st March, 2018 − ? 2,00,000, 31st March, 2017 − ? 1,80,000, and 31st March, 2016 − ? 1,60,000.
(c) Normal Rate of Return in similar business is 10%.
(d) Remuneration of ? 1,00,000 to partners is to be taken as charge against profit.
(e) Assets of the firm (excluding goodwill, fictitious assets and non-trade investments) is ? 7,00,000 whereas Partners' Capital is ? 6,00,000 and Outside Liabilities ? 1,00,000.
ANSWER:
(i) Goodwill=Average Profit×No. of years' purchase =80,000×3=Rs 2,40,000
(ii) Goodwill=Super Profit×No. of years' purchase =20,000×3=Rs 60,000
(iii) Goodwill=Super Profit×100Normal Rate of Return =20,000×100/10=Rs 2,00,000
(iv) Goodwill=Capitalised Value−Net Assets =8,00,000−6,00,000=Rs 2,00,000
Working Notes:
WN1: Calculation of Average and Super Profits
Average Profit=Total Profits of past years given/No. of Years =2,00,000+1,80,000+1,60,000/3
=Rs 1,80,000,
Average Profit (Adjusted) = Rs 1,80,000 -1,00,000 (Remuneration to partners)
= Rs 80,000
Normal Profit=Capital Employed×Normal Rate of Return/100
=6,00,000×10100=Rs 60,000
Super Profit=Average Profit (Adjusted)−Normal Profit
=80,000−60,000=Rs 20,000
Average Profit=Total Profits of past years given/No. of Years
=2,00,000+1,80,000+1,60,000/3
=Rs 1,80,000,
Average Profit (Adjusted) = Rs 1,80,000 -1,00,000 (Remuneration to partners)
= Rs 80,000
Normal Profit=Capital Employed×Normal Rate of Return/100
=6,00,000×10/100=Rs 60,000
Super Profit=Average Profit (Adjusted)-Normal Profit
=80,000-60,000=Rs 20,000
WN2: Calculation of Capital Employed
Capital Employed=Total Assets−Outside Liabilities
=7,00,000−1,00,000=Rs 6,00,000