Goodwill is the value of reputation of a firm in respect of profits expected in future over and above the normal rate of profits. In simpler Terms, Goodwill is nothing more than the probability that old customer will resort to old place again and again. The capacity of a business to earn super profits in the future is basically what is meant by term goodwill. Goodwill is an intangible asset; it cannot be seen; it cannot be felt; it cannot be transported physically. Even then it is very real. From accounting point of view, it is necessary that it has some monetary or saleable value. The implication of the term over and above is that there is always a certain normal rate of profits earned by similar firms in the same locality. The excess profit earned by a firm may be due to its locational advantage, better customer service, possession of a unique patent right, personal reputation of the partner or for similar other reasons. The necessity for valuation of goodwill in a firm arises in the following cases:
a) When the profit sharing ratio amongst the partners is changed;
b) When a new partner is admitted;
c) When a partner retires or dies; and
d) When the business is dissolved or sold.
Let us take a simple example. There is a small Book business owned by a firm. Its net worth i.e. Asset– liabilities, is Rs 140,000. Now if a purchaser is willing to pay Rs 150,000 for it, the extra Rs 10,000 is known in accounting as goodwill. The next question is: Why the purchaser is willing to pay Rs 10,000 for goodwill. One reason may be the future capability of the business to earn more profit than the normal profit. It may be on account of favourable location.
The major factors which affect value of goodwill are as follows:
The list is in no way exhaustive but only provides the basic guidelines:
(i) The quality of the goods sold.
(ii) The personal reputation of the owners i.e., their ability to attract the customers.
(iii) The location of the business premises e.g., a good position in a congested market.
(iv) The possession of near monopoly right e.g. main agent for a particular vehicle like, Maruti car, Bajaj scooter, etc.
(v) The possession of trademarks and patents.
(vi) The presence of managerial skill.
(vii) The cost of research and development which enables the production at low cost and of good quality.
(viii) The possession of special contracts for the availability of materials
RECOMMENDATION OF ACCOUNTING STANDARD
Accounting Standards require an enterprise to recognize an intangible asset, only if and only if, certain conditions are satisfied, namely:
(i) An intangible asset must have the characteristics of an asset. It means that it must have some value and must be clearly identifiable, so that it can be sold without disposing other assets or future benefits flowing from other assets.
(ii) An intangible asset should be recognized only if the future probable economic benefits (i.e., increased revenue from sales) will ffow to the business enterprise and not to others. It means that management can make reasonable estimates of future benefits.
(iii) The cost of the intangible asset can be measured reliably, that is, the cost is objectively verifiable. If the cost cannot be measured reliably, then it cannot be recognized as an asset.
It is thus clear that none of the conditions is satisfied by internally generated goodwill or inherent goodwill. The reasons are simple to explain. First, it is not an identifiable resource like patent, trademark or copyright. Second, it is very dicult to assess its future benefits. Finally, the cost of internally generated goodwill cannot be reliably measured in the absence of any consideration in money or money’ worth. There is no documentary evidence to support the value of goodwill as a resource.
Goodwill should be recorded in the books only when some consideration in money or money’ worth has been paid for it. Accordingly, on admission or retirement/death of a partner or even when there is a change in profit sharing ratio amongst the existing partners, goodwill should not be raised in the books of account of the partnership firm because no consideration in money or money’ worth has been paid for it. The conclusion is that only purchased goodwill should be recorded in the books of account whether the payment is made directly in cash or money’ worth. For example, ‘A’ and ‘B’ purchase the net assets (assets minus liabilities) of ‘C’ amounting to Rs 2,50,000 for Rs 3,00,000 in cash, the additional payment of Rs 50,000 is a payment for goodwill in cash. It is a case of purchased goodwill (an asset) and can be validly recorded in the books of A and B. When no payment is made for the purchase of goodwill and goodwill account is raised in the books, it is a case of internally generated goodwill or inherent goodwill and as per Accounting Standards, it is not permitted. For example, in the event of reconstitution of the firm due to admission, or retirement or death of a partner or even a change in the profit sharing ratio without reconstitution, goodwill of the firm is evaluated. In such a situation, the value of goodwill should not be brought into books of account because it is inherent or self-generated goodwill since no money or money’ worth has been paid for it. The only way out is that the value of goodwill as calculated with the help of different valuation methods should be adjusted through capital accounts of the partner(s) of the firm. In no case the goodwill account is to be raised in the books of account, either on the reconstitution of the firm or change in the profit sharing ratio.
