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Meaning, Factors Affecting and Valuation of Goodwill in Partnership Accounts
valuation of goodwill in partnership

Meaning, Factors Affecting and Valuation of Goodwill in Partnership Accounts

Meaning, Factors Affecting and Valuation of Goodwill in Partnership Accounts

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 1200 and the normal rate of profit expected to be earned by other similar firms in this industry is 10% say at this rate normal profit of your firm is 700 goodwill is ascertained as under :

Step 1 : Excess profit = Actual profit – Desired normal profit
1200 – 700 = 500
Step 2 : Goodwill = 500  100

10 = 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. It may also be defined as the present value of the capacity to earn future profits. This means that a firm can be said to have goodwill only if it has capacity to earn profit in future. A firm earning only normal profits like similar firms cannot claim to have any goodwill.

What are Factors that  are affecting the Goodwill

The factors affecting goodwill are as follows:

1. Location : If the firm is located at a central place, resulting in good sale, the goodwill tends to be high.

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

3. Efficient management : A well managed firm earns higher profit and so the value of goodwill will also be high.

4. Quality : If a firm is known for the quality of its products the value of goodwill will be high.

5. Market Situation : The monopoly condition leads to earn high profits which leads to higher value of goodwill.

6. Special Advantages : The firms which have special advantages like importing licenses, long term contracts for supply of material, patents, trademarks, etc. enjoy higher value of goodwill.

Methods of Valuation of Goodwill

The methods of valuation of goodwill are generally decided by the partners among themselves while preparing partnership deed. The following are the important methods of valuing the goodwill of a firm :

  • Average Profit Method
  • Super Profit Method
  • Capitalisation Method

Let us learn about these methods.

  1. Simple Average Profit Method : Under this method, average of the profits of certain given years is calculated. The value of the goodwill is calculated at an agreed number of years purchase of the average profit. Thus the goodwill is calculated as follows : 

Value of goodwill = Average Profit × Number of year of purchase

For example, the average profits of a firm of say 3 years is  25,000 and the goodwill is to be calculated at 2 years purchase of the average profit. The value of the goodwill will be  50,000[ 25,000 × 2]. Thus goodwill = average profits × Number of years purchase.

Example :

The profit for the last five years of a firm were as follows Year 2001

1,20,000: Year 2002  1,50,000: Year 2003  1,70,000: Year 2004  1,90,000: Year 2005  2,00,000. Calculate goodwill of the firm on the basis of 3 years purchases of 5 years average profits.

Year Profit
2001 120,000
2002 150,000
2003 1,70,000
2004 1,90,000
2005 2,00,000
Total 830,000

Average Profit =     Total Profit/No. of Years

  •  8,30,000/5 =  1,66,000

Goodwill      =                Average Profits × No. of years purchased

  • 1,66,000 × 3 =  4,98,000
  1. Super Profit Method : Super profit is the excess of actual profit over the normal If a new business earns certain percentage of the capital employed, it is called ‘normal profit’. The value of the goodwill is calculated at an agreed number of years purchase of super profit by multiplying the Super Profit by the certain number of years. Normal profit is that profit which is, earned by other business unit of the same business. Normal profit will be calculated as follows:

 

Normal profit = Capital employed × normal rate of return/100
Actual Profit : These are the profit earned during the year or it is also
taken as the average of the last few years profit.
Super Profit = Actual Profit – Normal Profit

For example, A firm earns profit of  65,000 on a capital of 4,80,000 and the normal rate of return in similar business is 10%. Then the normal profit is

  • 48,000[10% of the 4,80,000]. The actual profit is  65,000. Thus,

Super profit            =             Actual profit – Normal profit

  • 65,000 – 48,000
  • 17,000

If value of Goodwill is calculated by 3 years’ purchase of super profit then goodwill is equal to 51,000[  17,000 × 3].

3. Weighted average method :

This method is a modified version of average profit method. In this method each year profit is assigned a weight i.e. 1, 2, 3, 4 etc. Thereafter each year profit is multiplied by the weight and find product. The total of products is divided by the total of weight. As a result we find the weighted average profit. After this the value of goodwill is calculated multiplying the weighted average profit by the agreed number of year’s purchase. Thus the goodwill is calculated as follows :
Weighted average profit = Total product of profit/Total of weights

Value of goodwill = Weighted average profit × number of year of purchase

(Note : This method is used when we observe that there is a tendency to increase the annual profits. Latest year profit is assigned the highest weight.

Example:

The profit of firm for past years were as follow :

Year Profit
2002 80,000
2003 85000
2004 90,000
2005 100000
2006 110,000

The weight to be used are 1, 2, 3, 4, and 5 for the years from 2002 – 2006.

Calculate the value of goodwill on the basis of two year’s purchase of weighted average profit.

Year Profit Weight product
2002 80,000 1 80,000
2003 85000 2 170,000
2004 90,000 3 270,000
2005 100000 4 400000
2006 110,000 5 550000
15 1470,000

Weighted Average Profit =  14,70,000 /15= 98,000

Goodwill = 98000 × 2 = 1,96,000

4. Capitalisation Method :

In this method, goodwill is the amount of capital saved. Normally businessmen invest capital to operate business activities, and earn profit with the efficient utilisation of capital. If the business earns more profit by investing lesser amount of capital as compared to other business, who earned same amount of profit with more amount of capital, the saved amount is assumed to be goodwill.

Under this method, the Goodwill is calculated in two ways:

i. Capitalisation of Average profit

ii. Capitalisation of Super profit

i. Capitalisation of Average Profit : In this method, the value of goodwill is assumed to be excess of the capital value of average profit over the actual capital employed.

