Study Material & Notes for the Chapter 3
Partnership - Goodwill
I. GOODWILL - DEFINITION & FEATURES
A. Goodwill
Goodwill is the benefit and advantage of the good name, reputation, and connection of a business. It is the attractive force which brings in customers. It is one factor which distinguishes an old established business from a new business at its first start.
- Good will = Good name or Reputation
- Is an Intangible asset…cannot be seen or touched
- Places an enterprise at an advantageous position due to efforts made in the past
- Enterprise is able to earn higher profits without extra efforts
B. Factors affecting valuation of Goodwill
C. Need for valuation of Goodwill
- At the time of admission, retirement or death of a partner.
- Change in the profit-sharing ratio amongst the existing partners.
- When the partnership firm is sold out.
- When the firms amalgamate (merge)
- When the firm is converted into Company
D. Classification of Goodwill
1) Purchased (Acquired) Goodwill
- It is the goodwill that is acquired by a business after paying consideration in cash or in kind.
- For example, consideration paid Rs. 10 lacs for purchase of a business wherein Assets acquired valued Rs. 20 lacs & Liabilities taken over for Rs. 12 lacs. Extra Rs. 2 Lacs is paid here for Goodwill.
2) Self Generated Goodwill
- It is internally generated or hard-earned goodwill which arises due to continued hard work of the organization, its better-quality products and better customer services.
- Self-generated goodwill is not recorded in the books because no consideration in money or money’s worth is paid for it.
Important to Note: As per AS-26 Goodwill should not be recorded in books unless it is purchased
II. METHODS OF VALUATION OF GOODWILL
A. Simple Average Profit
Goodwill = Simple Average Profit X Number of years purchased
Where:
Simple Average profit = Simple Average of pure profit of last few years
Computation of Pure Profits
Profit or Loss of past year (before adjustments)
Add:
- Abnormal losses (e.g., loss by fire, theft etc.)
- Loss on sale of fixed assets
- Overvaluation of Opening stock or Undervaluation of Closing Stock
- Non-recurring expenses
- Assets treated as expense less depreciation
Less:
- Abnormal gains
- Profit on sale of fixed assets
- Overvaluation of Closing stock or Undervaluation of Opening Stock
- Non-recurring incomes
- Expenses treated as assets less depreciation
- Partners Salary
Number of years purchased = For how many years firm will earn same profits (this is given in the question)
B. Weighted Average Profit
Goodwill = Weighted Average Profit X Number of years purchased
Where:
Weighted Average profit = Weighted Average of pure profit of last few years
- Weights for each year Profit is given in the question
- Pure Profit is multiplied by weight of respective year and ‘Product’ is obtained
- Weighted Average Profit = Total Product / Total Weights
Number of years purchased = For how many years firm will earn same profits (this is given in the question)
C. Super Profit Method
Goodwill = Super Profit X Number of years purchased
Where:
Super Profit = Average Profit – Normal profit
Average profit = Simple Average of pure profit of last few years
Normal Profit = Normal Profit is the Profit earned by similar firms in similar businesses and can be computed with the formula
Average Capital Employed X Normal Rate of Return
Average Capital Employed =
(Capital Employed at beginning of year + Capital Employed at end of year) / 2
Normal Rate of Return = Rate of return earned by the similar firms in the market. This rate is already given in the question
Number of years purchased = For how many years firm will earn same profits (this is given in the question)
Computation of Capital Employed
Liabilities Side Approach
Capital
Add:
- Reserves
Less:
- Non-trade Investments
- Goodwill
- Advertisement Suspense
Assets Side Approach
All Assets (excluding goodwill, fictitious assets, Non-trade Investments)
Less:
- Outside Liabilities
D. Capitalization of Super Profit Method
Goodwill = Super Profit X
Where:
Super Profit = Average Profit – Normal profit
Average profit = Simple Average of pure profit of last few years
Normal Profit = Profit earned by similar firms in similar businesses and can be computed with the formula:
Average Capital Employed X Normal Rate of Return
Normal Rate of Return = Rate of return earned by the similar firms in the market. This rate is already given in the question
E. Capitalization of Average Profits
Goodwill Employed = Average Profits X
– Net Assets or Average Capital
- As per the profit earned by firm, how much capital is required for the same (using normal rate)
- How much Capital Firm has put in the business (Capital Employed)
- If the Firm is able to earn more profits even by putting lesser capital, it is because of Firm’s Goodwill
Where:
Average Profits = Simple Average of pure profit of last few years
Normal Rate of Return = Rate of return earned by the similar firms in the market. This rate is already given in the question
Average Capital Employed =
