Valuation of Goodwill - partnership accounting

Valuation of Goodwill

Goodwill is an intangible asset. Therefore it is very difficult to assess the value of it. Its value depends on the seller & purchaser’s mutual agreement. There are different methods of valuing goodwill. Some are discussed as below:

1.     Average Profit Method: This is a very simple method. Goodwill is calculated on the basis of the no. of past years profits. Because past profits indicate as to what profits are likely to accrue in the future. Therefore past profits are averaged. Average of such profits is multiplied by the agreed no. of years to find out the value of goodwill.

Value of Goodwill = Average Profit × Number of Years of Purchase

Some adjustment should be done while calculating the average profit:

·        Abnormal income of a year should be deducted out of the net profit of that year.

·        Abnormal loss of a year should be added back to the net profit of that year.

·        Income from investments should be deducted out of the net profit of that year.

Example: X sold his business to Y. Calculate the value of goodwill taking into consideration the following factors:

·        Goodwill is valued at three years purchase of the average profits of the last four years. Profits of the last four years were as : year 2011 – ₹40,000, year 2012 – ₹58,000, year 2013 – ₹53,000, year 2014 – ₹62,000.

·        Abnormal loss of ₹2,000 due to theft has reduced the profits of the year 2011.

·        Profits for the year 2012 include abnormal profit of ₹4,000.

·        A speculative and lottery profit of ₹5,000 was received during the year 2013 which was included in that year’s profit.

·        Profits of the year 2014 were reduced by ₹10,000 of the depreciation on such a machinery which was destroyed by the fire during the year.

Solution: Valuation of Goodwill

                                                                             ₹                     ₹

              Profit for 2011                             40,000              

Add:     Abnormal Loss                               2,000                42,000

             Profit for 2012                              58,000

Less:    Abnormal Gain                               4,000                54,000

             Profit for 2013                              53,000

Less:    Abnormal Gain                               5,000                48,000

             Profit for 2014                              62,000

Add:     Abnormal Loss                             10,000               72,000

              Total Profit                                                                 2,16,000

Average Profits = ₹ 2,16,000 / 4  = ₹ 54,000

Goodwill at 3 years purchase = ₹ 54,000 × 3 = ₹ 1,62,000       

                       

2.     Weighted Average Profit Method: It is considered better than the simple average profit method because each year’s profit is assigned a weight and highest weightage is given to the latest year. Then the each year’s profit is multiplied by the weight assigned to it and the total of their product is then divided by the total of weights in order to calculate the weighted average profits. Then goodwill is calculated by multiplying the weighted average profit obtained with the no. of year’s purchase agreed.

 

Weighted Average Profit=Total of Products of Profits/Total of Weights

           Goodwill = Weighted Average Profit × No. of Year’s of Purchase 

Example: The profits earned by a firm during the last four years were as follows:

Year ended 31^st March                         Profits (₹)

2009                                                             80,000

2010                                                           1,00,000

2011                                                           1,10,000

2012                                                           1,50,000

Calculate the value of goodwill on the basis of 3 year’s purchase of weighted average profits. Weights to be used 1, 2, 3 and 4 respectively to the profits for 2009, 2010, 2011 and 2012.

Solution: Valuation of Goodwill

Year ended 31^st March                   Profits (₹)             Weight               Products

2009                                                    80,000                     1                         80,000

2010                                                 1,00,000                     2                      2,00,000

2011                                                 1,10,000                     3                      3,30,000

2012                                                 1,50,000                     4                      6,00,000

                                                                                             10                   12,10,000

Weighted Average Profit = 12,10,000 / 10 = ₹ 1,21,000

Goodwill = ₹ 1,21,000 × 3 = ₹ 3,63,000

This method is preferred when the profits over the past 4 or 5 years have been continuously rising or falling.

