Samacheer Kalvi Class 12 Accountancy Solutions Chapter 4 Goodwill in Partnership Accounts

I Multiple Choice Questions

Choose the correct answer

 

Question 1. Which of the following statement is true?
(a) Goodwill is an intangible asset
(b) Goodwill is a current asset
(c) Goodwill is a fictitious asset
(d) Goodwill cannot be acquired
Answer: (a) Goodwill is an intangible asset
In simple words: Goodwill is a non-physical asset that helps a business earn more profit because of its good name. You cannot touch or see it, but it adds value to the company.

🎯 Exam Tip: Remember that intangible assets lack physical form but are crucial for a business's long-term value, unlike tangible assets like buildings or machinery.

 

Question 2. Super profit is the difference between
(a) Capital employed and average profit
(b) Assets and liabilities
(c) Average profit and normal profit
(d) Current year's profit and average profit
Answer: (c) Average profit and normal profit
In simple words: Super profit means a business earns more money than what is normally expected in the same type of business. It's the extra profit made above the usual amount.

🎯 Exam Tip: Understanding super profit is key for goodwill valuation methods, as it represents the extra earning power of a business due to its reputation or efficiency.

 

Question 3. The average rate of return of similar concerns is considered as
(a) Average profit
(b) Normal rate of return
(c) Expected rate of return
(d) None of these
Answer: (b) Normal rate of return
In simple words: Normal rate of return is the usual profit percentage that businesses in the same industry typically make. It helps compare how well one business is doing against others.

🎯 Exam Tip: Normal rate of return is a benchmark for assessing a firm's performance and is vital in calculating super profit, which directly impacts goodwill valuation.

 

Question 4. Which of the following statement is true?
(a) Super profit = Total profit / number of years
(b) Super profit = Weighted profit / number of years
(c) Super profit = Average profit – Normal profit
(d) Super profit = Average profit \( \times \) Years of purchase
Answer: (c) Super profit = Average profit – Normal profit
In simple words: The correct way to find super profit is to subtract the normal profit (what other similar businesses earn) from the average profit (what this business earned on average). This shows the extra profit made.

🎯 Exam Tip: Memorize the formula for super profit, as it is a fundamental concept for calculating goodwill under several methods.

 

Question 5. Identify the incorrect pair.
(a) Goodwill under average profit method – Average profit \( \times \) Number of years of purchase
(b) Goodwill under Super profit method – Super profit \( \times \) Number of years of purchase
(c) Goodwill under Annuity method – Average Profit \( \times \) Present value annuity factor
(d) Goodwill under Weighted average profit method - Weighted average profit \( \times \) Number of years of purchase
Answer: (c) Goodwill under Annuity method – Average Profit \( \times \) Present value annuity factor
In simple words: The annuity method for goodwill calculation uses super profit, not average profit. So, if it says average profit, that formula is incorrect for this method.

🎯 Exam Tip: Pay close attention to the specific profit type (average profit, super profit, weighted average profit) used in each goodwill valuation method's formula to avoid common errors.

 

Question 6. When the average profit is Rs. 25,000 and the normal profit Rs. 15,000 super profit is
(a) Rs. 25,000
(b) Rs. 5,000
(c) Rs. 10,000
(d) Rs. 15,000
Answer: (c) Rs. 10,000
In simple words: Super profit is found by taking the average profit and subtracting the normal profit. In this case, Rs. 25,000 minus Rs. 15,000 equals Rs. 10,000. This Rs. 10,000 is the extra profit the business earns.

🎯 Exam Tip: Always clearly identify the average profit and normal profit values from the problem before applying the super profit formula.

 

Question 7. Book profit of 2017 is Rs. 35,000; non-recurring income included in the profit is Rs. 1,000 and abnormal loss charged in the year 2017 was Rs. 2,000, then the adjusted profit is
(a) 36,000
(b) Rs. 35,000
(c) Rs. 38,000
(d) Rs. 34,000
Answer: (a) 36,000
In simple words: To get the adjusted profit, you remove the non-recurring income (income not expected to happen again) from the profit and add back any abnormal losses (losses that are not normal for the business). These adjustments make the profit more realistic for future predictions.

🎯 Exam Tip: Always adjust profits for non-recurring items (income and expenses) and abnormal gains or losses to arrive at a true representation of the firm's normal earning capacity for goodwill calculations.

 

Question 8. The total capitalised value of a business is Rs. 1,00,000; assets are Rs. 1,50,000 and liabilities Rs. 80,000. The value of goodwill as per the capitalisation method will be
(a) Rs. 40,000
(b) Rs. 70,000
(c) Rs. 1,00,000
(d) Rs. 30,000
Answer: (d) Rs. 30,000
In simple words: Goodwill is calculated by subtracting the actual capital used in the business from the total value the business is expected to have if its profits were capitalized. First, find the actual capital by subtracting liabilities from assets. Then, subtract this actual capital from the given total capitalized value to find the goodwill.

Hints:
Goodwill = Total capitalized value of the business – Actual capital employed
(i) Capital employed = Fixed Assets + Current assets – Current Liabilities
= Rs. 1,50,000 - Rs. 80,000
= Rs. 70,000
(ii) Capitalized Value = Rs. 1,00,000
= Rs. 1,00,000 - Rs. 70,000
= Rs. 30,000

🎯 Exam Tip: The capitalisation method values goodwill as the difference between the capitalised value of average profits and the actual capital employed in the business.

II. Very Short Answer Questions

 

Question 1. What is goodwill?
Answer: Goodwill is the good name or reputation of a business. This good name helps the business to earn more profit than other similar businesses. It is the estimated value of a firm's future extra earnings due to its reputation.
In simple words: Goodwill is the good name of a business. It means the business is well-liked and trusted, which helps it make more money.

🎯 Exam Tip: Define goodwill as an intangible asset and explain its core benefit: enabling a firm to earn super profits due to its reputation.

