3. Goodwill - Meaning, Nature & Valuation

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

Since goodwill is an intangible asset it is very difficult to accurately calculate its value. Various methods have been advocated for the valuation of goodwill of a partnership firm. Goodwill calculated by one method may differ from the goodwill calculated by another method. Hence, the method by which goodwill is to be calculated, may be specifically decided between the existing partners and the incoming partner.

The important methods of valuation of goodwill are as follows:

1. Average Profits Method

2. Super Profits Method

3. Capitalisation Method

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.

For example, if the past average profits of a business works out at Rs. 20,000

and it is expected that such profits are likely to continue for another three years, the value of goodwill will be Rs. 60,000 (Rs. 20,000 × 3).

Revision 9

The profit for the five years of a firm are as follows – year 2013 Rs. 4,00,000; year 2014 Rs. 3,98,000; year 2015 Rs. 4,50,000; year 2016 Rs. 4,45,000 and year 2017 Rs. 5,00,000. Calculate goodwill of the firm on the basis of 4 years purchase of 5 years average profits.

Solution

Average Profit Total Profit of Last 5 Years/ No. of years

= Rs  21, 93, 000/5 = Rs 4,  38, 600

Goodwill = Average Profits x  No. of years purchased

= Rs. 4,38,600 × 4 = Rs. 17,54,400

The above calculation of goodwill is based on the assumption that no change in the overall situation of profits is expected in the future. The above Revision is based on simple average. Sometimes, if there exists an increasing on decreasing trend, it is considered to be better to give a higher weightage to the profits to the recent years than those of the earlier years. Hence, it is a advisable to work out weighted average based on specified weights like 1, 2, 3, 4 for respective year’s profit. However, weighted average should be used only if specified. (See Revisions 10 and 11).

Revision  10

The profits of firm for the five years are as follows:

Calculate the value of goodwill on the basis of three years’ purchase of weighted average profits based on weights 1,2,3,4 and 5 respectively.

Solution

 

Weighted Average Profit =  Rs 3, 48, 000/ 15 = Rs 23, 200

Goodwill                       = Rs. 23,200 × 3 =  Rs. 69,600

Revision  11

Calculate goodwill of a firm on the basis of three year’ purchase of the weighted average profits of the last four years. The profit of the last four years were: 2012 Rs. 20,200; 2013 Rs. 24,800; 2014 Rs. 20,000 and 2015 Rs. 30,000. The weights assigned to each year are : 2012 – 1; 2013 – 2; 2014 – 3 and 2015 – 4. You are supplied the following information:

1. On September 1, 2014 a major plant repair was undertaken for Rs. 6,000, which was charged to revenue. The said sum is to be capitalised for goodwill calculation subject to adjustment of depreciation of 10% p.a. on reducing balance method.

2. The Closing Stock for the year 2013 was overvalued by Rs. 2,400.

3. To cover management cost an annual charge of Rs. 4,800 should be made for purpose of goodwill valuation.

Solution

Calculation of weighted average profits:

Weight Average Profit  = Rs 2, 19, 280/ 10 = Rs 21, 928

Goodwill   = Rs. 21,928 × 3 = Rs. 65,784

Notes to Solution

1. Depreciation of 2014 =  10% of Rs. 6000 for 4 months = Rs. 6000 × 10/100 × 4/12 = Rs. 200.
2. Depreciation of 2015 = 10% of Rs. 6000 – Rs. 200 for one year = Rs. 5800 × 10/100 + Rs. 580.
3. Closing Stock of 2014 will become opening stock for the year 2015.

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. Hence, the person who purchases an existing business has to pay in the form of goodwill a sum equal to the total profits he is likely to receive for the first ‘few years’. But it is contended that the buyer’s real benefit does not lie in total profits; 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. 