Following formula is applied for Calculation of capital employed:
Capital employed = Total Assets – Outsider Liabilities.

Admission of a Partner

Following formula is applied for calculation of capitalised value of profit :
Capitalised Value of Profit = Average Profit × 100/ Normal Rate of Profit

Goodwill = Capitalised Value of Profits – Capital Employed

Example

A firm earned average profit during the last few years is ` 40,000 and the normal rate of return in similar business is 10%. The total assets is ` 3,60,000 and outside liabilities is ` 50,000. Calculate the value of goodwill with the help of Capitalisation of Average profit method.

Solution :

Capital employed = Total assets – Outside liabilities

= 3,60,000 – 50,000

= 3,10,000

Capitalised value of average profit = Average Profit × 100/ Normal rate of profit

= 40,000 × 100/10

= 4,00,000

Goodwill = Capitalised value – Capital employed

= 4,00,000 –  3,10,000

=  90,000

 

ii. Capitalisation of Super Profit : In this method, the value of goodwill is calculated on the basis of super profit method. Goodwil is the capitalised value of super profit. Following formula is applied for Calculation of capitalised value i.e., goodwill.
Goodwill = Super Profit × 100/Normal Rate of Profit

Example

A firm earns a profit of ` 26,000 and has invested capital amounting to  2,20,000. In the same business normal rate of earning profit is 10%. Calculate the value of goodwill with the help of Capitalisation of super profit method.

Solution :
Actual profit = 26,000
Normal profit =2,20,000 x 10/ 100 =22,000
Super Profit = Actual Profit – Normal Profit
= 26,000 –  22,000
= 4,000

Goodwill = Super profit × 100/normal rate of profit

= 4,000 × 100/10

= 40,000

 

Treatment of Goodwill

The new partner acquires his/her share of profit from the existing partners. This will result in the reduction of the share of existing partners. Therefore, he/she compensates the existing partners for the sacrifices. He/she compensates them by making payment in cash or in kind. The payment is equal to his/her share in the goodwill.
As per Accounting Standard 10(AS-10) that goodwill should be recorded in the books only when some consideration in money has been paid for it. Thus, if a new partner does not bring necessary cash for goodwill, no goodwill account can be raised in the books. He/she should pay for goodwill in addition to his/ her contribution for capital.

If, he/she does not pay for goodwill, then amount equal to his/her share of goodwill will be deducted from the capital. The amount brought in by him/her as goodwill or amount of goodwill deducted from his/her capital is divided between the existing partners in their sacrificing ratio. At the time of admission of a new partner any goodwill appearing in the books, will be written off in existing ratio among the existing partners.

There are different situations relating to treatment of goodwill at the time of admission of a new partner. These are discussed as under:

1. When the amount of goodwill is paid privately by the new partner.

2. When the new partner brings his/her share of goodwill in cash.

3. When the new partner does not bring his/her share of goodwill in cash.

1. The amount of goodwill is paid privately by the new partner : If the amount of goodwill is paid by the new partner to the existing partner privately, no journal entries are made in the books of the firm.

2. The new partner brings his/her share of goodwill in cash and the amount of goodwill is retained in the Business : When, the new partner brings his/ her share of goodwill in cash. The amount brought in by the new partner is transferred to the existing partners in the sacrificing ratio. If there is any goodwill account in the balance sheet of existing partners, it will be written off immediately in existing ratio among the partners. The journal entries are as follows:

(i) The existing goodwill in the books of the firm will be written off in existing profit ratio as;

Existing Partners Capital A/c Dr. [individually]

To Goodwill A/c

(Existing goodwill written off)

(ii) For bringing cash for Capital and goodwill

Cash/Bank A/c Dr.

To Goodwill Premium A/c

To New partner’s Capital A/c

(Cash brought in for capital and goodwill)

(iii) For amount of goodwill transferred to existing partner capital account:

Goodwill A/c Dr.

To Existing Partner’s Capital/current A/c [individually]

(The amount of goodwill credited to existing partner’s capitals in sacrificing ratio)

EXample:

Tanaya and Sumit are partners in a firm sharing profit in the ratio 5 : 3. They admitted Gauri as a new partner for 1/4th share in the profit. Gauri brings ` 30,000 for her share of goodwill and ` 1,20,000 for capital. Make journal entries in the books of the firm after the admission of Gauri. The new profit sharing ratio will be 2 : 1 : 1.

Solution :

Books of Tanaya, Sumit and Gauri

1. Bank A/c Dr. 1,50,000
To Goodwill Premium A/c 30,000
To Gauri’s Capital A/c 1,20,000
(cash brought by Gauri for her
share of goodwill and capital)

Goodwill Premium A/c Dr. 30,000
To Tanaya’s Capital A/c 15,000
To Sumit’s Capital A/c 15,000
(Goodwill transferred to existing partners
capital account in their sacrificing ratio)

Working Note:
Calculation of sacrificing ratio [existing ratio – new ratio]

Partners Existing Ratio New Ratio Sacrifice Sacrifice ratio
Tanya 5/8 2/4 5/8 – 2/4 = 1/8 Tanya : sumit
Sumit 3/8 ¼ 3/8 – ¼  = 1/8 1: 1

The amount of goodwill is withdrawn by the existing partners:

(iv) Existing Partners Capital/current A/c Dr. [individually] To Cash/Bank A/c

(The amount of goodwill withdrawn by the existing partners)

It is to be noted that sometimes partner’s withdraw only 50% or 25% amount of goodwill. In such a case, entry will be made for the withdrawn amount only.

See also: treatment of goodwill change in profit sharing ratio

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