 

Question 2. What is acquired goodwill?
Answer: Acquired or purchased goodwill is the goodwill a business buys by making a payment in cash or other form. This happens when a firm buys another existing business. The amount paid that is more than the net assets (assets minus liabilities) of the business bought is called acquired goodwill. This extra payment is for the good name and customer loyalty of the purchased business.
In simple words: Acquired goodwill is when you buy another business and pay extra for its good name, beyond the value of its physical things.

🎯 Exam Tip: Distinguish acquired goodwill (purchased with consideration) from self-generated goodwill (earned over time) as only acquired goodwill is recorded in the books of accounts.

 

Question 3. What is super profit?
Answer: Super profit is the extra profit a business earns above the normal profit that similar businesses make. It shows how much better a firm is performing compared to its competitors. The formula for super profit is:
Super Profit = Average Profit – Normal Profit
In simple words: Super profit is the extra money a business makes that is more than what other similar businesses usually earn.

🎯 Exam Tip: Clearly state the definition of super profit and provide its formula, as it's a foundational concept in goodwill valuation.

 

Question 4. What is normal rate of return?
Answer: The normal rate of return is the profit percentage that similar businesses in the same industry usually earn under normal conditions. It acts as a benchmark to see if a business is making more or less profit than average. This rate helps determine the normal profit for a business when evaluating its goodwill.
In simple words: It is the usual rate of profit that businesses in the same type of industry generally make.

🎯 Exam Tip: Explain the normal rate of return as a benchmark and clarify its role in calculating normal profit for goodwill assessment.

 

Question 5. State any two circumstances under which goodwill of a partnership firm is valued.
Answer: Goodwill of a partnership firm is valued under the following circumstances:
1. When there is a change in the profit-sharing ratio among existing partners.
2. When a new partner is admitted into the firm.
3. When an existing partner retires from the firm or when a partner dies.
4. When a partnership firm is dissolved, and its business is sold to another entity.
This valuation ensures fairness among partners during these key changes in the firm.
In simple words: Goodwill is valued when partners change their profit share, a new partner joins, an old partner leaves, or the firm closes down.

🎯 Exam Tip: For this type of question, listing specific and common scenarios is crucial. Focus on events that affect partners' shares or the firm's existence.

III Short Answer Questions

 

Question 1. State any six-factor determining goodwill.
Answer: Here are some factors that determine the value of goodwill for a business:
1. Profitability of the firm: A business that consistently earns high profits will have more goodwill.
2. Favourable location of the business enterprise: Being in a good, easily reachable spot helps attract more customers.
3. Good quality of goods or services offered: Providing excellent products or services builds customer trust and loyalty.
4. Tenure of the business enterprise: An older, well-established business usually has a stronger reputation and more goodwill.
5. Efficiency of management: Good management can lead to better profits and a stronger business image.
6. Degree of competition: Less competition can mean a stronger market position and higher goodwill.
7. Other factors: These can include things like special contracts, good customer relations, or a unique product.
In simple words: Goodwill depends on how much profit a business makes, where it is located, the quality of its products, how long it has been running, good management, and how much competition it faces.

🎯 Exam Tip: When listing factors for goodwill, aim for a clear explanation of how each factor positively or negatively impacts the firm's reputation and earning capacity.

 

Question 2. How is goodwill calculated under the super profits method?
Answer: Under the super profits method, goodwill is calculated based on the extra profit a business earns above the normal profit. This "super profit" is then multiplied by a certain number of years of purchase. The idea is that the firm's ability to earn super profit for a few future years represents its goodwill.

Steps for calculation:
1. Calculate Average Profit: This is found by dividing the total adjusted actual profits of a certain number of years by the total number of those years. This gives a fair idea of the firm's typical profit.
2. Calculate Normal Profit: This is the profit that similar businesses usually earn under normal market conditions. It is found using the formula:
Normal Profit = Capital employed \( \times \) Normal rate of return
(Capital employed means Fixed assets + Current assets – Current liabilities.)
3. Calculate Super Profit: Subtract the normal profit from the average profit:
Super Profit = Average Profit – Normal Profit
4. Calculate Goodwill: Multiply the super profit by the agreed-upon "number of years of purchase." This number shows how many years the business is expected to earn this extra profit.
Goodwill = Super Profit \( \times \) Number of years of purchase
In simple words: First, find the average profit your business makes. Then, find the normal profit similar businesses make. The extra profit you make is 'super profit'. Multiply this super profit by how many years you expect to keep making it to find the goodwill.

🎯 Exam Tip: When explaining the super profit method, clearly outline each step: average profit, normal profit, super profit, and finally, goodwill calculation, including their respective formulas.

 

Question 3. How is the value of goodwill calculated under the capitalisation method?
Answer: The capitalisation method calculates goodwill by finding the difference between the total capitalised value of the business and its actual capital employed. This method basically sees what capital would be needed to earn the firm's average profit at the normal rate of return.

Steps for calculation:
1. Calculate Average Profit: Determine the average profit earned by the business over a few past years.
2. Calculate Capitalised Value of the Business: This is the total value the business should have based on its average profits and the normal rate of return. It is calculated as:
Capitalised value of the business = \( \frac{\text{Average profit}}{\text{Normal rate of return}} \times 100 \)
3. Calculate Actual Capital Employed: This is the actual amount of capital invested in the business. It is calculated as:
Actual capital employed = Fixed assets (excluding goodwill) + Current assets – Current liabilities
4. Calculate Goodwill: Subtract the actual capital employed from the capitalised value of the business:
Goodwill = Total capitalised value of the business – Actual capital employed
This method essentially values the firm based on its earning capacity and then identifies the extra value (goodwill) beyond its physical assets.
In simple words: Find out what capital would be needed to make your average profit. Then, subtract the actual capital you have. The difference is the goodwill.

🎯 Exam Tip: Differentiate between the two capitalisation methods: capitalisation of average profits and capitalisation of super profits, as they involve slightly different calculations for the capitalised value.