Firms capital includes partners capital and reserves and surplus but excludes fictitious assets and goodwill. Suppose an existing firm earns Rs. 18,000 on the capital of Rs. 1,50,000 and the normal rate of return is 10%. The Normal profits will work out at Rs. 15,000 (1,50,000 × 10/100). The super profits in this case will be Rs. 3,000 (Rs. 18,000 – 15,000). The goodwill under the super profit method is ascertained by multiplying the super profits by certain number of years’ purchase. If, in the above example, it is expected that the benefit of super profits is likely to be available for 5 years in future, the goodwill will be valued at Rs. 15,000 (3,000 × 5). Thus, the steps involved under the method are:

1. Calculate the average profit.
2. Calculate the normal profit on the firm’s capital on the basis of the normal rate of return.
3. Calculate the super profits by deducting normal profit from the average profits.
4. Calculate goodwill by multiplying the super profits by the given number of years’ purchase.

Revision  12

The books of a business showed that the firm’s capital employed on December 31, 2015, Rs. 5,00,000 and the profits for the last five years were: 2010–Rs. 40,000: 2012-Rs. 50,000; 2013-Rs. 55,000; 2014- Rs.70,000 and 2015-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

Average Profits:

Average Profits = 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

Revision 13

The capital of the firm of Anu and Benu is Rs. 1,00,000 and the market rate of interest is 15%. Annual salary to partners is Rs. 6,000 each. The profits for the last 3 years were Rs. 30,000; Rs. 36,000 and Rs. 42,000.  Goodwill is to be valued at 2 years purchase of the last 3 years’ average super profits. Calculate the goodwill of the firm.

Solution

Interest on capital  =  1,00,000 × 15/100 = Rs 15, 000     (i)

Add: partner’s salary    =  Rs. 6,000 × 2             = Rs.  12,000…………(ii)

 Normal Profit(i+ii)         = Rs.  27,000

Average Profit                =  Rs. 30,000+Rs.36,000+Rs.42,000 = Rs. 1, 08, 000/3 = Rs 36, 000

Super Profit                  =  Average Profit–Normal Profit

=  Rs. 36,000–Rs. 27,000

=  Rs. 9,000

Goodwill                       =  Super Profit × No of years’ purchase

=  Rs. 9,000 × 2

=  Rs. 18,000

Capitalisation Method

Under this method the goodwill can be calculated in two ways: (a) by capitalizing the average profits, or (b) by capitalising the super profits.

(a) Capitalisation of Average Profits: Under this method, the value of goodwill is ascertained by deducting the actual firm’s capital in the business from the capitalized value of the average profits on the basis of normal rate of return. This involves the following steps:

(i)  Ascertain the average profits based on the past few years’ performance.

(ii) 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 firm’s capital (net assets) by deducting outside liabilities from the total assets (excluding goodwill and ficticious assets).

Firms’ Capital = Total Assets (excluding  goodwill)  – Outside Liabilities

Where outside Liabilities include both long term and short term Liabilities.

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

       Revision 14

A business has earned average profits of Rs. 1,00,000 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. 8,20,000.

Solution

Capitalised Value of Average Profits

Rs 1, 00, 000 × 100/ 10 = Rs 10, 00, 000

Goodwill       =  Capitalised value – Net Assets

=  Rs. 10,00,000 – Rs. 8,20,000

=  Rs.1,80,000

(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.

1. Calculate capital of the firm, which is equal to total assets (excluding goodwill and ficticious assets) minus outside liabilities.
2. Calculate normal profits on capital employed.
3. Calculate average profit for past years, as specified.
4. Calculate super profits by deducting normal profits from average profits.
5. 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 Revision 14 where the average profits are Rs.1,00,000 and the normal profits are Rs. 82,000 (10% of Rs. 8,20,000), the super profits worked out as Rs. 18,000 (Rs. 1,00,000 – Rs. 82,000), the goodwill will be calculated as follows.