The amount of goodwill is written off over a period of time. In case when the goodwill account exists at the time of reconstitution of firm, it should be written off immediately whether it is internally generated or goodwill has been bought for some consideration.
2.2 METHODS FOR GOODWILL VALUATION
There are three methods for valuation of goodwill
1) Average profit basis,-Simple and Weighted 2) Super profit basis,-Number of Year Purchase, Annuity basis, and Capitalization of Super Profit 3 Capitalization basis- Average Profits
(1) Average Profit Basis: In this case the average profits of past years are adjusted for any expected change in future. The number of year are decided on the basis of judgement and negotiation.
If goodwill is valued at three years’ purchase of profit, the ninth is case the value of goodwill is Rs 56,667 (approx) × 3 = Rs 1,70,000.
However, if any such trend is not visible from the figures of past profits, then one should take simple average profit and calculate goodwill accordingly. Let us suppose, profits of a partnership firm for five years were Rs 30,000, Rs 25,000, Rs 20,000, Rs 30,000 and Rs 28,000. In this case, there is no clear increasing or decreasing trend of profit. So average profit comes to Rs 26,600 (arrived at by taking simple average). If the goodwill is valued by taking three years’ of purchase of profit, the ninth is case, value of goodwill becomes Rs 79,800.
Weighted average is used when profit has increased or decreasing Trend. Highest weight is always given to current year, as it reflects the more realistic view of the future profitability
The past profits of five years of a partnership firm are: Rs 50,000; Rs 40,000; Rs 52,000; Rs 48,000 and Rs 56,000 respectively. Calculate the value of goodwill on the basis of 4 years’ purchase of the average profits of the last five years.
Total profits for five years = Rs (50,000 + 40,000 + 52,000 + 48,000 + 56,000) = Rs 2,46,000
Average profit = Sum of profits/No. of years
Average Profit = Rs 2,46,000 ÷ 5 = Rs 49,200
Value of goodwill (being four years’ purchase of the average profit of five years) = 4 × Rs 49,200 = Rs 1,96,800.
(2) Super Profit Basis: In case of super profit method, goodwill is valued on the basis of super profits earned by the firm.
Super Profit=Actual Profit-Normal Profit
Actual Profit is average profit
Normal Profit=Normal rate of Return (NRR) x Capital Employed
The rationale for using the super profit is the partner who gains excess earning owing to reconstitution of firm should compensate to partners sacrificing their share in the reconstitution. Super profit means, excess profit that can be earned by a firm over and above the normal profit usually earned by similar firms under similar circumstances. Under this method, the partner who gains in terms of profit sharing ratio has to contribute only for excess profit because normal profit he can earn by joining any partnership firm. Under super profit method, what excess profit a partnership firm can earn is to be determined first.
Calculation of super profit:
(i) identify the capital employed by the partnership firm;
(ii) Identify the average profit earned by the partnership firm based on past few years’ figures;
(iii) Determine normal rate of return prevailing in the locality of similar firms;
(iv) Apply normal rate of return on capital employed to arrive at normal profit;
(v) Deduct normal profit from the average profit of the firm. If the average profit of the firm is more than the normal profit, there exists super profit and goodwill.
Let us suppose, total capital employed by a partnership firm was Rs 1,00,000 and its average profit was Rs 25,000. Normal rate of return is 22% in case of similar firms working under similar conditions. So, normal profit is Rs 22,000 and average profit is Rs 25,000. The partnership firm earns Rs 3,000 super profit.