 

Question 4. Compute average profit from the following information.
2016: Rs. 8,000; 2017: Rs. 10,000; 2018: Rs. 9,000
Answer:
Average Profit \( = \frac{\text{Total profit}}{\text{No. of Years}} \)
Average Profit \( = \frac{\text{8,000 + 10,000 + 9,000}}{\text{3}} \)
Average Profit \( = \frac{\text{27,000}}{\text{3}} \)
Average Profit = Rs. 9,000
The average profit shows the typical earning over these years, smoothing out any year-to-year differences.
In simple words: Add up all the profits from each year, then divide that total by the number of years. This gives you the average profit.

🎯 Exam Tip: Remember to include all profit/loss figures for the given period when calculating average profit and divide by the correct number of years.

 

Question 5. Calculate the value of goodwill at 2 Years purchase of average profit when average profit is Rs. 15,000.
Answer:
Goodwill = Average profit \( \times \) No. of years of purchase
Goodwill = 15,000 \( \times \) 2 Years
Goodwill = Rs. 30,000
This calculation directly applies the average profit method, where future goodwill benefits are estimated based on past average earnings.
In simple words: Multiply the average profit by the number of years the goodwill is expected to last. This gives you the value of goodwill.

🎯 Exam Tip: Ensure you use the correct number of 'years of purchase' as specified in the problem for the goodwill calculation.

IV Exercises

Simple average profit method

 

Question 1. The following are the profits of a firm in the last five years:
2014: Rs. 10,000; 2015: Rs. 11,000;
2016: Rs. 12,000; 2017: Rs. 13,000; and 2018: Rs. 14,000
Calculate the value of goodwill at 2 years purchase of average profit of five years.
Answer:
Calculation of Average Profit:
Average profit \( = \frac{\text{Total profit}}{\text{No. of Years}} \)
Average profit \( = \frac{\text{10,000 + 11,000 + 12,000 + 13,000 + 14,000}}{\text{5}} \)
Average profit \( = \frac{\text{60,000}}{\text{5}} \)
Average profit = Rs. 12,000

Calculation of Goodwill:
Goodwill = Average profit \( \times \) No. of years of purchase
Goodwill = 12,000 \( \times \) 2 years
Goodwill = Rs. 24,000
The calculation of average profit and then goodwill using a multiplier helps estimate the firm's future earning capacity based on its consistent performance.
In simple words: First, add up all the profits for five years and divide by five to get the average profit. Then, multiply this average profit by two (for two years purchase) to find the goodwill amount.

🎯 Exam Tip: For problems with multiple years' data, carefully sum all profits/losses and divide by the correct number of years to avoid arithmetic errors in average profit calculation.

 

Question 2. From the following information, calculate the value of goodwill on the basis of 3 years purchase of average profits of last four years.

Answer:
Calculation of Average Profit:
Average profit \( = \frac{\text{Total profit}}{\text{No. of Years}} \)
Average profit \( = \frac{\text{5,000 + 8,000 + 6,000 - 3,000}}{\text{4}} \)
Average profit \( = \frac{\text{16,000}}{\text{4}} \)
Average profit = Rs. 4,000

Calculation of Goodwill:
Goodwill \( = \) Average profit \( \times \) No. of years of purchase
Goodwill \( = \) 4,000 \( \times \) 3 years
Goodwill = Rs. 12,000
Including losses in the total profit calculation gives a more accurate average profit, which is essential for a realistic goodwill valuation.
In simple words: Add up profits and subtract losses for all four years. Divide this total by four to get the average profit. Then, multiply this average profit by three (for three years purchase) to get the goodwill.

🎯 Exam Tip: Remember to subtract losses when calculating the total profit for the average profit, as they reduce the overall profitability of the firm.

 

Question 3. From the following information relating to a partnership firm, find out the value of its goodwill based on 3 years purchase of average profits of the last 4 years.
(a) Profit of the years 2015, 2016, 2017 and 2018 are Rs. 10,000, Rs. 12,500, Rs. 12,000 and Rs. 11,500 respectively.
(b) The business was looked after by a partner and his fair remuneration amounts to Rs. 1,500 per year. This amount was not considered in the calculation of the above profits.
Answer:
Calculation of Average Profit before adjustment:
Average profit \( = \frac{\text{Total profit}}{\text{No. of Years}} \)
Average profit \( = \frac{\text{10,000 + 12,500 + 12,000 + 11,500}}{\text{4}} \)
Average profit \( = \frac{\text{46,000}}{\text{4}} \)
Average profit = Rs. 11,500

Calculation of Goodwill:
Goodwill \( = \) Average profit \( \times \) No. of years of purchase
Goodwill \( = \) 10,000 \( \times \) 3 years
Goodwill = Rs. 30,000
Adjusting for partner's remuneration is important because it represents an expense that should be consistently considered for a true average profit.
In simple words: First, find the average profit. Then, subtract the partner's yearly payment from this average profit to get the true average. Finally, multiply this adjusted average profit by three to get the goodwill.

🎯 Exam Tip: Always adjust profits for recurring expenses like partner's remuneration, even if not explicitly recorded earlier, to arrive at a truly representative average profit for goodwill valuation.

 

Question 4. From the following information relating to Sridevi enterprises, calculate the value of goodwill on the basis of 4 years purchase of the average profits of 3 years ending 31st December 2016, 2017 and 2018 were Rs. 1,75,000, Rs. 1,50,000 and Rs. 2,00,000 respectively.
(b) A non-recurring-income of Rs. 45,000 is included in the profits of the year 2016.
(c) The closing stock of the year 2017 was overvalued by Rs. 30,000.
Answer:
Calculation of Adjusted profit:

Note: Overvaluation of closing stock in 2017 will result in overvaluation of opening stock in 2018.

Calculation of Average Profit:
Average Profit \( = \frac{\text{1,30,000 + 1,20,000 + 2,30,000}}{\text{3}} \)
Average Profit \( = \frac{\text{4,80,000}}{\text{3}} \)
Average Profit = Rs. 1,60,000

Calculation of Goodwill:
Goodwill = Average profit \( \times \) No. of years of purchase
Goodwill = 1,60,000 \( \times \) 4 years
Goodwill = Rs. 6,40,000
Adjusting for non-recurring income and stock valuation errors is crucial to arrive at the true and fair profit figure for goodwill valuation.
In simple words: First, adjust each year's profit for any unusual income or stock errors. Add the adjusted profits, divide by three for the average. Then, multiply this average by four (years of purchase) to find the goodwill.

