Goodwill in Partnership Accounts | Accountancy - Methods of valuation of goodwill | 12th Accountancy : Chapter 4 : Goodwill in Partnership Accounts
Chapter: 12th Accountancy : Chapter 4 : Goodwill in Partnership Accounts
Methods of valuation of goodwill
Methods
of valuation of goodwill
Following are the
methods generally followed to value goodwill:
1. Average profit method
Under this method,
goodwill is calculated as certain years of purchase of average profits of the
past few years. The number of years of purchase is generally determined on the
basis of the average period a new business will take in order to bring it to
the current state of the existing business. It may also be determined on the
basis of the number of years for which the past average profit will be earned
in future.
While computing the
average profit, in addition to rectification of errors, the following
adjustments are to be made:
Adjusted profit = Actual profit + Past expenses not required in
the future – Past revenues not likely to be earned in the future + Additional
income expected in the future – Additional expenses expected to be paid in the
future
The average profit may
be either simple average profit or weighted average profit.
(a) Simple average profit method
Under this method,
goodwill is calculated by multiplying the average profits by a certain number
of years of purchase. Simple average profit is calculated by adding the
adjusted profits of certain number of years by dividing the total number of
such years.
Goodwill = Average
profit × Number of years of
purchase
Average profit = Total
profit / Number of years
Illustration 1
The following are the
profits of a firm in the last five years:
2014: ₹ 4,000; 2015: ₹ 3,000; 2016: ₹ 5,000; 2017: ₹ 4,500 and 2018: ₹ 3,500 Calculate the
value of goodwill at 3 years purchase of average profits of five years.
Solution
Goodwill = Average
profit × Number of years of purchase
Goodwill = Average profit × Number
of years of purchase
= 4,000 × 3 = ₹ 12,000
Illustration 2
The profits and losses
of a firm for the last four years were as follows:
2015: ₹ 15,000; 2016: ₹ 17,000; 2017: ₹ 6,000 (Loss); 2018: ₹ 14,000
You are required to
calculate the amount of goodwill on the basis of 5 years purchase of average
profits of the last 4 years.
Solution
Goodwill = Average
profit × Number of years of purchase
Average profit = Total
profit / Number of years
Goodwill = Average
profit × Number of years of purchase
= 10,000 × 5 = ₹ 50,000
Illustration 3
A partnership firm has
decided to value its goodwill for the purpose of settling a retiring partner.
The profits of that firm for the last four years were as follows:
2015: ₹ 40,000; 2016: ₹ 50,000; 2017: ₹ 48,000 and 2018: ₹ 46,000
The business was looked
after by a partner. No remuneration was paid to him. The fair remuneration of
the partner valued at comes to ₹
6,000 per annum.
Find out the value of
goodwill, if it is valued on the basis of three years purchase of the average
profits of the last four years.
Solution
Goodwill = Average profit × Number
of years of purchase
= 40,000 × 3 = ₹ 1,20,000
Illustration 4
From the following
information relating to Arul enterprises, calculate the value of goodwill on
the basis of 2 years purchase of the average profits of 3 years.
a) Profits for the years
ending 31st December 2016, 2017 and 2018 were ₹ 46,000, ₹
44,000 and ₹ 50,000 respectively.
b) A non-recurring income
of ₹ 5,000 is included in
the profits of the year 2016.
c) The closing stock of the
year 2017 was overvalued by ₹
10,000.
Solution
Calculation of adjusted profit
Tutorial note: Over valuation of
closing stock in 2017 will result in over valuation of opening stock in 2018
Goodwill = Average profit × Number
of years of purchase = 45,000 × 2 = ₹ 90,000
Illustration 5
The following
particulars are available in respect of a business carried on by a partnership
firm:
a) Profits earned: 2016: ₹ 30,000; 2017: ₹ 29,000 and 2018: ₹ 32,000.
b) Profit of 2016 includes
a non-recurring income of ₹
3,000.
c) Profit of 2017 is
reduced by ₹ 2,000 due to stock
destroyed by fire.
d) The stock is not
insured. But, it is decided to insure the stock in future. The insurance
premium is estimated at ₹
5,600 per annum.
You are required to
calculate the value of goodwill on the basis of 2 years purchase of average
profits of the last three years.
Solution
(a) Calculation of adjusted profit
Goodwill = Average profit × Number
of years of purchase
= 24,400 × 2
= ₹ 48,800
(b) Weighted average profit method
Under this method,
goodwill is calculated by multiplying the weighted average profit by a certain
number of years of purchase.
Goodwill = Weighted
average profit × Number of years of purchase
In this method, weights
are assigned to each year’s profit. Weighted profit is ascertained by
multiplying the weights assigned with the respective year’s profit. The sum of
the weighted profits is divided by the sum of weights assigned to determine the
weighted average profit.
Weighted average profit = Total of weighted profits / Total of weights
This method is used when
the profits show an increasing or decreasing trend. More weight is generally
given to the profits of the recent years.
Illustration 6
For the purpose of
admitting a new partner, a firm has decided to value its goodwill at 3 years
purchase of the average profit of the last 4 years using weighted average
method. Profits of the past 4 years and the respective weights are as follows:
Compute the value of goodwill.
