GOODWILL

GOODWILL

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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.

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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 :

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Step 1 : Excess profit = Actual profit – Desired normal profit

1200 – 700 = 500

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Step 2 : Goodwill = 500×?????? ????? = Rs 5000

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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.

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Factors affecting the Goodwill

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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.

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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.

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

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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 to earn high profits which leads to higher value of goodwill.

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

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Methods of valuation of Goodwill

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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:

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(i) Average Profit Method

(ii) Super Profit Method

(iii) Capitalisation Method

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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 and the goodwill is to be calculated at 2 years purchase of the average profits works out at Rs.25,000 and it is assumed that the same profits will be the value of the goodwill will be Rs.50,000[Rs.25,000 × 2].

Thus the goodwill is calculated as goodwill???? = average profits × Number of years purchase.

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Illustration : 1

The profit for the last five years of a firm were as follows Year 2001 Rs. 1,20,000: Year 2002 Rs.1,50,000: Year 2003 Rs.1,70,000: Year 2004 Rs.1,90,000: Year 2005 Rs.2,00,000. Calculate goodwill of the firm on the basis of 3 years purchases of 5 years average profits.

Solution :

Year ??????????Profit (Rs.)

2001 ????????? 1,20,000

2002 ????????? 1,50,000

2003 ????????? 1,70,000

2004?????????? 1,90,000

2005 ????????? 2,00,000

Total ????????? 8,30,000

Average Profit = Total Profit/No. of Years

= Rs.8,30,000/5 = Rs.1,66,000

Goodwill ??? = Average Profits × No. of years purchased

= Rs.1,66,000 × 3 = Rs.4,98,000

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2. Super Profit Method : Super profits is the excess of actual profit over

the normal profits. 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 is multiplied by the Super profit. Normal profit is that profit which is, earned by other business unit of the same business. Normal profit will be calculated as follows:

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Normal profit = Capital employed × normal rate of return/100

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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

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For example, A firm earns profit of Rs.65,000 on a capital of Rs.4,80,000 and the normal rate of return in similar business is 10%. Then the normal profit is Rs.48,000[10% of the Rs.4,80,000]. The actual profit is

Rs.65,000. Thus,

Super profit ???????? = Actual profit – Normal profit

= Rs.65,000 – Rs.48,000

= Rs.17,000

If value of Goodwill is calculated by 3 years’ purchase of super profit then goodwill is equal to

Rs.51,000[ Rs.17,000 × 3].

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(b) 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 to multiplied the weight average profit into the agreed number of year’s purchase. Thus the goodwills calculated as follows

Weighted average profit =

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

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(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.)

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Illustration : 2

The profit of firm for past years were as follow :

Profit Rs.

2002 ????????? ???80,000

2003?????????? ?? 85,000

2004 ????????? ???90,000

2005 ????????? 1,00,000

2006 ????????? 1,10,000

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.

Solution

Year Profit ????????? Weight ?????? Products

2002 80,000 ?????? 1 ???????????????? 80,000

2003 85,000 ?????? 2 ???????????????? 170000

2004 90,000 ?????? 3 ???????????????? 270000

2005 1,00,000 ??? 4 ???????????????? 400000

2006 1,10,000 ??? 5 ???????????????? 550000

15 ?????????????? 1470000

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

Goodwill = Rs 98000 × 2 = Rs 1,96,000

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Illustration : 3

A firm earned the following net profits during the last 4 years

??? Rs.

2003 90,000

2004 1,20,000

2005 1,60,000

2006 1,80,000

Capital employed in the firm is Rs.10,00,000. The normal rate of profit is 10%. Calculate the value of the goodwill on the basis of 4 year purchase.

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Solution:

Total profit of 4 years = Rs. 90,000 + Rs. 1,20,000 + Rs. 1,60,000 + Rs.1,80,000

= Rs.5,50,000

Average annual profit = Rs.5,50,000/4

= Rs.1,37,500

Normal Profit?????? ???????? = Rs.10% of Rs.10,00,000 = Rs.10,00,000× 10/ 100

= Rs.1,00,000

Super profit ?????????????????? = Rs. 1,37,500 – Rs. 1,00,000

= Rs.37,500

Value of goodwill at ???? = Rs. 37,500 × 4 = Rs. 1,50,000

4 years’ of purchase

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3. 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:

1. Capitalisation of Average profit

2. Capitalisation of Super profit

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1. 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

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 cimployed

Illustration : 3

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

goodwill with the help of Capitalisation of Average profit method.

