Study Material & Notes-Partnership-Goodwill

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
Table 3.1.B1
C. Need for valuation of Goodwill
  1. At the time of admission, retirement or death of a partner.
  2. Change in the profit-sharing ratio amongst the existing partners.
  3. When the partnership firm is sold out.
  4. When the firms amalgamate (merge)
  5. 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:

  1. Abnormal losses (e.g., loss by fire, theft etc.)
  2. Loss on sale of fixed assets
  3. Overvaluation of Opening stock or Undervaluation of Closing Stock
  4. Non-recurring expenses
  5. Assets treated as expense less depreciation

Less:

  1. Abnormal gains
  2. Profit on sale of fixed assets
  3. Overvaluation of Closing stock or Undervaluation of Opening Stock
  4. Non-recurring incomes
  5. Expenses treated as assets less depreciation
  6. 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:

      1. Reserves

Less:

      1. Non-trade Investments
      2. Goodwill
      3. Advertisement Suspense

Assets Side Approach

All Assets (excluding goodwill, fictitious assets, Non-trade Investments)

Less:

    1. 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 =