Study Material & Notes for the Chapter-3 Partnership-Goodwill
1. GOODWILL – DEFNITION & FEATURES
| SN | Nature | Explanation |
| 1 | Nature of Business | If 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. |
| 2 | Market Situation | If 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. |
| 3 | Quality of Products | Good product quality leads to more satisfied customers there will be repeated and higher sales as a result the value of goodwill will increase. |
| 4 | Efficiency of Management | Capable & competent management invests in research & development, better product quality, cost efficiency, increasing market share leading to higher profits & Goodwill. |
| 5 | Location | If 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:
- 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
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:
- 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 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