Solution:

Capital employed ???????? = Total assets - Outside liabilities

= Rs.3,60,000 - Rs.50,000

= Rs.3,10,000

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

= Rs. 40,000 × 100/10

= Rs. 4,00,000

Goodwill???? = Capitalised value – Capital employed

= Rs. 4,00,000 – Rs. 3,10,000

= Rs. 90,000

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Illustration : 3

The capital invested in a firm is Rs.4,60,000 and the rate of return in the similar business is 12%. The firm earns the following profit in the last 4 years:

2003 Rs. 60,000 2005 Rs. 80,000

2004 Rs. 70,000 2006 Rs. 90,000

Calculate the value of goodwill by Capitalisation method.

Solution

Total Profit = Rs.60,000 + Rs.70,000 + Rs.80,000 + Rs.90,000/4

Average Profit = Rs.3,00,000/4

= Rs.75,000

Capitalised Value ???????? = Average profit × 100/12

= Rs.75,000x100/12

= Rs.6,25,000

Goodwill ??? = Capitalised value – Capital employed

= Rs.6,25,000 – Rs.4,60,000

= Rs.1,65,000

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2. Capitalisation of Super profit

In this method, the value of goodwill is calculated on the basis of super profit method. Following formula is applied for Calculation of capital employed:

Goodwill = Super profit × 100/normal rate of profit

Illustration : 4

A firm earns a profit of Rs.26,000 and has invested capital amounting to Rs.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.

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Solution

Actual profit ??????? = Rs. 26,000

Normal profit ?????? = Rs. 2,20,000 x 10/ 100 = Rs.22,000

Super Profit ??????? = Actual Profit – Normal Profit

= Rs. 26,000 – Rs.22,000

= Rs. 4,000

Goodwill ??? = Super profit × 100/normal rate of profit

= Rs. 4,000 × 100/10

= Rs. 40,000

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19.5 TREATMENT OF GOODWILL

The new partner acquires his/her share 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 and 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.

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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.

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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.

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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 partner in the sacrificing ratio. If there is any goodwill account in the balance sheet of existing partner, 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 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)

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Ilustration : 5

In previous illustration, it is assumed that the full amount of goodwill is withdrawn by the Tanaya and Sumit . Make journal entry in the books of the firm.

Solution:

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Books of Tanaya, Sumit and Gauri

Date ?? Particulars ????????????????????????????????????????? LF??????? Debit ???????????? Credit

amount ?????????? amount

Tanaya’s Capital A/c ???????????????????????? Dr. ????????????????? 15,000

Sumit’s Capital A/c ??????????????????????????? Dr. ????????????????? 15,000

To Bank A/c ?????????????????????????????????????????????????????????????????????????? 30,000

(Amount of Goodwill is withdrawn by them)

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3. New partner does not bring his/her share of goodwill in cash:

When the goodwill of the firm is calculated and the new partner is not able to bring his/her share of goodwill in cash, goodwill will be adjusted through new partner’s capital accounts. In this case new partner’s capital account is debited for his/her share of goodwill and the existing partner’s capital accounts are credited in their sacrificing ratio. The journal entry is as under:

New Partner’s Capital A/c ???????????????????????? Dr.

To Existing Partner’s Capital A/c??? [individually in sacrificing ratio]

(New partner’s share in goodwill credited to exisitng partner’s in sacrificing ratio)

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Goodwill appears in the books of the firm and new partner does not bring his/her share of goodwill in cash:

If the goodwill account appears in the books of the firm, and the new partner is not able to bring goodwill in cash. In this case, the amount of goodwill existing in the books is written off by debiting the capital account of existing partners in their existing profit sharing ratio.

