Treatment of
Goodwill in Partnership Accounts
Introduction -:
Goodwill is the value of reputation of a firm in respect of profit expected in future over and above the normal rate of profit.
Meaning -:
Goodwill can be
defined as ''the present value of a firm's anticipated excess earnings'' or as "the
capitalized value attached to the differential
profit capacity of a business". Thus, goodwill
exists only when the firm earns super
profits. Any firm that earns normal profits or is incurring losses has no goodwill.
Factors giving rise to Goodwill -:
1. Nature of Business : A firm
that produces high value added products or
having a stable demand is able to
earn more profits and therefore has
more goodwill.
2. Location
: If the business is centrally located or is at a place having heavy
customer traffic, the goodwill
tends to be high.
3. Efficiency of
Management : A well-managed concern usually enjoys the
advantage of high productivity and
cost efficiency. This leads to higher
profits and so the value of goodwill will also be
high.
Necessity of
valuation of Goodwill -:
- Change in the profit sharing ratio amongst the existing partners.
- Admission of a new partner.
- Death / Retirement of a partner.
- Dissolution of a firm which involves sale of business as a going concern.
- Amalgamation of firms.
Methods of Valuation of Goodwill -:
1.
Average Profit Method2. Super Profit Method
3. Annuity Method
4. Capitalisation Method
1. Average
Profit Method -:
In Average
Profit Method, The profits of the past few years are averaged and adjusted for
any expected change in future. For averaging the past profit, either simple
average or weighted average may be employed depending upon the circumstance. If
there exists clear incrasing or decrasing trend of profits, it is better to
give more weight to the profits of the recent yeaars than those of earlier
years. But if there is no clear trend of profit, it is better to go by
simple average.
Average Profit = Total profit of
last year
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No. of years
Goodwill = Average Profits × No. of years purchased
2. Super
Profit Method -:
In
Super Profit 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
can earn i to be determined first. The steps to be followed are given below -:
·
Identify the capital employed by the
Partnership firm.
·
Calculate average profit.
·
Calculate the normal profit on the capital
employed on the basic of the normal rate of return.
capital
employed X normal rate of return / 100
·
Super profit = Normal Profit – Average Profit.
·
Goodwill = Super Profit X No. of year’s
Purchases.
3.
Annuity Method -:
In Annuity
Method, Goodwill is calculated by taking average super profit as the value of
an annuity over a certain number of years. The present value of this annuity
is commputed by discounting at the given normal rate of return. This discounted
present value of the annuity is the value of goodwill. The value of annuity for rupee 1 can be known by
reference to the annuity tables.
4.
Capitalization Method -:
In this method the goodwill can be calculated in
two ways -:
· Capitalization of Average Profit -:
In this method,
the value of goodwill is ascertained by deducting the
actual capital employed (net assets) in the business from
the capitalized value of the average profits on the basis
of normal rate of return. This involves the following steps :
(i) Ascertain
the average profits based on the past few years'
performance.
(ii) Capitalize
the average profits on the basis of the normal rate of
return as follows :
Average Profits × 100/Normal Rate of Return
This will give the total value of business.
(iii) Ascertain
the actual capital employed (net assets) by deducting
outside liabilities from the total assets (excluding goodwill).
Capital
Employed = Total Assets (excluding goodwill) – outside liabilities
(iv) Compute
the value of goodwill by deducting net assets from the
total value of business, i.e. (ii) – (iii).
·
Capitalization of Super Profits :
Under this method following steps
are involved :
(i) Calculate
Capital employed of the firm, which is equal to total
assets minus outside liabilities.
(ii) Calculate
required profit on capital employed by using the
following formula :
Profit = Capital Employed × Required Rate of Return/100
(iii) Calculate
average profit of past years, that is, 3 to 5 years.
(iv) Calculate
super profits by deducting required profits from average
profits.
(v) Multiply
the super profits by the required rate of return multiplier,
that is,
Goodwill = Super Profits ×
100/Normal Rate of Return
Change in
Profit Sharing Ratio
Sometimes, the partners of a firm may agree to change their
existing profit
sharing ratio. As a result of this, some partners will gain in
future profits while
others will lose. In such a situation, the partner who gains by the
change in
the profit sharing ratio must compensate the partner who has made
the sacrifice because this effectively amounts to one
partner buying the share of profits from another partner.
For example, Gourav and Pragya are partners in a firm sharing profits
in the ratio of 3:2. They decide to have an equal share in profits in future. In this case, Gourav looses 1/l0th
(3/5 – 1/2) share of profits and Pragya gains this 1/l0th.
Hence, Pragya must compensate Gourav
for her loss in the share of future profits.
The amount of compensation will be equal to the proportionate
amount of
goodwill. Suppose, the total value of goodwill is ascertained as
Rs. 50,000/-, then Pragya must pay 1/10 of Rs.
50,000/-, i.e. Rs. 5,000 to Gourav.
Alternatively, Pragya's Capital
Account be debited by Rs 5,000 and Gourav's Capital Account credited with Rs. 5,000. The entry, thus, will be :
Pragya's Capital a/c Dr. 5,000
To Gourav's Capital a/c 5,000
Alternatively, if the amount is paid privately by the gaining
partner to the
other partner, then no entry is made in the books of the firm. Apart from the payment of compensation for goodwill, the change
in profit sharing ratio may also necessitate adjustment in the partners'
capital accounts with regard to reserves, revaluation of
assets and liabilities, etc. These are similar to those made at the time of the
admission or retirement of a partner. All these aspects
will be discussed in details in chapter dealing with admission of a partner.