(a) Number of Years Purchase Method: Goodwill is generally valued by multiplying the amount of super profit by certain number of years depending upon the expectation about the maintenance of such profit in future. If it is expected that the super profit can be maintained for another five years in future, then value of goodwill may be taken as Rs 3,000 × 5 = Rs15,000.
A firm of A, B and C has a total capital investment of Rs 4,50,000. The firm earned net profits during the last four years as: I-Rs 70,000; II-Rs 80,000; III-Rs 1,20,000 and IV-Rs 1,00,000. The reasonable expected return is 15 per cent having regard to the risk involved. Find out the value of goodwill of the business if it is based on 3 years’ purchase of the average super profits of the past four years.
Average Profit = Sum of profits/no. of years
Normal Profit = NRR x Capital Employed
Super Profit = Average profit- Normal Profit
Value of goodwill (being 3 years’ purchase of the average super profit :
Rs 25,000 x 3 = 75,000
(b) Annuity Method: The major drawback of number of number of years purchase method is that time value of money is not considered. Although it was expected that super profit would be earned in five future years, still no devaluation was done on the value of money for the time difference. In fact when money will be received in different points of time, its value should be different depending upon the rate of interest. If 15% rate of interest is considered appropriate, then discounted value of super profit to be earned in different future years will be as follows:
So, under the annuity method, discounted value of total super profit becomes Rs 10,056.60 and not Rs 15,000 as was done under super profit method. The word annuity is used to mean identical annual amount of super profit. So, for discounting it is possible to refer to annuity table. As per the annuity table, present value of Rs 1 to be received at the end of each year for n year @15% interest p.a. is 3.3522. So value of goodwill under annuity method is Rs 3,000×3.3522 = Rs 10,056.60.
Calculate the goodwill by annuity method of super profit from the following facts:
(a) Annual maintainable profit after tax is Rs 65,000.
(b) Capital employed is Rs 4,00,000.
(c) Normal rate of return is expected at 12% p.a.
(d) Present value of an annuity of Rs 1 for five years is 3.604776.
The present value of annuity of Rs 17,000 for five years at 12% compound interest = 17,000 x 3.604776 = Rs 61,281 (Approx.)
Capitalization of Super Profit: Goodwill = Super Profit/ Normal rate of Return (NRR) = Rs 17,000/ 12% = Rs 14,167
3 Capitalization Basis: Under this basis, value of whole business is determined applying normal rate of return. If such value (arrived at by applying normal rate of return) is higher than the capital employed in the business, then the difference is goodwill. The steps to be followed under this method are given below:
a. Determine the normal rate of return.
b. Find out the average profit of the partnership firm for which goodwill is to be determined.
c. Determine the capital employed by the partnership firm for which goodwill is to be determined.
d. Find out normal value of the business by dividing average profit by normal rate of return.
e. Deduct average capital employed from the normal value of the business to arrive at goodwill.
Goodwill = Normal Capital-Actual Capital
Normal capital = Average Profit/NRR
Let us suppose capital employed by a partnership firm is Rs 1,00,000. Its average profit is Rs 20,000. Normal rate of return is 15%.
Value of goodwill = Rs 1,33,333 – Rs 1,00,000 = Rs 33,333
1. The net tangible assets of a firm are worth Rs 4,10,000 and the average profit of last four years amounts to Rs 60,000. Find out of the value of goodwill if the reasonable return on capital invested is 12%.
Above method are explained below with the help of following illustrations:
Lee and Lawson are in equal partnership. They agreed to take Hicks as one-fourth partner. For this it was decided to find out the value of goodwill. M/s. Lee and Lawson earned profits during 2013-2016 as follows:
On 31.12.2016 capital employed by M/s. Lee and Lawson was Rs 5,00,000. Rate of normal profit is 20%.
Find out the value of goodwill following various methods.
Weighted Average Profit = Rs 13,60,000 divided by 10 = Rs 1,36,000
Method(1): Average Profit Basis
Assumption: Goodwill is valued at 3 year’s purchase
Value of Goodwill: Rs 1,36,000 ×3 = Rs 4,08,000
Method(2): Super Profit Basis
Assumption: Goodwill is valued at 3 years’ purchase.
