Back to Main Page

Web Notes

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-

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

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

Calculation of Adjusted profits-

Particular

Amount

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)

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:

Year

2018-19

2017-18

2016-17

2015-16

2014-15

Profits

8,00,000

15,00,000

18,00,000

4,00,000

Loss

13,00,000

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:

Year ended	31^st march,2015	31^st march,2016	31^st march,2017	31^st march,2018	31^st march,2019
Profits	90,000 loss	1,60,000	1,50,000	65,000	1,77,000

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:

Particulars

Year

31st Mar., 2015

31st Mar., 2016

31st Mar., 2017

31st Mar., 2018

31st Mar., 2019

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.

90, 000

1,60,000

50,000

1,50,000

20,000

65,000

1,00,000

15000

1,77,000

17,000

Normal Profit/Loss

90,000

1,10,000

1,70,000

1,50,000

1,60,000

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:

Year

Profit before Partners’ Remuneration

Partner’s Remuneration

Profit after Partners’ Remuneration

Weight

Product

Profit after Partner’s remuneration x Weight

2016-17

2017-18

2018-19

2,00,000

2,30,000

2,50,000

90,000

1,10,000

1,40,000

1,60,000

1,10,000

2,80,000

4,80,000

8,70,000

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:

Year	2014-15	2015-16	2016-17	2017-18
Profit (?)	1,01,000	1,24,000	1,00,000	1,40,000
Weight	1	2	3	4

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:

Particulars	2014-15	2015-16	2016-17	2017-18
Profits	1,01,000	1,24,000	1,00,000	1,40,000
Repair Capitalised			+30,000
Depreciation			(1,000)	(2,900)
Overvaluation of Closing Stock		(12,000)	12,000
Management Cost	(24,000)	(24,000)	(24,000)	(24,000)
Sale Proceeds Wrong Depreciation		(10,000)	900	810
Adjusted Profits	77,000	78,000	1,17,900	1,13,910
Weights	1	2	3	4
Product	77,000	1,56,0000	3,53,700	4,55,640

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%.

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-

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

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

= 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

= 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:

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

(ii) Calculation of Goodwill by Capitalisation of Average Profit Method

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,