Rs 18, 000 × 100/10 = Rs 1, 80, 000

Revision  15

1. The goodwill of a firm is to be worked out at three years’ purchase of the average profits of the last five years which are as follows:

2.    The capital of the firm is Rs. 1,00,000 and normal rate of return is 8%, the average profits for last 5 years are Rs. 12,000 and goodwill is to be worked out at 3 years’ purchase of super profits.

3.    Rama Brothers earn an average profit of Rs. 30,000 with a capital of

 Rs. 2,00,000. The normal rate of return in the business is 10%. Using capitalisation of super profits method work out the value the goodwill of the firm.

Solution

 1. Total Profits = Rs. 10,000 + Rs. 15,000 + Rs. 4,000 + Rs. 6,000 – Rs. 5,000 = Rs. 30,000

Average Profits = Rs. 30,000/5   = Rs. 6,000

Goodwill = Average Profits × 3   = Rs. 6,000 × 3 = Rs.18,000

Average Profit                             = Rs. 12,000

2. Normal Profit = Rs.1,00,000 × 8 / 10 0  = Rs 8, 000

Super Profit=Average Profit – Normal profit = Rs. 12,000 – Rs. 8,000

= Rs 4, 000

Goodwill=Super Profit × 3          = Rs. 4,000 × 3 = Rs. 12,000

3.  Normal Profit= Rs. 2,00,000 × 10/100 = Rs. 20,000

Super Profit = Average Profit – Normal Profit = Rs. 30,000 – Rs. 20,000

= Rs 10, 000

Goodwill=Super Profit × 100/Normal Rate of Return

= 10,000 × 100/10 = Rs. 1,00,000.

Treatment of Goodwill

As stated earlier, the incoming partner who acquires his share in the profits of the firm from the existing partners brings in additional amount to compensate them for loss of their share in super profits. It is termed as his share of goodwill (also called premium for goodwill).

When the new Partner brings goodwill in cash.

The amount of premium brought in by the new partner is shared by the existing partners in their ratio of sacrifice. If this amount is paid to the old partners directly (privately) by the new partner, no entry is passed in the books of the firm. But, when the amount is paid through the firm, which is generally the case, the following journal entries are passed:

  

 

Alternatively, it is credited to the new partner’s capital account and then adjusted in favour of the existing partners in their sacrificing ratio. In that case the journal entries will be as follows:

 

If the partners decide that the amount of premium for goodwill credited to their capital accounts should be retained in business, an additional entry is not passed. If, however, they decide to withdraw their amounts, (in full or in part) the following additional entry will be passed:

Existing Partner’s Capital A/c (Individually)        

Dr. To Bank A/c

(The amount of goodwill withdrawn by the existing partners)

Revision 16

Sunil and Dalip are partners in a firm sharing profits and losses in the ratio of

Sachin is admitted in the firm for 1/5th  share of profits. He brings in Rs. 20,000 as capital and Rs. 4,000 as his share of goodwill by cheque. Give the necessary journal entries,

(a) When partners decided to retain goodwill in business.

(b) When the amount of goodwill is fully withdrawn.

(c) When 50% of the amount of goodwill is withdrawn.

Solution

(a) When the amount of goodwill credited to existing partners is retained in business.

        Books  of  Sunil  and  Dalip Journal

Alternatively,

Note: It assumed that the sacrificing ratio is the same as old profit sharing ratio.

(b) When the amount of goodwill credited to existing partners is fully withdrawn.

        Journal

(c) When 50% of the amount of goodwill credited to existing partners is withdrawn.

Journal

Revision  17

Vijay and Sanjay are partners in a firm sharing profits and losses in the ratio of 3:2. They admitted Ajay into partnership with 1/4 share in profits. Ajay brings in Rs. 30,000 for capital and the requisite amount of premium in cash. The goodwill of the firm is valued at Rs. 20,000. The new profit sharing ratio is 2:1:1. Vijay and Sanjay withdraw their share of goodwill. Give necessary journal entries.