🎯 Exam Tip: When adjusting for stock overvaluation, remember that overvalued closing stock reduces profit in the current year but increases profit in the next year (as opening stock). Always adjust profits to reflect normal business operations.

 

Question 5. The following particulars are available in respect of the business carried on by a partnership firm:
(i) Profit earned: 2016 Rs. 25,000; 2017: Rs. 23,000 and 2018: Rs. 26,000.
(ii) Profit of 2016 includes a non-recurring income of Rs. 2,500.
(iii) Profit of 2017 was reduced by Rs. 3,500 due to stock destroyed by fire.
(iv) The stock was not insured. But, it is decided to insure the stock in future. The insurance premium is estimated to be Rs. 250 per annum.
You are required to calculate the value of goodwill of the firm on the basis of 2 years purchase of average profits of the last three years.
Answer:
Calculation of Adjusted profit:

Calculation of Average Profit (before insurance premium adjustment):
Average profit \( = \frac{\text{Total profit}}{\text{No. of Years}} \)
Average profit \( = \frac{\text{22,500 + 26,500 + 26,000}}{\text{3}} \)
Average Profit \( = \frac{\text{75,000}}{\text{3}} \)
Average Profit = Rs. 25,000

Calculation of Goodwill:
Goodwill \( = \) Average profit \( \times \) No. of years of purchase
Goodwill \( = \) 24,750 \( \times \) 2 years
Goodwill = Rs. 49,500
It's important to adjust for both past abnormal items and future expected recurring expenses like insurance to get a realistic view of profits.
In simple words: First, fix each year's profit by removing unusual income and adding back losses from events like fire. Get the average of these fixed profits. Then, subtract the future insurance cost from this average to get the final adjusted average profit. Finally, multiply this by two (years of purchase) for goodwill.

🎯 Exam Tip: When future expenses (like insurance premium) are indicated, treat them as normal recurring expenses and deduct them from the average profit to arrive at the actual maintainable profit for goodwill valuation.

Weighted average profit method.

 

Question 6. Find out the value of goodwill at three years purchase of weighted average profit of last four years.

Answer:
Calculation of Weighted Average profit:

Weighted Average Profit \( = \frac{\text{Total Weighted profits}}{\text{Total of weights}} \)
Weighted Average Profit \( = \frac{\text{1,54,000}}{\text{10}} \)
Weighted Average Profit = Rs. 15,400

Calculation of Goodwill:
Goodwill \( = \) Weighted Average Profit \( \times \) No. of years of purchase
Goodwill \( = \) 15,400 \( \times \) 3 years
Goodwill = Rs. 46,200
Giving more weight to recent years' profits helps ensure the goodwill calculation reflects the firm's current earning trend more accurately.
In simple words: First, multiply each year's profit by its given weight, then add up all these 'weighted profits'. Also, add up all the weights. Divide the total weighted profits by the total weights to get the weighted average profit. Finally, multiply this average by three (years of purchase) to find the goodwill.

🎯 Exam Tip: In the weighted average method, ensure you correctly multiply each year's profit by its assigned weight and accurately sum both weighted profits and weights before calculating the average.

Purchase of Super Profit Method

 

Question 7. From the following details, calculate the value of goodwill at 2 years purchase of super profit:
(a) Total assets of a firm are Rs. 5,00,000;
(b) The liabilities of the firm are Rs. 2,00,000
(c) Normal rate of return in this class of business is 12.5%.
(d) Average profit of the firm is Rs. 60,000.
Answer:
First, calculate the Capital Employed:
Capital Employed \( = \) Total Assets \( - \) Total Liabilities
\( = \) Rs. 5,00,000 \( - \) Rs. 2,00,000
\( = \) Rs. 3,00,000

Next, calculate the Normal Profit:
Normal Profit \( = \frac{\text { Capital Employed } \times \text { Normal Rate of return }}{100} \)
\( = \frac{3,00,000 \times 12.5}{100} \)
\( = \) Rs. 37,500

Now, calculate the Super Profit:
Super Profit \( = \) Average Profit \( - \) Normal Profit
\( = \) Rs. 60,000 \( - \) Rs. 37,500
\( = \) Rs. 22,500

Finally, calculate Goodwill:
Goodwill \( = \) Super Profit \( \times \) No. of years of purchase
\( = \) Rs. 22,500 \( \times \) 2 years
\( = \) Rs. 45,000. Goodwill reflects the extra earning power a business has compared to others.
In simple words: First, find how much money is used in the business (capital employed). Then, calculate the normal profit expected from this capital. Subtract the normal profit from the actual average profit to get the 'super profit'. Finally, multiply this super profit by the number of years of purchase to find the goodwill.

🎯 Exam Tip: Always remember that Super Profit is the extra profit earned above what is normally expected. Make sure to clearly identify average profit, normal profit, and capital employed before calculating goodwill.

 

Question 8. A partnership firm earned net profits during the last three years as follows: 2016 Rs. 20,000; 2017: Rs. 17,000 and 2018: Rs. 23,000. The capital investment of the firm throughout the above mentioned period has been Rs. 80,000. Having regard to the risk involved, 15% is considered to be a fair return on capital employed in the business. Calculate the value of goodwill on the basis of 2 years purchase of super profit.
Answer:
First, calculate the Average Profit for the last three years:
Average Profit \( = \frac{\text { Total Profits }}{\text { Number of years }} \)
\( = \frac{20,000 + 17,000 + 23,000}{3} \)
\( = \frac{60,000}{3} \)
\( = \) Rs. 20,000

Next, calculate the Normal Profit, which is the expected return on capital employed:
Normal Profit \( = \frac{\text { Capital Employed } \times \text { Normal rate of return }}{100} \)
\( = \frac{80,000 \times 15}{100} \)
\( = \) Rs. 12,000

Now, find the Super Profit:
Super Profit \( = \) Average Profit \( - \) Normal Profit
\( = \) Rs. 20,000 \( - \) Rs. 12,000
\( = \) Rs. 8,000

Finally, calculate Goodwill:
Goodwill \( = \) Super Profit \( \times \) No. of years of purchase
\( = \) Rs. 8,000 \( \times \) 2 years
\( = \) Rs. 16,000. This value represents the firm's extra earning capacity.
In simple words: First, add up all the profits and divide by the number of years to find the average profit. Then, calculate what a normal business would earn with the same capital. Subtract the normal profit from the average profit to get the 'super profit'. Multiply this super profit by the given number of years to find the goodwill.