Value of Goodwill = Rs 36,000 × 3 = Rs 1,08,000
Method (3): Annuity Basis
(a) Interest rate is equivalent to normal profit rate i.e. 20%p.a.
(b) Goodwill is valued at 3years’purchases
Valuation of Goodwill: Rs 36,000 × 2.1065 =Rs 75,834
Method (4): Capitalisation Basis
The following particulars are available in respect of the business carried on by Rathore
You are required to compute the value of goodwill on the basis of 5years’ purchase of super profit of the business calculated on the average profits of the last four years.
Hidden or Inferred or implied Goodwill
Sometimes the value of goodwill is not specifically given and has to be inferred or implied from the arrangement of capital or profit-sharing ratio. For example A’s capital is Rs 20,000 and B’s Capital is Rs 15,000 and they share profits equally. C is admitted as a partner with Rs 18,000 as his capital for 1/4 share in the profits. The total capital of the firm now ought to be Rs 72,000 for the simple reason that if C contributes Rs 18,000 for 1/4 share, then for full or unit profit he ought to have contributed Rs 72,000 (18,000 x 4). But the total capital of A, B and C becomes only Rs 50,000. So the hidden value of the goodwill should be taken as Rs 22,000 so that the total capital becomes Rs 72,000
2.3 NEED FOR VALUATION OF GOODWILL
Whenever there is any change in the existing relationship of the partners in terse, some partners have to sacrifice their future profit and some others would gain. Those who are sacrificing future profit should be compensated by the others who are gaining. This adjustment of the partnership rights may arise due to admission of a new partner, change in the profit sharing ratio, retirement or death of a partner and a dissolution of the partnership. The partners, who gain in terms of profit sharing ratio, have to pay for such gain as a proportion to the value of goodwill. The partners, who lose in terms of profit sharing ratio, receive payments for the sacrifice as a proportion to the value of goodwill. Dissolution of partnership firms is not covered in this study material and will be discussed in the Intermediate Course Study Material.
2.4 VALUATION OF GOODWILL IN CASE OF ADMISSION OF A
When a new partner is admitted into a partnership, certain adjustments in accounts become necessary. Chiefly, this is because the new partner will acquire a share in the profits of the firm and because of this, the old partners will stand to lose. Suppose, A and B are partners sharing profits in the ratio of 3:2. If their profits are Rs 20,000, A will get Rs 12,000 and B will get Rs 8,000. If C is admitted and given one fourth share in profits, then out of Rs 20,000 he will get Rs 5,000. The remaining Rs 15,000 will be divided between A and B; A will get Rs 9,000 and B will get Rs 6,000. Thus on C’s admission A loses Rs 3,000 per year and B loses Rs 2,000 per year. C will have to compensate A and B for this loss. It is no argument to say that on C’s admission the profits will not remain at `20,000; extra profits will arise and therefore, A and B will both get more than what they previously got. But it should be noted that the additional profits will be earned by the combined efforts of all the partners A, B and C. Therefore, if A and B get a share of the extra profits they are not particularly obliged to C. Out of the present profits of Rs 20,000 they have to give up a share in favour of C and, therefore, they are entitled to a compensation. The problem of compensation is the chief problem while dealing with admission of a partner. This is tackled through goodwill. But one point should be made clear here. Goodwill is a compensation to old partners for their sacrifice in connection with admission of a new partner. So it is to be credited to the partners according to their profit sacrificing ratio. Whatever share the new partner is getting, it may be sacrificed by the old partners in proportion to their old profit sharing ratio or in different proportion.
