CHAPTER2

Goodwill:NatureandValuation
Meaning of Goodwill:
Goodwillplacestheorganizationatagoodpositionduetowhichtheorganizationisable
toearnhigherprofitswithoutanyextraefforts.Goodwillcannotbeseenbutfelt.
ThereforegoodwilliscalledanIntangibleasset.
Factors affecting the value of Goodwill :
1. Efficient management
2. Qualityofproducts
3. Locationofbusiness
4. Availabilityofrawmaterial
5. Favorablecontracts
Needforvaluinggoodwill:Wheneverthemutualrightsofthepartnerschangesthen
party which makes a sacrifice must be compensated. This basis of compensation is
goodwillsoweneedtocalculategoodwill.
Mutualrightschangeunderfollowingcircumstances
1)Whenprofitsharingratiochanges
2)Onadmissionofapartner
3)OnRetirementordeathofapartner
4)Whenamalganationoftwofirmstakenplace.
5)Whenpartnershipfirmissold.
Methods of valuation of goodwill :
1. Averageprofit method
2. Superprofitmethod
3. Capitalizationmethod
Average Profit Method
TheprofitearnedbyaFirmduringpreviousaccountingperiodsonanaveragebasisis
calledaverageprofit.Goodwilliscalculatedonthebasisofaverageprofitduetofuture
expectationsofearningcapacityofthefirm.
Illustration 1. (Average Profit Method)
Akanksha,ChetnaandDipanshuarepartnersinafirmsharingprofitsandlossesinthe
ratioof3:2:1.TheydecidetotakeJatinintopartnershipfromJanuary1,2012for1/5
share inthe futureprofits. For this purpose ,goodwill is to be valuedat 2times the
averageannualprofitsofthepreviousfouryears.Theaverageprofitsforthepastfour
years were:
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Accountancy& XII

Formula
Average Profit = Total Profits/No. ofYears
Goodwill =Average Profit x Number of years of purchase.
Year
`
2008
96,000
2009
60,600
2010
62,400
2011
84,400
Calculatethevalueofgoodwill.
Solution:
Year
`
2008
96,000
2009
60,600
2010
62,400
2011
84,400
Total
3,03,400
AverageProfit=TotalProfit/No.ofYears
Averageprofit=3,03,400/4=75,850
Goodwill=AverageProfitxNumberofYearsofPurchase
Goodwill=75,850x2=1,51,700
Super Profit Method
Ifafirmearnshigherprofitincomparisontonormalprofit(generallyearnedbyother
firmsofsameindustry)thenthedifferenceiscalledSuperProfit.Goodwilliscalculated
onthebasisofSuperprofitduetofutureexpectationsoflearningcapacityofthefirm.
Superprofit=AverageprofitNormalprofit
NormalProfit=Investment(CapitalEmployed)xNormalRateofReturn/100
Illustration 2. (Super Profit Method)
Afirmearnednetprofitsduringthelastthreeyearsas:
Year
200809
200910
201011
Profit (`)
36,000
40,000
44,000
Thecapitalinvestmentofthefirmis ` 1,20,000.Afairreturnonthecapitalhavingregard
totheriskinvolvedis10%.Calculatethevalueofgoodwillonthebasisofthreeyears
purchaseoftheaverageprofitforthelastthreeyears.
Solution :
Averageprofit:36000+40000+44000/3=40000
NormalProfit=CapitalEmployedxNormalRateofReturn/100
NormalProfit:120000x10/100=12,000
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Accountancy& XII

Superprofit=AverageprofitNormalprofit
=40,00012,000=28,000
Goodwill=Superprofitxnumberofyearspurchased
=28,000x3=84,000
Capitalisation Method
Inthismethodcapitalizedvalueofthefirmiscalculatedonthebasisofnormalrateof
return.Differencebetweentehcapitalizedvalueandactualcapitalemployediscalled
goodwill.
Illustration 3 (Capitalisation Method)
Aearns`1,20,000asitsannualprofits,theratesofnormalprofitbeing10%Theassets
oftehfirmamountedto` 14,40,000andliabilitiesto` 4,80,000.Findoutthevalueof
goodwillbycapitalizationmethod.
Solution :
Capitalizedvalueofthefirm=Averageprofitx1000/Rateofnormalprofit
=1,20,000x10/100=12,00,0005
Capitalemployed=Totalassetsliabilities
=14,40,0004,80,000=9,60,000
Goodwill=capitalizedvaluecapitalemployeed
=12,00,0009,60,000=2,40,000
Illustration 4 . (Average profit method)
AandBarepartnersinafirm.TheyadmitCintothefirm.Thegoodwillforthepurpose
istobecalculatedat 2year'spurchaseoftheaveragenormalprofitsofthelastthree
years which were ` 10,000, ` 15,000 and ` 30,000respectively. Secondyears profit
includedprofitonsaleofMachinery` 10,000.Findthevalueofgoodwillofthefirmon
C'sAdmission.
Solution
(1)CalculationofAverageProfit:
Year ended
`
IstYear
10,000
2ndYear(`15,000`10,000)

5,000

3rdYear
TotalProfits
Averageprofit=Totalprofit/No.ofyears

30,000
45,000

= ` 45,000/3=15,000
Illustration 5 (Super profit method)
Theaveragenetprofitsexpectedofafirminfutureare ` 68,000peryearandcapital
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Accountancy& XII

investedinthebusiness bythefirmis ` 3,50,000.Therateofinterestexpectedfrom

capitalinvested inthis class ofbusiness is 12%.The remunerationofthe partners is
estimatedtobe `8,000fortheyear.Youarerequiredtofindoutthevalueofgoodwillon
thebasisoftwoyears'purchaseofsuperprofits.
Solution
AverageProfit=AverageNet ProfitPartner'sremuneration
(1)Averageprofit=` 68,000` 8,000=`60,000
(ii)Normalprofit=CapitalemployedxNormalrateofreturn/100
= ` 3,50,000x12/100= ` 42,000
(iii)SuperProfit=AverageprofitNormalprofit
= `60,000 `42,000= `18,000
(iv)Valueofgoodwill=SuperprofitxNo.ofyears'purchase
= `18,000x2= ` 36,000
Illustration 6. (Super profit method)
OnApril1st,1998anexistingfirmhadassetsof `75,000includingcashof ` 5,000.The
partners' capitalaccounts showeda balanceof ` 60,000 andreserves constituted the
rest.Ifthenormalrateofreturnis20%andthegoodwillofthefirmisvaluedat ` 24,000
at4yearspurchaseofsuperprofits,findtheaveragesprofitsofthefirm
Solution:
(1)CalculationofNormalProfit:
Capitalemployedxnormalrate/100
=75,000x20/100= ` 15,000
(2)CalculationofSuperProfit:
Goodwill=SuperprofitxNo.ofyears'purchase
`24,000=SuperProfitx4
SuperProfit= `24,000= `6,000
(3)CalculatingofAverageProfit:
SuperProfit=AverageProfitNormalProfit
` 6,000=AverageProfit` 15,000
AverageProfit=` 6,000+` 15,000=` 21,000

25

Accountancy& XII