🎯 Exam Tip: When calculating average profit, ensure you sum all relevant years' profits correctly. For normal profit, correctly apply the given rate of return to the capital employed.

 

Question 9. From the following information, calculate the value of goodwill under annuity method:
(i) Average profit Rs. 14,000
(ii) Normal profit Rs. 4,000
(iii) Normal rate of return 15%
(iv) Years of purchase of goodwill 5
Present value of 1 for 5 years at 15% per annum as per the annuity table is 3.352
Answer:
First, calculate the Super Profit:
Super Profit \( = \) Average Profit \( - \) Normal Profit
\( = \) Rs. 14,000 \( - \) Rs. 4,000
\( = \) Rs. 10,000

Next, calculate Goodwill using the Annuity Method:
Goodwill \( = \) Super Profit \( \times \) Present value of Annuity factor
\( = \) Rs. 10,000 \( \times \) 3.352
\( = \) Rs. 33,520. The annuity method recognizes the time value of money when valuing goodwill.
In simple words: First, find the super profit by taking the average profit and subtracting the normal profit. Then, multiply this super profit by the "present value of annuity factor" to find the goodwill. This factor helps to value future earnings correctly.

🎯 Exam Tip: The annuity method requires the super profit and a present value annuity factor. Make sure to use the correct factor for the given interest rate and number of years.

Capitalisation of Super Profit Method:

 

Question 10. Find out the value of goodwill by capitalising super profits:
(a) Normal Rate of Return 10%
(b) Profits for the last four years are Rs. 30,000, Rs. 40,000, Rs. 50,000, Rs. 45,000,
(c) A non-recurring income of Rs. 3,000 is included in the above mentioned profit of Rs. 30,000,
(d) Average capital employed is Rs. 3,00,000.
Answer:
First, adjust the profit for the 1st year (Rs. 30,000) for the non-recurring income:
Adjusted Profit for 1st year \( = \) Rs. 30,000 \( - \) Rs. 3,000 \( = \) Rs. 27,000

The adjusted profits for the four years are: Rs. 27,000, Rs. 40,000, Rs. 50,000, Rs. 45,000.

Next, calculate the Average Profit from these adjusted profits:
Average Profit \( = \frac{27,000 + 40,000 + 50,000 + 45,000}{4} \)
\( = \frac{1,62,000}{4} \)
\( = \) Rs. 40,500

Now, calculate the Normal Profit:
Normal Profit \( = \frac{\text { Capital Employed } \times \text { Normal rate of return }}{100} \)
\( = \frac{3,00,000 \times 10}{100} \)
\( = \) Rs. 30,000

Then, calculate the Super Profit:
Super Profit \( = \) Average Profit \( - \) Normal Profit
\( = \) Rs. 40,500 \( - \) Rs. 30,000
\( = \) Rs. 10,500

Finally, calculate Goodwill using the Capitalisation of Super Profit Method:
Goodwill \( = \frac{\text { Super Profit }}{\text { Normal rate of return }} \times 100 \)
\( = \frac{10,500}{10} \times 100 \)
\( = \) Rs. 1,05,000. This method capitalizes the excess earnings a business generates.
In simple words: First, adjust any profits that include one-time income. Then, find the average of these adjusted profits. Calculate what a normal business would earn with the same capital (normal profit). Subtract the normal profit from the average profit to get the 'super profit'. Finally, divide this super profit by the normal rate of return and multiply by 100 to find the goodwill.

🎯 Exam Tip: Always adjust profits for non-recurring items (like non-recurring income or loss) before calculating average profit. This ensures the average profit truly reflects regular earnings.

 

Question 11. From the following information, find out the value of goodwill by capitalization method:
(i) Average profit Rs. 20,000
(ii) Normal rate of return 10%
(iii) Tangible assets of the firm Rs. 2,20,000
(iv) Liabilities of the firm Rs. 70,000.
Answer:
First, calculate the Capitalized Value of the business:
Capitalized Value \( = \frac{\text { Average Profit }}{\text { Normal rate of return }} \times 100 \)
\( = \frac{20,000}{10} \times 100 \)
\( = \) Rs. 2,00,000

Next, calculate the Actual Capital Employed (Net Tangible Assets):
Actual Capital Employed \( = \) Tangible Assets \( - \) Liabilities
\( = \) Rs. 2,20,000 \( - \) Rs. 70,000
\( = \) Rs. 1,50,000

Finally, calculate Goodwill:
Goodwill \( = \) Capitalized Value of the business \( - \) Actual Capital Employed
\( = \) Rs. 2,00,000 \( - \) Rs. 1,50,000
\( = \) Rs. 50,000. This method values goodwill based on the business's overall earning capacity.
In simple words: First, find out the total value of the business based on its average earnings and the normal return rate. Then, calculate the actual capital used in the business by subtracting liabilities from assets. The difference between these two values is the goodwill.

🎯 Exam Tip: The capitalization method can be done using either average profit or super profit. For average profit, the goodwill is the difference between capitalized average profit and actual capital employed.

 

Question 1. The excess of average profit over normal profit is
(a) Super profit
(b) Goodwill
(c) Undistributed profit
Answer: (a) Super profit
In simple words: When a business makes more money than what is normally expected for its type, that extra amount is called super profit.