Solution

(a)  Ajay will bring Rs. 5,000 (1/4 of Rs. 20,000) as his share of goodwill (premium)

(b)  Sacrificing Ratio is 2:3 as calculated below:

For Vijay, old ratio is 3/5 and the new ratio is 2/4, hence, his sacrificing ratio is = 3/5 – 2/4 = 12 – 10/ 20 = 2/20

For Sanjay, old ratio is 2/5 and the new ratio is 1/4, hence, his sacrificing Ratio is = 2/5 – ¼ = 8 – 5/20 = 3/20

Books of Vijay and Sanjay Journal

Note: Alternatively, journal entries (1) and (2) could be as follows

Books  of  Vijay  and Sanjay Journal

When goodwill already exists in books: Goodwill, if existing in the books of the firm, it is written off at the time of admission of a partner.

For example, in Revision 17, the goodwill of the firm is valued at Rs. 20,000 and Ajay who is admitted to 1/4 share in its profits, brings in Rs. 5,000 as his share of goodwill. Suppose, goodwill already appeared in books at Rs. 10,000 the following additional journal entry shall be passed for writing off the existing amount of goodwill.

Revision 18

Srikant and Raman are partners in a firm sharing profits and losses in the ratio of 3:2. They admit Venkat into partnership with 1/3 share in the profits. Venkat brings in Rs. 30,000 as his capital. He also brings in the necessary amount for his share of goodwill. On the date of admission, the goodwill is valued at Rs. 24,000 and the goodwill account appears in the books at Rs.

12,000. Venkat brings in the necessary amount for his share of goodwill and agrees that the existing goodwill account be written off. Record the necessary journal entries in the books of the firm.

Solution

Books of Srikant and Raman Journal

Note:  Since nothing is given about the ratio in which the new partner acquires his share of profit from Srikant and Raman, it is implied that they sacrifice their share of profit in favour of Venkat in the old ratio i.e., 3:2.

When the new partner does not bring goodwill  in cash, partly or fully Goodwill not brought by the new partner will be debited to current account of new partner while sacrificing partners' capital accounts will be credited for their respective shares. When the new partner does not bring the share of goodwill, there exists two possibilities :

(a) Goodwill does not exist in the books.

(b) Goodwill exists in the books.

Goodwill does not exist in the books.

When goodwill does not exist in the books, sacrificing partners are credited with their share of goodwill and new partner is debited by the amount of goodwill not brought by him. The journal entry in this case is :

Incoming (New) Partners Current A/c                                                      Dr.

To Sacrificing Partners Capital A/c (individually) (Account of goodwill not brought in by new partner) Sometimes the new partner brings part of premium for goodwill in cash. In such a situation, new partners current account will be debited by the amount not brought by new partner.

For example, for the share of goodwill of Rs. 50,000 the new partner brings

Rs. 20,000 only. In this situation the journal entry will be :

Revision 19

Ahuja and Barua are partners in a firm sharing profits and losses in the ratio of

3:2. They decide to admit Chaudhary into partnership for 1/5 share of profits, which he acquires equally from Ahuja and Barua.   Goodwill is valued at Rs. 30,000.  Chaudhary brings in Rs. 16,000 as his capital but is not in a position to bring any amount for goodwill. No goodwill account exists in books of the firm. Goodwill account is to be raised at full value. Record the necessary journal entries.

Solution

Book of Ahuja and Barua Journal

When goodwill exists in the books

Goodwill appearing in the books will be written-off by debiting old partners' capital accounts in their old profit sharing ratio. Thereafter new value of goodwill will be given effect by crediting sacrificing partners' capital accounts and debiting new partners' current account.

 Revision 20

Ram and Rahim are partners in a firm sharing profits and losses in the ratio of

3:2. Rahul is admitted into partnership for 1/3 share in profits. He brings in Rs.

