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CHAPTER2 Goodwill:NatureandValuation
Meaning of Goodwill: Goodwillplacestheorganizationatagoodpositionduetowhichtheorganizationisable toearnhigherprofitswithoutanyextraefforts.Goodwillcannotbeseenbutfelt. ThereforegoodwilliscalledanIntangibleasset. Factors affecting the value of Goodwill : 1. Efficient management 2. Qualityofproducts 3. Locationofbusiness 4. Availabilityofrawmaterial 5. Favorablecontracts Needforvaluinggoodwill:Wheneverthemutualrightsofthepartnerschangesthen party which makes a sacrifice must be compensated. This basis of compensation is goodwillsoweneedtocalculategoodwill. Mutualrightschangeunderfollowingcircumstances 1)Whenprofitsharingratiochanges 2)Onadmissionofapartner 3)OnRetirementordeathofapartner 4)Whenamalganationoftwofirmstakenplace. 5)Whenpartnershipfirmissold. Methods of valuation of goodwill : 1. Averageprofit method 2. Superprofitmethod 3. Capitalizationmethod Average Profit Method TheprofitearnedbyaFirmduringpreviousaccountingperiodsonanaveragebasisis calledaverageprofit.Goodwilliscalculatedonthebasisofaverageprofitduetofuture expectationsofearningcapacityofthefirm. Illustration 1. (Average Profit Method) Akanksha,ChetnaandDipanshuarepartnersinafirmsharingprofitsandlossesinthe ratioof3:2:1.TheydecidetotakeJatinintopartnershipfromJanuary1,2012for1/5 share inthe futureprofits. For thispurpose ,goodwill isto be valuedat 2times the averageannualprofitsofthepreviousfouryears.Theaverageprofitsforthepastfour years were:

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Accountancy& XII

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Formula Average Profit = Total Profits/No. ofYears Goodwill =Average Profit x Number of years of purchase. Year ` 2008 96,000 2009 60,600 2010 62,400 2011 84,400 Calculatethevalueofgoodwill. Solution: Year ` 2008 96,000 2009 60,600 2010 62,400 2011 84,400 Total 3,03,400 AverageProfit=TotalProfit/No.ofYears Averageprofit=3,03,400/4=75,850 Goodwill=AverageProfitxNumberofYearsofPurchase Goodwill=75,850x2=1,51,700 Super Profit Method Ifafirmearnshigherprofitincomparisontonormalprofit(generallyearnedbyother firmsofsameindustry)thenthedifferenceiscalledSuperProfit.Goodwilliscalculated onthebasisofSuperprofitduetofutureexpectationsoflearningcapacityofthefirm. Superprofit=AverageprofitNormalprofit NormalProfit=Investment(CapitalEmployed)xNormalRateofReturn/100 Illustration 2. (Super Profit Method) Afirmearnednetprofitsduringthelastthreeyearsas: Year 200809 200910 201011 Profit (`) 36,000 40,000 44,000 Thecapitalinvestmentofthefirmis ` 1,20,000.Afairreturnonthecapitalhavingregard totheriskinvolvedis10%.Calculatethevalueofgoodwillonthebasisofthreeyears purchaseoftheaverageprofitforthelastthreeyears. Solution : Averageprofit:36000+40000+44000/3=40000 NormalProfit=CapitalEmployedxNormalRateofReturn/100 NormalProfit:120000x10/100=12,000

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y. co m

Accountancy& XII

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AandBarepartnersinafirm.TheyadmitCintothefirm.Thegoodwillforthepurpose istobecalculatedat 2year'spurchaseoftheaveragenormalprofitsofthelastthree yearswhich were ` 10,000, ` 15,000 and ` 30,000respectively. Secondyears profit includedprofitonsaleofMachinery` 10,000.Findthevalueofgoodwillofthefirmon C'sAdmission. Solution (1)CalculationofAverageProfit: Year ended ` IstYear 10,000 2ndYear(`15,000`10,000) 5,000 3rdYear TotalProfits

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Superprofit=AverageprofitNormalprofit =40,00012,000=28,000 Goodwill=Superprofitxnumberofyearspurchased =28,000x3=84,000 Capitalisation Method Inthismethodcapitalizedvalueofthefirmiscalculatedonthebasisofnormalrateof return.Differencebetweentehcapitalizedvalueandactualcapitalemployediscalled goodwill. Illustration 3 (Capitalisation Method) Aearns`1,20,000asitsannualprofits,theratesofnormalprofitbeing10%Theassets oftehfirmamountedto` 14,40,000andliabilitiesto` 4,80,000.Findoutthevalueof goodwillbycapitalizationmethod. Solution : Capitalizedvalueofthefirm=Averageprofitx1000/Rateofnormalprofit =1,20,000x10/100=12,00,0005 Capitalemployed=Totalassetsliabilities =14,40,0004,80,000=9,60,000 Goodwill=capitalizedvaluecapitalemployeed =12,00,0009,60,000=2,40,000 Illustration 4 . (Average profit method)

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Averageprofit=Totalprofit/No.ofyears = ` 45,000/3=15,000 Illustration 5 (Super profit method) Theaveragenetprofitsexpectedofafirminfutureare ` 68,000peryearandcapital

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investedinthebusiness bythefirmis ` 3,50,000.Therateofinterestexpectedfrom capitalinvested inthis class ofbusiness is 12%.The remunerationofthe partnersis estimatedtobe `8,000fortheyear.Youarerequiredtofindoutthevalueofgoodwillon thebasisoftwoyears'purchaseofsuperprofits. Solution AverageProfit=AverageNet ProfitPartner'sremuneration (1)Averageprofit=` 68,000` 8,000=`60,000 (ii)Normalprofit=CapitalemployedxNormalrateofreturn/100 = ` 3,50,000x12/100= ` 42,000 (iii)SuperProfit=AverageprofitNormalprofit = `60,000 `42,000= `18,000 (iv)Valueofgoodwill=SuperprofitxNo.ofyears'purchase = `18,000x2= ` 36,000 Illustration 6. (Super profit method) OnApril1st,1998anexistingfirmhadassetsof `75,000includingcashof ` 5,000.The partners' capitalaccounts showeda balanceof ` 60,000 andreserves constituted the rest.Ifthenormalrateofreturnis20%andthegoodwillofthefirmisvaluedat ` 24,000 at4yearspurchaseofsuperprofits,findtheaveragesprofitsofthefirm Solution: (1)CalculationofNormalProfit: Capitalemployedxnormalrate/100 =75,000x20/100= ` 15,000 (2)CalculationofSuperProfit: Goodwill=SuperprofitxNo.ofyears'purchase `24,000=SuperProfitx4 SuperProfit= `24,000= `6,000 (3)CalculatingofAverageProfit: SuperProfit=AverageProfitNormalProfit ` 6,000=AverageProfit` 15,000 AverageProfit=` 6,000+` 15,000=` 21,000

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Accountancy& XII