🎯 Exam Tip: Understand the core definitions. Super profit directly measures a firm's superior earning capacity compared to its peers.

 

Question 2. The goodwill that can be recorded in the books of accounts and is shown on the assets side of the B/S is
(a) Acquired goodwill
(b) Self-Generated goodwill
(c) None of these two
Answer: (a) Acquired goodwill
In simple words: Only goodwill that you buy from someone else, like when you purchase a whole business, can be written down in the company's official records.

🎯 Exam Tip: Remember the accounting rule: only purchased or acquired goodwill is recognized as an asset in the balance sheet, not self-generated goodwill.

 

Question 3. How many methods are there for valuing G/W?
(a) 3
(b) 2
(c) 5
Answer: (a) 3
In simple words: There are three main ways to figure out the value of goodwill: average profit method, super profit method, and capitalization method.

🎯 Exam Tip: While there are variations, the main categories for goodwill valuation are Average Profit, Super Profit, and Capitalization methods.

III Short Answer Questions

 

Question 1. Describe the nature of G/W.
Answer: The nature of goodwill can be described as follows:

• Goodwill is an intangible fixed asset. This means it cannot be seen, touched, or physically held, but it helps the business.
• It has a definite value that changes based on how profitable the business is.
• Goodwill cannot be separated from the business itself. It is part of the whole business.
• It helps the business earn more profit and bring in more customers.
• It can only be bought or sold when the entire business is bought or sold, either fully or in part.

Goodwill is a valuable asset because it represents the reputation and customer loyalty a business builds over time.
In simple words: Goodwill is like the good name of a business. It's not something you can touch, but it makes the business earn more money and helps customers like it. You can only sell this good name if you sell the whole business.

🎯 Exam Tip: When describing goodwill, highlight its intangible nature and its role in increasing future earnings, as these are key characteristics.

 

Question 5. Explain any 5 factors that determine the value of G/W
Answer: Factors determining the value of goodwill of a partnership firm are:
1. Profitability of the firm: A firm that consistently earns high profits or has the potential to earn more profits in the future will have higher goodwill. People want to buy businesses that make a lot of money.
2. Favourable location of the business enterprise: If a business is in a good spot that is easy for customers to reach, it can attract more customers and make more sales. This leads to higher profits and a higher value of goodwill.
3. Good quality of goods or services offered: Businesses known for providing excellent products or services attract more customers and build a good reputation, which increases their goodwill.
4. Tenure of the business enterprise: An old business that has been around for many years usually has a better reputation among customers because they know it well. This long-standing reputation leads to higher earnings and a higher value of goodwill compared to a new business.
5. Efficiency of management: A business with smart and effective management can run its operations better and make more profits. Good management helps in managing resources and making wise decisions, which boosts the value of its goodwill.
6. Degree of competition: In markets with less competition, a business might have stronger earning power and, therefore, higher goodwill.
7. Other factors: Things like special licenses, effective advertising, or strong customer relationships can also increase goodwill.
In simple words: Many things make a business's good name (goodwill) worth more. These include how much profit it makes, if it's in a good location, if its products are great, how long it has been running, and if its managers are very good.

🎯 Exam Tip: When listing factors, provide a brief explanation for each, showing how it contributes to increased customer loyalty, higher sales, or better profitability, which are the essence of goodwill.

 

Question 6. What do you mean by self generated G/W?
Answer: Self-generated goodwill is the goodwill that a firm creates on its own through good business practices. This includes having a good location, loyal customers, and a strong brand name. This type of goodwill comes from within the business itself, rather than being bought. Such self-generated goodwill cannot be recorded as an asset in the official books of accounts.
In simple words: Self-generated goodwill is the good name a business builds by itself, like having happy customers or a famous brand. You cannot write this kind of goodwill in accounting books.

🎯 Exam Tip: Distinguish between self-generated and acquired goodwill. The key point for self-generated goodwill is that it is not recognized in accounting records because it doesn't involve a monetary transaction.

 

Question 7. How do you calculate Adjusted Profit?
Answer: Adjusted profit is calculated by starting with the actual profit and then making some changes to it. We add back any expenses that won't happen again in the future (like a one-time big repair cost). We also add any extra income we expect to receive in the future that wasn't included before. Lastly, we subtract any additional expenses that are expected to be paid in the future. This gives a more realistic view of ongoing profits.
Adjusted Profit \( = \) Actual profit
\( + \) Past expense not required in the future
\( + \) Additional income expected in the future
\( - \) Additional expenses expected to be paid in the future
In simple words: To find adjusted profit, you take the actual profit and then add back any costs that will not happen again. You also add any new income expected and subtract any new costs coming up.

🎯 Exam Tip: When adjusting profits, remember to exclude all non-recurring items (both incomes and expenses) to reflect the true operating profit of the business.

 

Question 8. How do you calculate G/W under weighted average profit method?
Answer: Under the weighted average profit method, goodwill is calculated by multiplying the weighted average profit by a certain number of years of purchase. This method gives more importance to recent profits, assuming they are a better indicator of future earnings. To find the weighted average profit, each year's profit is multiplied by a specific weight (e.g., 1 for the oldest year, 2 for the next, and so on). The total of these weighted profits is then divided by the total of all the weights assigned.
Goodwill \( = \) Weighted average profit \( \times \) Number of years of purchase
Weighted average profit \( = \frac{\text { Total of weighted profits }}{\text { Total of weights }} \)
In simple words: To find goodwill using this method, first give more importance (weights) to the newer profits and multiply them. Then add up all these weighted profits and divide by the total of the weights. This gives "weighted average profit," which is then multiplied by the number of years of purchase.

🎯 Exam Tip: The weighted average method is especially useful when profits show a clear trend (increasing or decreasing), as it gives more significance to recent performance.