10,000 as capital, but is not in a position to bring any amount for his share of

goodwill which has been valued at Rs. 30,000. Give necessary journal entries under each of the following situations:

(a) When there is no goodwill appearing in the books of the firm; and

(b) When the goodwill appears at Rs 15,000 in the books of the firm;

Solution

(a)  When no goodwill appears in the books

Books of Ram and Rahim Journal

(b) When goodwill appears in the books at Rs. 15,000

Applicability of Accounting Standard 26: Intangible  Assets

The Standard comes into effect in respect of expenditure incurred on intangible items during the accounting periods commencing on or after April 1, 2003. As per the Standard, Intangible Asset under AS 26 is defined as an identifiable, non monetary, without physical existence and held for use in the production or supply of goods or services for rental to others or for administrative purposes.

Significant requirements of AS 26 w.r.t Intangible Assets:

1. Intangible asset should be recognised by fulfilling the criteria as recognized under AS 26.

2. If an in asset does not satisfy recognition criteria, it should be expensed.

3. Internally generated goodwill should not be recognised as an asset.

4. Internally generated brands, mastheads, and publishing titles and other similar in substance should not be recognised as intangible assets.

5. Internally generated assets other than the goodwill, brands, mastheads, and publishing titles may be recognised provided they satisfy recognition criteria as prescribed by AS 26.

6. Intangible assets should be written off as early as possible but not exceeding its estimated life, which normally should not be beyond 10 years.

Accounting Standard 26 implies that:

(a) Purchased goodwill may be accounted for in the books and shown as an asset, where it is accounted for in the books and shown as assets, it should be written off as early as possible, but where it is to be written- off in more than one accounting year, it should be written off in a period not exceeding 10 years. In line with what is prescribed by the Accounting Standard, goodwill appearing in the balance sheet in written off at the time of firm's reconstitution.

(b) Self - generated goodwill is not accounted for in the books and shown as an asset. Thus if self generated goodwill be debited to goodwill account it should be written - off in the same financial year and should not be shown as an asset in the balance sheet. Alternatively value of goodwill may be adjusted by deducting new partners' current account and crediting in their sacrificing ratio. The effect under both the methods is same.

       Hidden Goodwill

Sometimes the value of goodwill is not given at the time of admission of a new partner. In such a situation it has to be inferred from the arrangement of the capital and profit sharing ratio. Suppose, A and B are partners sharing profits equally with capitals of Rs. 45,000 each. They admitted C as a new partner for one-third share in the profit. C brings in Rs. 60,000 as his capital. Based on the amount brought in by C and his share in profit, the total capital of the newly constituted firm works out to be Rs.1,80,000 (Rs. 60,000 × 3). But the actual total capital of A, B and C works out as Rs. 1,50,000 (Rs. 45,000 + Rs. 45,000

+ Rs. 60,000). Hence, it can be inferred that the difference is on account of goodwill i.e., Rs. 30,000 (Rs. 1,80,000 – Rs. 1,50,000). Which is to be shared equally (old ratio) by A and B. This shall raise their capital accounts to Rs. 60,000 each and total capital of the firm to Rs. 1,80,000. In this, C’s Current account will be debited by Rs. 10,000 (his share of goodwill) and A and B’s Capital accounts credited by Rs. 5,000 each.

Revision 22

Hem and Nem are partners in a firm sharing profits in the ratio of 3:2. Their capitals were Rs. 80,000 and Rs. 50,000 respectively. They admitted Sam on Jan. 1, 2017 as a new partner for 1/5 share in the future profits. Sam brought Rs. 60,000 as his capital. Calculate the value of goodwill of the firm and record necessary journal entries on Sam’s admission, if:

(a) Sam brings his share of goodwill

(b) Sam does not bring his share of goodwill

Solution

(a)  Sam brings his share of goodwill

Books of Hem, Nem and Samb Journal

(b)  Sam does not bring his share of goodwill

Books of Hem, Nem and Sam Journal 

       Working Notes :

Value of Firm's goodwill

Sam's Capital           =        Rs. 60,000