CBSE Class 12 Accountancy Goodwill Nature And Valuation Notes

CHAPTER 2

Goodwill : Nature and Valuation

Meaning of Goodwill:

Goodwill places the organization at a good position due to which the organization is able to earn higher profits without any extra efforts. Goodwill cannot be seen but felt. Therefore goodwill is called an Intangible asset.

Factors affecting the value of Goodwill :

1. Efficient management

2. Quality of products

3. Location of business

4. Availability of raw material

5. Favorable contracts

Need for valuing goodwill : Whenever the mutual rights of the partners changes then party which makes a sacrifice must be compensated. This basis of compensation is goodwill so we need to calculate goodwill. Mutual rights change under following circumstances

1) When profit sharing ratio changes

2) On admission of a partner

3) On Retirement or death of a partner

4) When amalganation of two firms taken place.

5) When partnership firm is sold.

Methods of valuation of goodwill :

1. Average profit method

2. Super profit method

3. Capitalization method

Average Profit Method

The profit earned by a Firm during previous accounting periods on an average basis is called average profit. Goodwill is calculated on the basis of average profit due to future expectations of earning capacity of the firm. 

Illustration 1. (Average Profit Method) 

Akanksha,Chetna and Dipanshu are partners in a firm sharing profits and losses in the ratio of 3:2:1. They decide to take Jatin into partnership from January 1,2012 for 1/5 share in the future profits. For this purpose , goodwill is to be valued at 2 times the average annual profits of the previous four years. The average profits for the past four years were:

Super profit = Average profit ­ Normal profit

= 40,000­12,000=28,000

Goodwill = Super profit x number of years purchased

= 28,000 x 3 = 84,000

Capitalisation Method
In this method capitalized value of the firm is calculated on the basis of normal rate of return. Difference between teh capitalized value and actual capital employed is called goodwill.

Illustration 3 (Capitalisation Method)
A earns ` 1,20,000 as its annual profits, the rates of normal profit being 10% The assets of teh firm amounted to ` 14,40,000 and liabilities to ` 4,80,000. Find out the value of goodwill by capitalization method.

Solution :

Capitalized value of the firm = Average profit x 1000/ Rate of normal profit

= 1,20,000x10/100 = 12,00,0005

Capital employed = Total assets ­ liabilities

= 14,40,000 ­ 4,80,000 = 9,60,000

Goodwill = capitalized value ­ capital employeed

= 12,00,000­9,60,000=2,40,000

Illustration 4 . (Average profit method)
A and B are partners in a firm. They admit C into the firm. The goodwill for the purpose is to be calculated at 2 year's purchase of the average normal profits of the last three years which were ` 10,000, ` 15,000 and ` 30,000 respectively. Second years profit included profit on sale of Machinery ` 10,000. Find the value of goodwill of the firm on C's Admission.

Solution

(1) Calculation of Average Profit :

                    Year ended `

                    Ist Year                                                   10,000

                   2nd Year (`15,000­`10,000)                        5,000

                   3rd Year                                                    30,000

                   Total Profits                                               45,000

                   Average profit = Total profit/No. of years

                    = ` 45,000/3=15,000

Illustration 5 (Super profit method)

The average net profits expected of a firm in future are ` 68,000 per year and capita invested in the business by the firm is ` 3,50,000. The rate of interest expected from capital invested in this class of business is 12%. The remuneration of the partners is estimated to be ` 8,000 for the year. You are required to find out the value of goodwill on the basis of two years' purchase of super profits.

Solution

Average Profit = Average Net Profit ­ Partner's remuneration

(1) Average profit = ` 68,000­` 8,000 = `60,000

(ii) Normal profit= Capital employed x Normal rate of return/100

                        = ` 3,50,000x12/100= ` 42,000

(iii) Super Profit = Average profit ­ Normal profit

                        = ` 60,000­ ` 42,000 = ` 18,000

(iv) Value of goodwill = Super profit x No. of years ' purchase

                              = ` 18,000x2 = ` 36,000

Illustration 6. (Super profit method)
On April 1st, 1998 an existing firm had assets of ` 75,000 including cash of ` 5,000. The partners' capital accounts showed a balance of ` 60,000 and reserves constituted the rest. If the normal rate of return is 20% and the goodwill of the firm is valued at ` 24,000 at 4 years purchase of super profits, find the averages profits of the firm

Solution :

(1) Calculation of Normal Profit : Capital employed x normal rate/100 =75,000x20/100 = ` 15,000

(2) Calculation of Super Profit :

                 Goodwill = Super profit x No. of years' purchase

               ` 24,000 = Super Profit x4

                  Super Profit = ` 24,000 = `6,000

(3) Calculating of Average Profit :

Super Profit = Average Profit ­ Normal Profit

`                   6,000 = Average Profit ­ ` 15,000

                     Average Profit = ` 6,000+ ` 15,000 = ` 21,000

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