 

Question 9. What do you mean by Annuity Method of valuing G/w?
Answer: Under the Annuity Method, the value of goodwill is calculated by multiplying the super profit with the present value of an annuity factor. This method considers that super profits are earned over a period of time and their value today is less than their future value due to the time value of money. The present value annuity factor tells you how much a series of equal future payments is worth today. It can be found from an annuity table or by using a formula such as \( \frac{\mathrm{i}(1+\mathrm{i})^{\mathrm{n}}}{(1+\mathrm{i})^{\mathrm{n}}-1} \) where 'i' is the interest rate and 'n' is the number of years.
Goodwill \( = \) Super profit \( \times \) Present value annuity factor
In simple words: The Annuity Method values goodwill by taking the extra profit (super profit) and multiplying it by a special number called the 'present value annuity factor'. This factor helps figure out how much future extra earnings are worth today, because money today is generally worth more than money in the future.

🎯 Exam Tip: The Annuity Method is considered more scientifically accurate as it incorporates the time value of money, which is important for long-term assets like goodwill.

 

Question 10. Write the formula for calculating G/w under capitalisation of Super profit method.
Answer: The formula for calculating goodwill under the capitalisation of Super Profit method is:
Goodwill \( = \frac{\text { Super profit }}{\text { Normal rate of return }} \times 100 \)
This formula essentially converts the super profit into a capital sum, which is the value of goodwill. It shows how much capital would be needed to earn that super profit at the normal rate of return.
In simple words: To find goodwill using the capitalization of super profit method, you divide the super profit by the normal rate of return, and then multiply by 100. This tells you what total amount of capital would be needed to generate that super profit.

🎯 Exam Tip: This method directly capitalizes the 'excess' earnings of the business, making it a straightforward way to value goodwill when super profits are consistent.

IV Additional Problems:

 

Question 1. The Goodwill is to be valued at two years purchase of last four years average profit. The profit were Rs. 40,000, Rs. 32,000, Rs. 15,000 and Rs. 13,000 respectively. Find out the value of goodwill.
Answer:
First, calculate the Total Profit for the four years:

Next, calculate the Average Profit:
Average Profit \( = \frac{\text { Total profit }}{\text { No.of years }} \)
\( = \frac{1,00,000}{4} \)
\( = \) Rs. 25,000

Finally, calculate Goodwill:
Goodwill \( = \) Average Profit \( \times \) No. of years of purchase
\( = \) Rs. 25,000 \( \times \) 2 years
\( = \) Rs. 50,000. This is a common way to estimate the value of a business's reputation.
In simple words: Add up all the profits for the last four years, then divide by four to get the average profit. After that, multiply this average profit by two (because of the "two years purchase") to find the goodwill.

🎯 Exam Tip: The "years of purchase" factor indicates how many years the firm expects to earn the average profit due to its goodwill. Use this multiplier at the very end of your calculation.

 

Question 2. Three year's purchase of the last four years average profits is used to find the value of goodwill. The profits and losses for the last four years are: I year Rs. 50,000, II year Rs. 80,000; III year Rs. 30,000 (Loss): IV year Rs. 60,000. Calculate the amount of goodwill.
Answer:
First, calculate the Total Profit for the four years. Remember to subtract the loss.

Total Profit \( = \) Rs. 50,000 \( + \) Rs. 80,000 \( - \) Rs. 30,000 \( + \) Rs. 60,000
\( = \) Rs. 1,60,000

Next, calculate the Average Profit:
Average Profit \( = \frac{\text { Total profit }}{\text { No. of years }} \)
\( = \frac{1,60,000}{4} \)
\( = \) Rs. 40,000

Finally, calculate Goodwill:
Goodwill \( = \) Average Profit \( \times \) Three years purchase
\( = \) Rs. 40,000 \( \times \) 3
\( = \) Rs. 1,20,000. It's important to treat losses as negative profits when calculating averages.
In simple words: Add up all the profits, but subtract any losses, to get the total profit for four years. Divide this total by four to find the average profit. Then, multiply the average profit by three (for "three years purchase") to get the goodwill amount.

🎯 Exam Tip: Be careful to deduct losses from total profits when calculating the average. A common mistake is to add losses instead of subtracting them.

 

Question 3. A firm's net profits during the last three years were Rs. 90,000, Rs. 1,00,000 and Rs. 1,10,000. The capital employed in the firm is Rs. 3,00,000. A normal return on the capital is 10%. Calculate the value of goodwill on the basis of two year's purchase of super profit.
Answer:
First, calculate the Average Profit for the last three years:

Average Profit \( = \frac{3,00,000}{3} \)
\( = \) Rs. 1,00,000

Next, calculate the Normal Profit:
Normal Profit \( = \frac{\text { Capital employed } \times \text { Normal rate of return }}{100} \)
\( = \frac{3,00,000 \times 10}{100} \)
\( = \) Rs. 30,000

Now, calculate the Super Profit:
Super Profit \( = \) Average Profit \( - \) Normal Profit
\( = \) Rs. 1,00,000 \( - \) Rs. 30,000
\( = \) Rs. 70,000

Finally, calculate Goodwill:
Goodwill \( = \) Super Profit \( \times \) No. of years of purchase
\( = \) Rs. 70,000 \( \times \) 2
\( = \) Rs. 1,40,000. Super profit is the basis for goodwill calculation in this method, showing earnings beyond the industry norm.
In simple words: First, find the average profit over the past three years. Then, calculate what a normal business would earn with the same capital. Subtract this 'normal profit' from the average profit to get the 'super profit'. Finally, multiply this super profit by two (for "two years purchase") to find the goodwill.

🎯 Exam Tip: This question combines average profit calculation with the super profit method. Ensure each step is performed accurately to avoid errors in the final goodwill value.