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Illustration 6

Ashmita and Sahil are partners sharing profit in the ratio of 3 : 2. They agree to admit Charu for 1/5 share in future profit. Charu brings Rs. 2,50,000 as capital and enable to bring her share of goodwill in cash, the goodwill of the firm to be valued at Rs. 1,80,000. At the time of admission goodwill existed in the books of the firm at Rs.80,000. Make necessary journal entries in the books of the firm.

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Solution:

Books of Ashmita, Sahil and Charu

Date ?? Particulars ????????????????????????????????????????????????????????????????? LF ?????? Debit ? ??????????? Credit

amount ?????????? ??????????? amoun

Bank A/c ??????????????????????????????????????????????????????? Dr. ????????????????? 2,50,000

To Charu’s Capital A/c?????????????????????????????????????????????????????????????????????? ??????????? 2,50,000

[Cash brought by Charu for her capital]

Ashmita’s Capital A/c ??????????????????????????????????? Dr. ????????????????? ????48,000

Sahil’s Capital A/c ???????????????????????????????????????? Dr. ????????????????? ????32,000

To Goodwill A/c ???????????????????????????????????????????????????????????????????????????????? ???80,000

[Goodwill written off before Charu’s admission]

Charu’s Capital A/c ??????????????????????????????????????? Dr. ????????????????? ????36,000

To Ashmita’s Capital A/c ?????????????????????????????????????????????????????????????????? ???21,600

To Sahil’s Capital A/c ??????????????????????????????????????????????????????????????????????? ???14,400

[Existing partners capital a/c credited for goodwill

?on Charu’s admission in sacrificing ratio]

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Working Note :

Ashmita and Sahil sacrifice their profit in favour of Charu in their existing

profit sharing ratio i.e. 3 : 2. Therefore, the sacrificing ratio is 3 : 2.

Value of Goodwill = Rs.1,80,000

Charu’s share in Profit = 1/5

Charu’s share of Goodwill = Rs. 1,80,000 × 1/5 = Rs. 36,000

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New partner brings in only a part of his share of goodwill

When new partner is not able to bring the full amount of his/her share of goodwill in cash and brings only a part of cash. In this case, the amount of goodwill brought by him is credited to goodwill account. At the time

of goodwill transferred to capital account of existing partner’s, new partner’s capital account is debited with his unpaid share of goodwill besides debiting goodwill account with the amount of goodwill is paid by him. The journal entries is as

Bank A/c ???????????????????????????????? Dr.

To Goodwill A/c

[Part Amount of goodwill brought by new partnerI

Goodwill A/c ???????????????????????????????????? Dr.

New Partner’s Capital A/c ?????????????? Dr.

To Existing Partner’s Capital A/c [individually in sacrificing ratio]

[Credit given to sacrificing partner by new partner’s in full share of goodwill

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Tanu and Puneet are partners sharing profit in the ratio of 5 : 3. They admit Tarun into the firm for 1/6 share in profit which he takes 1/ 18 from Tanu and 2/ 18 from Puneet. Traun brings Rs.9,000 as goodwill out of his share of Rs. 12,000. No goodwill account appears in the books of the firm. Make necessary journal entries in the books of the firm.

Solution:

JOURNAL

Date ?? Particulars ????????????????????????????????????????????????????????????????? LF ?????? ?Debit ??????????? Credit

?????????? Amount ?????????? ??????????Amount

Bank A/c ??????????????????????????????????????????????????????? Dr ?????????????????? 9,000

To Goodwill A/c ???????????????????????????????????????????????????????????????????? ??????????? 9,000

[A part of his share of goodwill brought in by Tarun]

Goodwill A/c Dr. ???????????????????????????????????????????????????????????????????? 9,000

Tarun Capital A/c Dr. ???????????????????????????????????????????????????????????? 3,000

To Tanu’s Capital A/c ??????????????????????????????????????????????????????????????????????? ??????????? 4,000

To Puneet’s Capital A/c ???????????????????????????????????????????????????????? ??????????? 8,000

[Goodwill credited to Tanu and Puneet in their

sacrificing ratio i.e 1 : 2]

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