Goodwill Introduction

Goodwill is the value of a business that is determined by calculating the difference between the values of the assets minus the liabilities. It is an intangible asset reflecting the company's name, reputation and earning power.The name and fame of an organization can be termed as goodwill. Goodwill is the benefit and merit
of good name and reputation. Goodwill refers to a measure of the capacity of a business to earn excess profit. Therefore, goodwill can be defined as an intangible asset of the business. Thus, goodwill may also be defined as "value of the reputation of business". It is a valuable asset if the concern is profitable. It is useless if the concern is a loosing concern. Goodwill can be described as the extra sale able value attached to a prosperous business beyond the intrinsic value of net assets. Thus the existence of goodwill can be felt through extra earning power. Because of such a nature, it seems like a real assets. But since it is invisible such as patents, trademark, copyrights etc. goodwill is termed as intangible assets. Need For Valuation Of Goodwill The need for valuation of goodwill arises in various circumstances. Some of the circumstances are as follow: 1. In the case of sole trading concern, goodwill is valued at the time of selling of business, to take any person as a partner, to convert sole trading concern into a company. 2. In the case of partnership, when there is an admission, retirement and death of partner, amalgamation, conversion into a company and change in profit sharing ratio. 3. In the case of company, goodwill is valued at the time of amalgamation of two or more companies, absorption of company, reconstruction and holding company. The valuation of goodwill also becomes necessary, if the shares have to be valued on the basis of intrinsic value, market value or fair value and if the stock exchange quotation of the value of shares of a company is not available. 4. For taxation purpose such as wealth tax also, the valuation of goodwill is necessary.

Methods of Valuation of Goodwill

There are three methods of valuation of goodwill of the firm;
1. Average Profits Method 2. Super Profits Method 3. Capitalisation Method

1. Average Profits Method:

Under this metod goodwill is calculated on the basis of the average of some agreed number of past years. The average is then multiplied by the agreed number of years. This is the simplest and the most commonly used method of the valuation of goodwill.

Goodwill = Average Profits X Number of years of Puchase Before calculating the average profits the following adjustments should be made in the profits of the firm: a. Any abnormal profits shoulld be deducted from the net profits of that year. b. Any abnormal loss should be added back to the nat profits of that year. c. Non operating incomes eg. income from investments etc should be deducted from the net profits of that year. Now we will explain this method with the help of a simple example. A Ltd agreed to buy the business of B Ltd. For that purpose Goodwill is to be valued at three years purchase of Average Profits of last five years. The profits of B Ltd. for the last five years are:

Year

Profit/Loss (Rs)

2005

10,000,000

2006

12,250,000

2007

7,450,000

2008

2,450,000 (Loss)

2009

12,400,000

Following additional information is available: 1. In the year 2008 the company suffered a loss of Rs 1,000,500 due to fire in the factory. 2. In the year 2009 the company earned an income from investments outside the business $ 4,500,250. Solution: Total profits earned in the past five years= 10,000,000 + 12,250,000 + 7,450,000 - 2,450,000 + 12,400,000 = $ 39,650,000 Total Profits after adjustments = $ 39,650,000 + $ 1,000,500 - $ 4,500,250=$ 36,150,250 Average Profits= $ 36,150,2505=$ 7,230,050 Goodwill = $ 7,230,0503=$ 21,690,150

Thus A Ltd would pay $ 21,690,150 as the price of Goodwill earned by B Ltd.

2. Super profits method:

Super Profits are the profits earned above the normal profits. Under this method Goodwill is calculated on the basis of Super Profits i.e. the excess of actual profits over the average profits. For examplle if the normal rate of return in a particular type of business is 20% and your investment in the business is $1,000,000 then your normal profits should be $ 200,000. But if you earned a net profit of $ 230,000 then this excess of profits earned over the normal profits i.e. $ 230,000 - $ 200,000= Rs.30,000 are your super profits. For calculating Goodwill, Super Profits are multiplied by the agreed number of years of purchase. Steps for calculating Goodwill under this method are given below: i) Normal Profits = Capital Invested X Normal rate of return/100 ii) Super Profits = Actual Profits - Normal Profits iii) Goodwill = Super Profits x No. of years purchased For example, the capital employed as shown by the books of ABC Ltd is $ 50,000,000. And the normal rate of return is 10 %. Goodwill is to be calculated on the basis of 3 years puchase of super profits of the last four years. Profits for the last four years are:

Year 2005 2006 2007 2008

Profit/Loss ($) 10,000,000 12,250,000 7,450,000 5,400,000

Total profits for the last four years = 10,000,000 + 12,250,000 + 7,450,000 + 5,400,000 = $35,100,000 Average Profits = 35,100,000 / 4 = $ 8,775,000 Normal Profits = 50,000,000 X 10/100 = $ 5,000,000 Super Profits = Average/ Actual Profits Normal Profits = 8,775,000 5,000,000 = $ 3,775,000

Goodwill = 3,775,000 3 = $ 11,325,000

3. Capitalisation Method:
There are two ways of calculating Goodwill under this method: (i) Capitalisation of Average Profits Method (ii) Capitalisation of Super Profits Method (i) Capitalisation of Average Profits Method: Under this method we calculate the average profits and then assess the capital needed for earning such average profits on the basis of normal rate of return. Such capital is called capitalised value of average profits. The formula is:Capitalised Value of Average Profits = Average Profits X (100 / Normal Rate of Return) Capital Employed = Assets - Liabilities Goodwill = Capitalised Value of Average Profits - Capital Employed For example a firm earns $40,000 as its average profits. The normal rate of rteturn is 10%. Total assets of the firm are $1,000,000 and its total external liabilities are $ 500,000. To calculate the amount of goodwill: Total capitalized value of the firm = 40,000 100/10 = 400,000 Capital Employed = 1,000,000 500,000 = 500,000 Goodwill = 500,000 400,000 = 100,000

(ii)Capitalisation of Super Profits: Under this method first of all we calculate the Super Profits and then calculate the capital needed for earning such super profits on the basis of normal rate of return. This Capital is the value of our Goodwill . The formula is:Goddwill = Super Profits X (100/ Normal Rate of Return) For example ABC Ltd earns a profit of Rs 50,000 by employing a capital of $ 200,000, The normal rate of return of a firm is 20%. To calculate Goodwill: Normal Profits = 200,000 20/100 =$ 40,000 Super profits = 50,000 40,000 = $10,000 Goodwill = 10,000 100 / 20 = $50,000

Accounting treatment of goodwill at the time of admission

Admission of a Partner
* How can a New Partner be Admitted:According to section 31(1) of Indian Partnership Act 1932, a person can be admitted as a new partner only with the consent of all exiting partners. * A new partner is needed into the business due to the following reasons:1. When more capital is needed for the expansion of the business. 2. When a competent and experienced person is needed for the efficient running of the business. 3. To increase the goodwill and reputation of the business by taking a reputed and renowned Person into the partnership. 4. To encourage a capable employee by taking him into the partnership. * Following

Adjustments are needed at the time of the admission of a new

partner :1. 2. 3. 4. 5. Calculation of new profit sharing ratio. Accounting treatment of goodwill. Accounting treatment for revaluation of Assets and Liabilities. Accounting treatment of reserves and accumulated profits. Adjustment of capitals on the basis of new profit sharing ratio.

* Calculation of New Profit Sharing Ratio:

1. When only the ratio of new partner is given in the question, then in the absence of any instructions. It is presumed that the old partner will continue to share the remaining profits in the same ratio in which they were sharing before the admission of a new partner. 2. The new partner purchases his share of profit from the old partners equally. In such cases the new profit sharing ratios of the old partners will be as certained by deducting the sacrifice made by them from their existing share of profits.

New Profit Ratio = Old Ratio - Sacrifice

3. The new partner purchases his share of profit from the old partners in particular ratio. In such cases the new profit sharing ratio of the old partners will be calculated after deducting the sacrifice made by a partner from his existing share of profit.

New Profit Ratio = Old Ratio Sacrifice

4. When the old partners surrender a particular fraction of their share in favour of the new Partner then.,

Surrendering Share = Surrendered Share X Old Ratio. New Ratio = Old Ratio - Surrendering Share. Sacrifice Ratio = Old Ratio - New Ratio.

*Accounting Treatment of Goodwill on the Admission of a Partner :

1. When the amount of goodwill (premium) is paid privately. :No Entry 2. When the new partner brings his share of goodwill (premium) in cash: a.) When the amount of goodwill/ premium brought in by the new partner is retained in the business:-

i.)
ii.)

Cash/ Bank A/c To goodwill A/c

Dr.

Goodwill A/c Dr ( in sacrifice ratio) To Old partners capital A/c i.) Old Partners capital A/c To Cash / Bank A/c Dr.

b.) When

goodwill/premium brought in by the new partner is withdrawn by the old partners:-

* When goodwill already appears in the books and new partners brings his share of goodwill/premium in cash:First of all the existing goodwill account will have to be written off. For this purpose old partners capital accounts are debited in old ratio and goodwill account is credited.

Old partners capital A/c To goodwill A/c

Remaining entries remains same for bring goodwill in cash.

Dr. ( in old ratio)

* When the new partner does not bring his share of goodwill/premium in cash:New partners current A/c goodwill) To old partners capital A/c (in sacrifice ratio) Dr. (from his share of

* When goodwill already appears in the books and new partner does not bring his share of goodwill/premium in cash:i.) Old partners capital A/c Dr.

To goodwill A/c (in old ratio) ii.) New partners current A/c Dr. To old partners capital A/c (in sacrifice ratio )

When new partner brings in only a part of his share of goodwill:i.) ii.) Cash/bank A/c To goodwill A/c Dr.

Goodwill A/c Dr. New partners current A/c Dr. To Old partners capital A/c (in sacrifice ratio)

* Revaluation of assets & liabilities :Revaluation account :Account which is prepared to record changes in the value of assets & liabilities at time of admission, retirement, death and change in profit ratio of existing partners. Proforma of Revaluation Account is given below :-

Revaluation Account Particulars

To Decrease in value of assets To Increase in value of liabilities To Unrecorded liabilities To Profit on revaluation transferred to partners capital accounts (in old ratio)

Amount Particulars
By Increase in value of assets By Decrease in value of liabilities By unrecorded assets By loss on revaluation transferred to partners capital accounts (in old ratio)

Amount

Particulars
To drawings To interest on drawings To profit & loss (Share of loss) To revaluation A/c (share of loss) To balance c/d

Partners Capital Account A B C Particulars

By balance b/d By cash/bank A/c By interest on capital By salary By commission By P&L appropriation A/c (share of profit) By revaluation A/c (share of profit)

i.) For decrease in the value of assets & increase in the value of Assets / unrecorded Assets:1. ) 2. 3. Assets A/c To revaluation A/c Dr. (increase) Revaluation A/c To assets A/c Dr. (decrease

Unrecorded assets A/c Dr. To revaluation A/c / decrease liabilities or unrecorded liabilities :1. Revaluation A/c. Dr. To liabilities A/c (increase ) (decrease) of

ii.)

For

increase

2. 3.

Liabilities A/c Dr. To Revaluation A/c Revaluation A/c Dr To unrecorded liabilities A/c

iii.) Revaluation A/c shows profit or loss :1. Revaluation A/c. Dr. To Old partners capital A/c ratio) 2. ratio)
* Accounting

(in profit) (in old (in loss) (in old

Old partners capital A/c. Dr. To revaluation A/c

treatment of reserves and accumulated profits or losses :General reserve A/c Dr. Reserve A/c Dr. P&L A/c {cr. Balance} Dr. To old partners capital a/c / current a/c.

i.) For distributing reserves and accumulated profits among old partners in old ratio -

ii.) For distributing accumulated losses among old partners in old ratio-

Old partners capital A/c Dr. To P&L A/c { Dr. balance}

iii.) For distributing surplus of specific funds:-

Workmens compensation fund A/c

Dr.

Investment fluctuation fund A/c Dr. To Old Partners Capital a/c. / Current a/c.

* Adjustment of old partners capital accounts on the basis of new partners capital:i.) If the existing capital of any partner is less then his newly calculated capital:-

Bank A/c / Partners Current a/c. Dr. To Old Partners Capital A/c. ii) If the existing capital of any partner is more than his newly calculated capital : Old Partners Capital A/c. Dr. To Bank A/c. / Partners Current A/c .

accounting treatment in case of retirement of partner

A Partner has the right to retire from the firm after giving due notice in advance. A new partnership comes into existence between the remaining partners.

*A retiring partner is entitled to get the following:

1) Share in goodwill; Goodwill of the firm is valued and the retiring partners share of goodwill is credited to his capital account. 2) Share in Reserves: Reserves are the undistributed profits and it is also credited to the capital account of retiring partner. 3) Share in revaluation of assets and liabilities: Assets and liabilities are revalued on the date of retirement and retiring partners share of profit is credited or the loss is debited to his capital account.

*Accounting problems:
1) 2) 3) 4) 5) 6) 7) Calculation of new profit sharing ratio and gaining ratio of the continuing partners. Treatment of goodwill. Accounting treatment for revaluation of assets and liabilities. Accounting treatment of reserves, accumulated profits and losses. Accounting treatment of joint life policy. Payment to retiring partner. Adjustment of capitals in proportion to profit sharing ratios.

*Calculation of new profit sharing ratio:

.1) If the new profit sharing ratios of the remaining partners are not given in the question ,it will be assumed that the remaining partners continue to share profits and losses in the old ratio.

2) Sometimes the remaining partners purchase the share of retiring partner in some specified proportion .In such cases the fraction of shares purchased by them is added to their old share and the new ratio is calculated as follows:New ratio = old ratio + gain

*Calculation of Gaining Ratio:

Meaning of Gaining Ratio: Gaining ratio is the ratio in which the remaining partners will pay the amount of goodwill to the retiring partners. Calculation of Gaining Ratio: 1) If the new profits sharing ratios of the remaining partners are not given in the question, it will be assumed that the remaining partners continue to gain in the old ratio. 2) If the new profit sharing ratio of the remaining partners is given in the question, gaining ratio is calculated by deducting old ratio from the new ratio.

Gaining Ratio = New Ratio Old Ratio *Difference between sacrificing Ratio and Gaining Ratio:
Basis
1) Meaning:

Sacrificing Ratio
The ratio in which the old partners surrender a part of their share in favour of a new partner. Calculated at the time of the admission of a new partner. Sacrificing Ratio=Old RatioNew Ratio New partners share of goodwill is divided between the old partners in sacrificing ratio.

Gaining Ratio
The ratio in which the remaining partners acquire the outgoing partners share. Calculated at the time of the retirement or death of a partner. Gaining Ratio=New Ratio-Old Ratio Goodwill paid to retiring partner is paid by the remaining partners in their gaining ratio.

2)When calculated

3)Formula for calculation 4) Purpose

*Accounting Treatment of Goodwill:

1) Remaining partners capital A/c Dr. (In gaining ratio) To Retiring/Deceased partners capital A/c ( with his share of goodwill)

2) When the goodwill A/c is already appearing in the books: i) All partners capital A/c To Goodwill A/c Dr.( in old ratio ) (goodwill existing in the books) Dr. (in the gaining ratio)

ii) Remaining partners capital A/c

To Retiring/Deceased partners capital A/c

*Adjustment of Accumulated profits and reserves:

1) For distributing reserves and accumulated profitsGeneral Reserve A/c Dr. Reserve Fund A/c Dr. Profit and loss A/c (cr.) Dr. To All partners capital or current A/c (in old ratio)

2) For distributing accumulated losses:

All partners capital or current A/c To Profit and loss A/c Dr. (in old ratio)

3) For distributing surplus of specific funds:

Workmen compensation fund A/c Dr. Investment fluctuation fund A/c Dr. To All partners capital or current A/c (in old ratio)

*Adjustment of joint life policy on retirement of a partner:

1) when premium paid has been considered as revenue expenditure: - Joint life policy A/c Dr. (surrender value on the date of retirement)
To All partners capital A/c (in old ratio)

2) when remaining partners decide not to show Joint life policy in books:
Remaining partners capital A/c To Joint life policy A/c 3) Dr. (in new profit sharing ratio)

when premium paid has been considered as capital expenditure: No further treatment required
if remaining partners decide not to show Joint life policy in booksRemaining partners capital A/c (in new ratio) To Joint life policy A/c

Payment to retiring partner

a) If the amount is paid in cash or by cheque to retiring partner:

Retiring partners capital A/c Dr. To cash/Bank A/c (His share paid off) b) If the amount is not paid in cash, the amount due to him will be transferred to his loan A/c: Retiring partners capital A/c Dr. To Retiring partners loan A/c

* Death of a partner :
On the death of a partner, the amount payable to him is to be paid to his legal representatives 1) 2) 3) 4) 5) 6) 7)

following amounts will be his capital account:

The amount standing to the credit of his capital A/c. His share of the increase in the value of goodwill of the firm. Interest on capital, if provided in the partnership deed. His share of profit on the revaluation of assets and liabilities. His share of undistributed profits or reserves. His share of life policy. His share of profit upto the date of his death.

Following amounts will be debited to the account of the deceased partner for ascertaining the amount due to his legal representatives:

1) Drawings.

2) 3) 4) 5)

Interest on drawings. His share of loss on the revaluation of assets and liabilities. His share of undistributed loss, such as debit balance of profit and loss A/c. His share of the reduction in the value of goodwill.

*Calculation of profit :

If the death of a partner occurs on any day during the year , the executors of the deceased partner will also be entitled to the share of profits earned by the firm from the beginning of the year till the date of his death.

Two methods to ascertain profit:

In this method , we have to take into consideration the profit of the last year and the time for which he remained a partner during the current year.

A) On Time Basis:

Firms Profit = Average Profit X Number of months

12 Share of deceased person in profit = Firms profit X Share of deceased person B) On Turnover or sales Basis:
= Profit of pervious year/Sales of previous year X Sales of current year

* Individual life policy:

- Instead of taking only one joint life policy, the firm may take individual policies on the lives of partners. Accounting Treatment : (1) When surrender values are not appearing in the books, For amount received from the insurance company on maturity or death of a partner, Insurance company A/c Dr. To life policy A/c Life policy A/c Dr. To All partners capital A/c (in old ratio) For recording the deceased partners share in the surrender value of surviving partners policies, Surviving partners capital A/c Dr.(in gaining ratio) To Deceased partners capital A/c (2) When surrender values are already appearing in the books, For amount received from the insurance company on maturity or death of a partner, Insurance company A/c Dr. To life policy A/c Life policy A/c Dr.(amount received minus surrender value Appearing in the balance sheet) To All partners capital A/c (in old ratio) > Entry for recording the surrender value of surviving partners policies will not be passed in this case since they are already appearing in the balance sheet.