 

Question 4. Goodwill is to be valued at three years purchase of five year's average profits. The profits for the last five years of the firm were: 2000-Rs.4,200; 2001-Rs.4,500; 2002-Rs.4,700; 2003-Rs.4,600; and 2004-Rs.5,000.
Answer:
First, calculate the Total Profit for the five years:
Total Profit \( = \) Rs. 4,200 \( + \) Rs. 4,500 \( + \) Rs. 4,700 \( + \) Rs. 4,600 \( + \) Rs. 5,000
\( = \) Rs. 23,000

Next, calculate the Average Profit:
Average Profit \( = \frac{\text { Total Profits }}{\text { No. of yrs }} \)
\( = \frac{23,000}{5} \)
\( = \) Rs. 4,600

Finally, calculate Goodwill:
Goodwill \( = \) Average Profits \( \times \) No. of yrs of purchase
\( = \) Rs. 4,600 \( \times \) 3 years
\( = \) Rs. 13,800. This calculation provides an estimate of the value of the firm's non-physical assets based on its past earning trend.
In simple words: Add up all the profits from the last five years. Divide that total by five to get the average profit. Then, multiply this average profit by three (for "three years purchase") to find the goodwill amount.

🎯 Exam Tip: Always correctly identify the number of years for both the average profit calculation and the goodwill purchase factor. Make sure not to mix them up.

 

Question 5. Calculate the amount of goodwill on the basis of two year's purchase of the last four years average profits. The profits for the last four years are: I year Loss Rs. 10,000, II Year Profit Rs. 26,000, III Year Profit Rs. 34,000, IV Year Profit Rs. 50,000.
Answer:
First, calculate the Total Adjusted Profit for the last four years:

Total Adjusted Profit \( = \) Rs. 26,000 \( + \) Rs. 34,000 \( + \) Rs. 50,000 \( - \) Rs. 10,000
\( = \) Rs. 1,00,000

Next, calculate the Average Profit:
Average Profit \( = \frac{1,00,000}{4} \)
\( = \) Rs. 25,000

Finally, calculate Goodwill:
Goodwill \( = \) Average Profits \( \times \) No. of yrs of purchase
\( = \) Rs. 25,000 \( \times \) 2
\( = \) Rs. 50,000. Remember to account for losses by subtracting them from total profits.
In simple words: Add up all the profits for the last four years, but subtract any loss from the total. Then, divide this final sum by four to get the average profit. Multiply this average profit by two (for "two year's purchase") to find the goodwill.

🎯 Exam Tip: Always pay close attention to whether a given figure is a profit or a loss when summing up for average profit calculation, as an incorrect sign will lead to a wrong answer.

 

Question 6. A firm earned net profits during the last three years as follows: I Year Rs. 36,000, II Year Rs. 40,000, III Year Rs. 44,000.
Answer:
First, calculate the Total Profit for the three years:

Total Profit \( = \) Rs. 36,000 \( + \) Rs. 40,000 \( + \) Rs. 44,000
\( = \) Rs. 1,20,000

Next, calculate the Average Profit:
Average Profit \( = \frac{1,20,000}{3} \)
\( = \) Rs. 40,000

Now, calculate the Normal Profit. The capital investment of the firm is Rs. 1,20,000 and the normal rate of return is 10%.
Normal Profit \( = \frac{\text { Capital employed } \times \text { Normal rate of return }}{100} \)
\( = \frac{1,20,000 \times 10}{100} \)
\( = \) Rs. 12,000

Then, calculate the Super Profit:
Super Profit \( = \) Average Profit \( - \) Normal Profit
\( = \) Rs. 40,000 \( - \) Rs. 12,000
\( = \) Rs. 28,000

Finally, calculate Goodwill based on three years purchase of super profits:
Goodwill \( = \) Super Profit \( \times \) No. of years of purchase
\( = \) Rs. 28,000 \( \times \) 3 years
\( = \) Rs. 84,000. This goodwill reflects the firm's extra earning power for the specified period.
In simple words: First, add up all the profits for the three years and divide by three to find the average profit. Then, figure out what a normal business would earn with the same capital (normal profit). Subtract the normal profit from the average profit to get the 'super profit'. Lastly, multiply this super profit by three (for "three years purchase") to calculate the goodwill.

🎯 Exam Tip: This question combines several steps. Ensure you clearly identify the average profit, normal profit, super profit, and then correctly apply the years of purchase to arrive at the goodwill.

 

Question 7. From the following information, calculate the value of goodwill at three year's purchase of super profit:
(a) Average Capital employed in the business Rs. 6,00,000
(b) Net trading profits of the firm for the past three years were Rs. 1,07,600, Rs. 90,700, and Rs. 1,12,500.
(c) Rate of interest expected from capital having to the risk involved is 12%.
(d) Fair remuneration to the partners for their service Rs. 12,000 p.a.
Answer:
First, we calculate the average profit:
Average Profit \( = \frac{\text{1,07,600 + 90,700 + 1,12,500}}{\text{3}} \)
Average Profit \( = \frac{\text{3,10,800}}{\text{3}} \)
\( \implies \) Average Profit \( = \) Rs. 1,03,600

Next, we adjust the average profit for the partners' remuneration:
Profit before adjusting remuneration \( = \) Rs. 1,03,600
Less: Remuneration to partners \( = \) Rs. 12,000
\( \implies \) Adjusted Average Profit \( = \) Rs. 91,600

Now, we calculate the normal profit:
Normal Profit \( = \frac{\text{Capital Employed} \times \text{Normal Rate of Return}}{\text{100}} \)
\( = \text{6,00,000} \times \frac{\text{12}}{\text{100}} \)
\( \implies \) Normal Profit \( = \) Rs. 72,000

Then, we find the super profit:
Super Profit \( = \) Adjusted Average Profit - Normal Profit
\( = \text{91,600 - 72,000} \)
\( \implies \) Super Profit \( = \) Rs. 19,600

Finally, we calculate the value of goodwill:
Goodwill \( = \) Super Profit \( \times \) No. of years of purchase
\( = \text{19,600} \times \text{3 years} \)
\( \implies \) Goodwill \( = \) Rs. 58,800
In simple words: First, we found the average money the business made. Then, we subtracted the money paid to partners. After that, we figured out how much profit a similar business would normally make. We compared these two to get the 'extra' profit, called super profit. Lastly, we multiplied this extra profit by the number of years to find the total value of goodwill.

🎯 Exam Tip: Remember to always adjust the average profit for any non-recurring items or regular expenses like partners' remuneration before calculating super profit to get a true picture of business performance.