Solution
Calculation of weighted
average profit
Goodwill = Weighted average profit × Number of years of purchase
= 24,800 × 3 = ₹ 74,400
2. Super profit methods
Under these methods,
super profit is the base for calculation of the value of goodwill. Super profit
is the excess of average profit over the normal profit of a business.
Super profit = Average
profit – Normal profit
Average profit is
calculated by dividing the total of adjusted actual profits of certain number
of years by the total number of such years. Normal profit is the profit earned
by the similar business firms under normal conditions.
Normal profit = Capital employed × Normal rate of
return
Capital employed = Fixed assets + Current assets – Current
liabilities
Normal rate of return
= It is the rate at which profit is earned by similar business entities
in the industry under normal circumstances.
(a) Purchase of super profit method
Under this method,
goodwill is calculated by multiplying the super profit by a certain number of
years of purchase.
Goodwill = Super profit
× Number of years of purchase
Illustration 7
From the following
information, calculate the value of goodwill based on 3 years purchase of super
profit
i.
Capital employed: ₹
2,00,000
ii.
Normal rate of return: 15%
iii.
Average profit of the business: ₹ 42,000
Solution
Normal profit = Capital
employed × Normal rate of return
= 2,00,000 × 15% = ₹
30,000
Super profit = Average
profit – Normal profit
= 42,000 – 30,000
= ₹ 12,000
Goodwill = Super profit
× Number of years of purchase
= 12,000 × 3
= ₹ 36,000
Illustration 8
Calculate the value of
goodwill at 5 years purchase of super profit from the following information:
(a) Capital employed: ₹ 1,20,000
(b) Normal rate of
profit: 20%
(c) Net profit for 5
years:
2014: ₹ 30,000; 2015: ₹ 32,000; 2016: ₹ 35,000; 2017: ₹ 37,000 and 2018: ₹ 40,000
(d) Fair remuneration to
the partners ₹ 2,800 per annum.
Solution
Normal profit = Capital
employed × Normal rate of return
= 1,20,000 × 20%
= ₹ 24,000
Super profit = Average profit – Normal profit
= 32,000 – 24,000
= ₹ 8,000
Goodwill = Super profit × Number of years of
purchase
= 8,000 × 5
= ₹ 40,000
(b) Annuity method
Under this method, value
of goodwill is calculated by multiplying the super profit with the present
value of annuity.
Goodwill = Super profit
× Present value annuity factor
Present value annuity
factor is the present value of annuity of rupee one at a given time. It can be
found out from annuity table or by using formula.
Illustration 9
From the following
information, compute the value of goodwill as per annuity method:
(a) Capital employed: ₹ 50,000
(b) Normal rate of
return: 10%
(c) Profits of the years
2016, 2017 and 2018 were ₹
13,000, ₹ 15,000 and ₹ 17,000 respectively.
The present value of
annuity of ₹ 1 for 3 years at 10% is
₹ 2. 4868.
Solution
Average profit = Total
profit / Number of years
= 13,000 + 15,000 +
17,000 / 3
= 45,000/3
= ₹ 15,000
Normal profit = Capital
employed × Normal rate of return = 50,000 × 10% = ₹ 5,000
Super profit = Average
profit – Normal profit = 15,000 – 5,000
= ₹ 10,000
Goodwill = Super profit × Value of annuity = 10,000 × 2.4868 = ₹ 24,868
c. Capitalisation of super profit method
Under this method, value
of goodwill is calculated by capitalising the super profit at normal rate of
return, that is, goodwill is the capitalised value of super profit.
Goodwill = [ Super
profit / Normal rate of return ] × 100
Illustration 10
From the following
information, compute the value of goodwill by capitalising super profit:
a) Capital employed is ₹ 4,00,000
b) Normal rate of return is
10%
c) Profit for 2016: ₹ 62,000; 2017: ₹ 61,000 and 2018: ₹ 63,000
Solution
Average profit = Total profit/Number of years
= [62,000 + 61,000 + 63,000] /3
= ₹ 62,000
Normal profit = Capital employed × Normal rate of return
= 4,00,000 × 10%
= ₹ 40,000
Super profit = Average profit – Normal profit
= 62,000 – 40,000
= ₹ 22,000
Goodwill = Super profit/Normal rate of return x 100
= 22,000/10 x 100
= ₹ 2,20,000
3. Capitalisation method
Under this method,
goodwill is the excess of capitalised value of average profit of the business
over the actual capital employed in the business.
Goodwill = Total capitalised
value of the business – Actual capital employed
The total capitalised
value of the business is calculated by capitalising the average profits on the
basis of the normal rate of return.
Capitalised value of the business = [ Average profit / Normal rate of return ] x 100
Actual capital employed
= Fixed assets (excluding goodwill) + Current assets – Current liabilities
Illustration 11
From the following
information, find out the value of goodwill by capitalisation method:
(a) Average profit = ₹ 60,000
(b) Normal rate of
return = 10%
(c) Capital employed = ₹ 4,50,000
Solution
Total capitalised value
of the average profit = [ Average profit / Normal rate of return ] x 100
= 60,000 / 10 = x 100
Goodwill = Total
capitalised value of the average profit – Capital employed
= 6,00,000 – 4,50,000
= ₹ 1,50,000
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