For example, Nigam and Dhameja are in partnership sharing profits and losses equally. They agreed to take Ghosh as one-third partner. Now one-third share of Ghosh may come out of sacrifice made by Nigam and Dhameja equally (i.e. at their old profit sharing ratio). See the following profit sharing pattern:
In other words, one-third share of Ghosh was borne by Nigam and Dhameja at their old profit sharing ratio. By this process Nigam sacrificed 1/2–1/3 = 1/6 in share and Dhameja sacrificed 1/2–1/3 = /1/6 in share. So the profit sacrificing ratio becomes:
Nigam = Dhameja
1/6 = 1/6
1 : 1
Which is the same as old profit sharing ratio.
But if the new profit sharing ratio of Nigam, Dhameja and Ghosh becomes 4:2:3, then profit sacrificed by Nigam and Dhameja on Ghosh’s admission is not at the old profit sharing ratio. In this case profit sacrificing ratio is as follows:
Nigam = 1/2–4/9=1/18
Dhameja = 1/2–2/9=5/18
i.e. 1 : 5
If Ghosh pays goodwill of Rs 24,000, then in the first case, Nigam and Dhameja should share it equally; but in second case Nigam should get Rs 4,000 and Dhameja should get Rs 20,000.
Take another example: Nigam and Dhameja are equal partners. They agreed to take Ghosh as one-third partner. The new profit sharing ratio is 4:2:3. Nigam and Dhameja agreed Rs 27,000 as value of goodwill.
Nigam - Rs 27,000 × 1/18
Dhameja - Rs 27,000 × 5/18)
As per the Accounting Standards, it is not recommended to raise goodwill account but to show the adjustment of goodwill through partners’ capital accounts.
2.5 ACCOUNTING TREATMENT OF GOODWILL IN CASE OF
ADMISSION OF A NEW PARTNER
The goodwill should be recorded in the books only when some consideration in money or money’s worth as been paid for it. Therefore, only purchased goodwill should be recorded in the books of the firm. In case of admission of a partner, goodwill cannot be raised in the books of the firm because no consideration in money or money’s worth is paid for it. If the incoming partner brings any premium over and above his capital contribution at the time of his admission, such premium should be distributed to other existing partners. When a new partner is admitted to a firm, the old partners generally sacrifice in favour of the new
partner in terms of lower profit sharing ratio in the future. Therefore, the premium for goodwill brought in by the new partner shall be given to the existing partners on the basis of profit sacrificing ratio. The profit sacrificing ratio is computed by deducting the new profit sharing ratio from the old profit sharing ratio. If the difference is positive, then there is a profit sacrifice and in case the difference is negative, then there is again in terms of higher future profit sharing ratio. In case of admission of a partner, only those existing partners are entitled to a share for goodwill who have sacrificed a part of their profits in favour of the new partner. Sometimes, goodwill may be evaluated in case of admission of a partner when incoming partner is unable to bring in cash any premium for goodwill. In that situation also, the value of goodwill should not be raised in the books since it is inherent goodwill. Rather it is preferable that such value of goodwill should be adjusted through partners’ capital accounts. It may also be noted that when the incoming partner pays any premium for goodwill privately to the existing partners, no entry is required in the books of the firm. In that case, the amount to be paid to each partner should be calculated as per the profit sacrificing ratio.
Example 1: A, B & C are in partnership sharing profits and losses in the ratio 2:2:1. They want to admit D into partnership with one-fifth share. D brings in Rs 30,000 as capital and Rs 10,000 as premium for goodwill.
The necessary journal entry will be:
Example 2: A & B are equal partners. They wanted to take C as a third partner and for this purpose goodwill was valued at Rs 1,20,000. The journal entry for adjustment of value of goodwill through partners’ capital accounts will be:
The net effect in partners’ capital accounts is shown on the basis of profit sacrificing ratio:
A = 1/6 × Rs 1,20,000 = Rs 20,000 (Cr.)
B = 1/6 × Rs 1,20,000 = Rs 20,000 (Cr.)
C = 1/3 × Rs 1,20,000 = Rs 40,000 (Dr.)
Example 3: A & B are equal partners. They wanted to admit C as 1/6th partner who brought Rs 60,000 as goodwill. The new profit sharing ratio is 3:2:1. Profit sacrificing ratio is to be computed as follows:
Old Share – New Share = Share Sacrificed
So the entire goodwill should be credited to B’s Capital A/c.
