Study Material & Notes-Partnership-Goodwill1

Study Material & Notes for the Chapter-3 Partnership-Goodwill

1. GOODWILL – DEFNITION & FEATURES

SNNatureExplanation
1Nature of BusinessIf the nature of the products, in which the firm deals, are in high demand although not short in supply, the firm will earn higher profits hence higher Goodwill.
2Market SituationIf firm’s products have higher demand than supply, it will lead to lower capital requirements and higher profit, which leads to higher value of goodwill.
3Quality of ProductsGood product quality leads to more satisfied customers there will be repeated and higher sales as a result the value of goodwill will increase.
4Efficiency of ManagementCapable & competent management invests in research & development, better product quality, cost efficiency, increasing market share leading to higher profits & Goodwill.
5LocationIf the business is located in a convenient or prominent locality it will attract more customers leading to higher sales and profits i.e. 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

2. 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:

Less:

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)          

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:

Less:

Assets Side Approach

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

Less:

D. Capitalization of Super Profit Method

Goodwill = Super Profits X 

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

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 = 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 =

(Capital Employed at beginning of year + Capital Employed at end of year) / 2                                                     

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