3.     Super Profit Method: In this method goodwill is calculated on the basis of super profits. Super profit is the profit which a firm earns over normal profit. If it has no excess profit then it will have no goodwill. Goodwill is calculated by multiplying the super profits by a reasonable no. of years purchase.

Normal Profit = Capital Invested × Normal Rate of Return/100

 

Super Profit = Actual or Average Profit – Normal Profit

 

Goodwill = Super Profit × No. of years purchase

Example: A partnership firm earned net profits during the last four years as follows:

Year                                                            Profits (₹)

1                                                                                                                  56,000

2                                                                                                                  64,000

3                                                                                                                  60,000

4                                                                                                                  62,000

The Capital investment in the firm throughout the above mentioned period has been ₹ 3,00,000. Having regard to the risk involved, 15% is considered to be a fair return on capital. Calculate the value of goodwill on the basis of 3 years’ purchase of average super profits earned during the above mentioned 4 years.

Solution: Total Profits of four years=₹56,000+₹64,000+₹60,000+₹62,000

                                                                 = ₹ 2,42,000

Average Profit = ₹ 2,42,000 / 4 = ₹ 60,500

Normal Profit = 3,00,000 × 15 / 100 = ₹ 45,000

Super profit = ₹ 60,500 – ₹ 45,000 = ₹ 15,500

Value of Goodwill = 15,500 × 3 = ₹ 46,500

4.     Capitalisation of Average Profit Method:  In this method, Goodwill is calculated by deducting the actual capital employed from the capitalized value of average profits. First we calculate average profits and then we capitalized it on the basis of normal rate of return.

Capitalized value of Average Profit=Average Profits×100/Normal Rate of Return

Capital Employed = Assets – Liabilities

Goodwill = Capitalized Value of Average Profits – Capital Employed

There will be no goodwill if the actual capital employed in the business exceeds or equals the capitalized value of average profits.

Example: The average profit of a firm is ₹ 48,000. The total assets of the firm are ₹ 8,00,000. Value of other liabilities is ₹ 5,00,000. Average rate of return in the same business is 12%. Calculate the goodwill from capitalization of average profits method.

Solution: Capitalized value of Average profits=₹48,000×100/12=₹4,00,000

Capital employed = ₹ 8,00,000 – ₹ 5,00,000 = ₹ 3,00,000

Goodwill = ₹ 4,00,000 - ₹ 3,00,000 = ₹ 1,00,000

5.     Capitalisation of Super Profit Method: In this method Goodwill is calculated on the basis of super profits. We have to calculate the capital needed for earning of super profits on the basis of normal rate of return. This capitalized value of super profit is actually called the Goodwill.

Super Profit = Average Profit – Normal Profit

Goodwill = Super Profit ×100 / Normal Rate of Return

Example: From the figures given below, calculate goodwill according to the capitalization of super profit method:

(i)                Actual Average Profits = ₹ 72,000

(ii)              Normal Rate of Return = 10%

(iii)            Assets = ₹ 9,70,000

(iv)            Liabilities = ₹ 4,00,000

Solution: Capital Employed = Assets – Liabilities

                                                  = ₹ 9,70,000 - ₹1,00,000 =₹ 5,70,000       

Normal Profit=Capital Employed×Normal Rate of Return/100

                          = ₹ 5,70,000 × 10 / 100 = ₹ 57,000

Super Profit = Average Profit – Normal Profit

                       = ₹ 72,000 - ₹ 57,000 = ₹ 15,000

Goodwill = Super Profit×100/Normal Rate of Return

                 = ₹ 15,000×100/10 = ₹1,50,000

 

Goodwill - Partnership accounting

GOODWILL

It means the reputation of a firm. It can be earned by a firm through the hard work and honesty of its owners. If the customers feel satisfied with the services of a firm they will come again and again. So we can say that Goodwill is the value of the reputation of a firm in respect of the profits expected in future over and above the normal profits earned by the other similar firms belonging to the same type of industry.

Main features:-

·        It is an intangible asset like patents, trademarks, copy rights etc.

·        It is a valuable asset. It can be purchased or sold with any other asset.

·        It is helpful in earning excess profits.

·        It cannot be sold in part. It can be sold with the entire business only.

·        The value of goodwill may fluctuate from time to time. It does not remain constant.

·        It is difficult to place an exact value of goodwill because it is fluctuating due to changing circumstances of the business.

·        It is not a fictitious asset. It has a value in case of profit making concerns.

 

CATEGORIES OF GOODWILL

There are two main categories of goodwill.

1.     Purchased Goodwill:

·        It arises on purchase of a business. It is acquired by making a payment.

·        It is recorded in the books of accounts because consideration is paid for it.

·        It is shown in the Balance Sheet in Assets side.

·        It can be amortized i.e. depreciated over its useful life.

·        It can be calculated by the excess of purchase consideration over its net assets on the time of purchase of a business.

 

2.     Self-Generated or Inherent Goodwill:

·        It is internally generated over a long period of time.

·        It arises from attributes of an on-going business.

·        Its valuation depends upon the judgement of the valuer.

·        It is not recorded in the books of accounts as per AS-26.

Factors affecting the value of Goodwill: Many factors are there which can be affect the value of a firm’s goodwill. Main are:

·        Location of the Business

·        Management’s efficiency

·        Nature of goods dealt by business firm

·        Possession of import-export licence

·        Longevity of the business i.e. how old your business is?

·        Risk involved in the business

·        Monopolististic & other special rights such as patents, trademarks, copyrights, concessions etc.

·        Increasing trend of profits

·        Possibility of increased future competition

·        Good industrial relations

·        Amount of capital required for the business

·        Favourable Government regulations

·        Research and Development efforts by the firm

·        Effective advertising to establish brand popularity

·        Stable political conditions of the country

·        Popularity of product in terms of quality

Need for valuation of Goodwill:- In partnership, need for valuing the goodwill arises:-

·        When there is a change in the profit sharing ratio among the existing partners;

·        When the firm is sold;

·        When a partner retires or dies;

·        When a new partner is admitted;

·        When the firm is amalgamated with another firm.

  

Capital Accounts of Partners in partnership accounting

CAPITAL ACCOUNTS OF PARTNERS

A partnership organisation maintains accounts of its transactions in the same manner as a Sole Trader ship. In partnership firms, there is a separate Capital account for each partner. The capital contributed by each partner is credited to his capital account.  Usually every partner contributes something in cash or in kind to provide funds for the running of a business. The amount of contribution is mutually settled and need not necessarily be equal.

The sum of the contributions represents the capital of the firm. The partnership deed usually mentions the method of maintaining capital accounts of partners. The capital account of the partners can be maintained by two methods.

1.     Fixed Capital Accounts

2.     Fluctuating Capital Accounts

FIXED CAPITAL ACCOUNTS:- Under the system of this account, the capitals invested by the partners remain constant or unchanged unless the additional capital introduced or any amount withdrawn by any of the partner. The main features of this system are:

·        Capitals of partners are not allowed to change during the life time of business except in extraordinary circumstances.

·        When the capitals are fixed, each partner has two accounts – Capital Account and a Current Account.

·        When this method is adopted, all entries relating to Drawings, interest on capitals, interest on drawings, salary to partner, share of profit or loss etc. are made in separate account i.e. Current Account.

·        Fixed Capital account can never show a negative balance.

Proforma of Capitals Accounts

Particulars	A ₹	B ₹	C ₹	Particulars	A ₹	B ₹	C ₹
To Cash/Bank A/c (Permanent withdrawal of Capital)      To Balance c/d (Closing Balance)				By Balance b/d (Opening Balance)      By Cash/Bank A/c (Additional Capital)

Proforma of Current Accounts

Particulars	A ₹	B ₹	C ₹	Particulars	A ₹	B ₹	C ₹
To Balance b/d (In case of debit opening balance)      To Drawings      To Interest on Drawings      To Profit & Loss A/c (share of loss, in case of loss)      To Balance c/d				By Balance b/d (In case of credit opening balance)      By Interest on Capital      By Salary      By Commission      By Profit & Loss Appropriation A/c (share of profit, in case of profit)

 

FLUCTUATING CAPITAL ACCOUNTS:-  When the capitals are not fixed, the balances of capital accounts keep on changing time to time. Because all the entries relating to partners are recorded in their capital accounts only. The main features of this system are:

·        When the capitals are fluctuating, each partner has only one account – Capital Account. Current Accounts are not prepared in this system.

·        In this system, all transactions relating to drawings, interest on capitals, interest on drawings, salary to partner, share of profit or loss etc. are to be made in the Capital Accounts itself.

·        Fluctuating Capital Account can show a negative balance.

·        In the absence of any instruction, the Capital Accounts should be prepared by this method.

 

 

 

Proforma of Capital Accounts

Particulars	A ₹	B ₹	C ₹	Particulars	A ₹	B ₹	C ₹
To Balance b/d (In case of debit opening balance)      To Cash/Bank A/c (Withdrawal of Capital)      To Drawings      To Interest on Drawings      To Profit & Loss A/c (share of loss, in case of loss)      To Balance c/d				By Balance b/d (In case of credit opening balance)      By Cash/Bank A/c (Additional Capital)      By Interest on Capital      By Salary      By Commission      By Profit & Loss Appropriation A/c (share of profit, in case of profit)

 

 

INTEREST ON CAPITAL

Interest on partner’s capital is to be allowed only when it is agreed to among the partners. It should be calculated with respect to the time, rate of interest and the amount of capital. It is recorded on the debit side of Profit & Loss Appropriation A/c because it is an item of expense for the firm. It is also recorded on the credit side of Capital Accounts, as it increases the Capitals.

Entry for Interest on Capital:-

1.     On allowing interest on capital:

Interest on Capital A/c

        To Partner’s Capital A/c

(Interest on capital at -----% p.a.)

 

2.     On closure of interest on capital A/c:

Profit & Loss Appropriation A/c

         To Interest on Capital A/c

Provision relating to interest on capital:-

·        When the partnership agreement is silent about it then no interest will be allowed on Capital.

·        When the partnership agreement provides for interest on capital but is silent in treating interest as a charge or appropriation, then interest will be allowed only when there is a profit.

·        In case of loss, no interest will be allowed on capital.

·        When the profit before interest is equal to or more than the amount of interest, then full interest will be allowed.

·        When the profit before interest is less than the interest itself, then the interest will be restricted to the amount of profit. Hence the profit will be distributed in the ratio of interest on capital of each partner.

·        When the partnership agreement provides for treating interest as a charge then full interest will be allowed whether there is a profit or loss.

Example: A and B are partners in a firm. Their Capitals on April 1, 2010 were ₹5,60,000 and ₹4,75,000 respectively. On August 1, 2010 they decided that their Capitals should be ₹5,00,000 each. The necessary adjustments in the Capitals were made by introducing or withdrawing cash. Interest on Capital is allowed at 6% p.a. You are required to compute interest on Capital for the year ending March 31, 2011.

Solution: Calculation of Interest on Capitals:

A:      On ₹5,60,000 for 4 months = 5,60,000 × 6/100 × 4/12
                                                           = ₹ 11,200
          On ₹5,00,000 for 8 months = 5,00,000 × 6/100 × 8/12
                                                           = ₹ 20,000
          Total Interest = ₹ 31,200

B:      On ₹4,75,000 for 4 months = 4,75,000 × 6/100 × 4/12
                                                           = ₹ 9,500
          On ₹5,00,000 for 8 months = 5,00,000 × 6/100 ×8/12
                                                           = ₹ 20,000
          Total Interest = ₹ 29,500