Cash A/c Dr. Rs 60,000
To B’s Capital A/c Rs 60,000
(Goodwill brought in by C credited to B’s Capital A/c)
Example 4: A, B & C are equal partners. They decided to take D who brought in Rs 36,000 as goodwill. The new profit sharing ratio is 3:3:2:2.
Old Share – New Share = Share Sacrificed
A = 1/3 less 3/10 = 1/30
B = 1/3 less 3/10 = 1/30
C = 1/3 less 2/10 = 4/30
So goodwill should be shared in the ratio 1:1:4
The following is the Balance Sheet of Yellow and Green as at 31st December, 2016:
The partners shared profits and losses in the ratio 3:2. On the above date, Black was admitted as partner on the condition that he would pay Rs 20,000 as Capital. Goodwill was to be valued at 3 years’ purchase of the average of four years’ profits which were:
The new profit sharing ratio is 6:5:5.
Give journal entries and Balance Sheet if goodwill is adjusted through partners’ capital accounts.
Balance Sheet as on....................
Note: Calculation of Profit Sacrificing Ratio
Old Share – New Share = Share Sacrificed
With the information given in illustration 3, let us give journal entries and prepare balance sheet assuming that goodwill is brought in cash.
Goodwill brought in cash
Balance Sheet as on....................
Continuing with the same illustration 3, let us give journal entries and prepare balance sheet assuming that goodwill is brought in cash, but withdrawn.
Goodwill brought in cash, but withdrawn
In addition to the treatment under Illustration 3 the following additional entry will be made:
Balance Sheet as on....................
On the basis of information given in illustration 3, let us give journal entries and prepare balance sheet assuming that goodwill is paid privately. There will be no entry for goodwill but Black will pay Rs 8,100 to Yellow and Rs 3,150 to Green. For capital brought in by Black, the entry is:
Balance Sheet as on....................
2.6 ACCOUNTING TREATMENT OF GOODWILL IN CASE OF
CHANGE IN PROFIT SHARING RATIO
In case of change in profit sharing ratio, the value of goodwill should be determined and preferably adjusted through capital accounts of the partners on the basis of profit sacrificing ratio.
A, B & C are equal partners. They wanted to change the profit sharing ratio into 4:3:2. Make the necessary journal entries. Goodwill of the firm is valued at Rs 90,000.
In this case due to change in profit sharing ratio
A’s gain is = 4/9 less 1/3 = 1/9
B’s gain is = 1/3 less 1/3 = 0
C’s loss is = 1/3 less 2/9 = 1/9
So, A should compensate C to the extent of 1/9th of goodwill i.e.
Rs 90,000 × 1/9 = Rs 10,000
A, B and C are in partnership sharing profits and losses in the ratio of 4:3:3. They decided to change the profit sharing ratio to 7:7:6. Goodwill of the firm is valued at Rs 20,000. Calculate the sacrifice / gain by the partners and make the necessary journal entry.
Thus, B gained 1/20th share while A sacrificed 1/20th share i.e. Rs 20,000 x = Rs 1,000. For C there was no loss no gain. Journal Entry
So if goodwill is valued at Rs 20,000, A and B should pay @Rs 1,000 each (i.e.,Rs 20,000×1/20) as compensation to C and D respectively for their sacrifice.
2.7 ACCOUNTING TREATMENT OF GOODWILL IN CASE OF
RETIREMENT OR DEATH OF A PARTNER
In case of retirement of a partner, the continuing partners will gain in terms of profit sharing ratio. Therefore they have to pay to retiring partner for his share of goodwill in the firm in the gaining ratio. Similarly, in case of death of the partner, the continuing partners should bear the share of goodwill due to the heirs of the deceased partner. For this purpose, the goodwill is value don the date of the retirement or death and adjusted through the capital accounts of the partners.
Example: A, B & C are equal partners. C wanted to retire for which value of goodwill is considered as Rs 90,000. The necessary journal entry will be: