Goodwill | ISC Class 12 Accounts Notes

This note covers the meaning, nature and features of goodwill, the factors that affect its value, and the three modes of valuation prescribed for a partnership firm: the average profit method (simple and weighted), the super profit method, and the capitalisation method (capitalisation of average profit and of super profit), with the meaning of capital employed, worked examples for each method and practice questions.

What is goodwill, and what are its features?

Over a period of time, a well-established business develops an advantage of good name, reputation and wide business connections. This helps the business to earn more profits as compared to a newly set up business. In accounting, the monetary value of such advantage is known as goodwill.

Definition: goodwill. Goodwill is the value of the reputation of a firm in respect of the profits expected in future over and above the normal profits. It is an intangible asset, being the present value of a firm's anticipated excess earnings.

Goodwill is an intangible asset: it has value but no physical existence. When a person pays for goodwill, he or she pays for something which places him in the position of being able to earn super profits as compared to the profit earned by other firms in the same industry.

Goodwill can also be described as the capitalised value attached to the differential profit capacity of a business.

The most important feature follows from this definition: goodwill exists only when the firm earns super profits. A firm that earns only normal profits, or is incurring losses, has no goodwill.

Goodwill therefore belongs to the firm as it stands at a point of time, and it is the old partners who have built it up.

Because goodwill is intangible, it is very difficult to calculate its value accurately. Goodwill calculated by one method may differ from the goodwill calculated by another method. Hence the method by which goodwill is to be calculated may be specifically decided between the existing partners and the incoming partner.

Why does goodwill need to be valued?

Normally the need for valuation of goodwill arises at the time of sale of a business. In the context of a partnership firm it may also arise in the following circumstances:

1. Change in the profit sharing ratio amongst the existing partners;
2. Admission of a new partner;
3. Retirement of a partner;
4. Death of a partner;
5. Dissolution of a firm involving sale of business as a going concern;
6. Amalgamation of partnership firms.

In each of these situations the firm is reconstituted. The partners who give up a share of future profits must be compensated for the goodwill they helped to build, and the partner who gains a share must pay for it.

Which factors affect the value of goodwill?

The main factors affecting the value of goodwill are as follows.

Note: Each factor works through profit. A factor raises goodwill only because it helps the firm earn profits above the normal return on capital employed in similar businesses.

What is capital employed, and why does it matter?

Two of the three methods compare the firm's actual profit with the profit it ought to earn on its capital. That comparison needs a clear figure for the capital actually at work in the business, called capital employed or net assets.

Definition: capital employed. Capital employed (net assets) is total assets, excluding purchased goodwill, non-trade investments and fictitious assets, less outside liabilities. Outside liabilities include both long-term and short-term liabilities.

Seen from the liabilities side, the firm's capital includes partners' capital and reserves and surplus, but excludes fictitious assets and goodwill. Investments are to be taken as non-trade investments unless they are specified as trade investments.

A fictitious asset, such as a debit balance of the Profit and Loss Account or advertisement suspense, has no realisable value and so is left out.

The rate of return a similar business would normally earn on its capital is the normal rate of return. Profit earned on capital at this rate is normal profit. Profit above normal profit is super profit, and it is super profit alone that creates goodwill.

Definition: super profit. Super profit is the excess of the actual average profit of a firm over the normal profit it is expected to earn on its capital employed at the normal rate of return.

How is goodwill valued by the average profit method?

Under this method, goodwill is valued at an agreed number of years' purchase of the average profits of the past few years.

It is based on the assumption that a new business will not be able to earn any profits during the first few years of its operations.

Hence the person who purchases a running business must pay, in the form of goodwill, a sum equal to the profits he is likely to receive for the first few years.

Goodwill is therefore calculated by multiplying the past average profits by the number of years during which the anticipated profits are expected to accrue.

If the past average profits of a business work out at ₹20,000 and such profits are likely to continue for another three years, the value of goodwill will be ₹60,000 (₹20,000 × 3).

Average profit = Total profit of the given years ÷ Number of years

Goodwill = Average profit × Number of years' purchase

Worked example 1. The profits of a firm for five years are: 2013 ₹4,00,000; 2014 ₹3,98,000; 2015 ₹4,50,000; 2016 ₹4,45,000; 2017 ₹5,00,000. Calculate goodwill on the basis of 4 years' purchase of 5 years' average profits.

Answer: Total profit = ₹4,00,000 + ₹3,98,000 + ₹4,50,000 + ₹4,45,000 + ₹5,00,000 = ₹21,93,000. Average profit = ₹21,93,000 ÷ 5 = ₹4,38,600. Goodwill = ₹4,38,600 × 4 = ₹17,54,400.

This calculation assumes that no change in the overall situation of profits is expected in the future.

How does the weighted average method differ?

If there is an increasing or decreasing trend in profits, it is considered better to give a higher weightage to the profits of recent years than to those of earlier years.

It is therefore advisable to work out a weighted average based on specified weights, such as 1, 2, 3, 4 for the respective years' profits. Weighted average should be used only if it is specified.

Weighted average profit = Total of products ÷ Total of weights

Goodwill = Weighted average profit × Number of years' purchase

Worked example 2. The profits of a firm for five years are: 2012-13 ₹20,000; 2013-14 ₹24,000; 2014-15 ₹30,000; 2015-16 ₹25,000; 2016-17 ₹18,000. Calculate goodwill on the basis of three years' purchase of weighted average profits, using weights 1, 2, 3, 4 and 5.

Answer: Products are ₹20,000 × 1 = ₹20,000; ₹24,000 × 2 = ₹48,000; ₹30,000 × 3 = ₹90,000; ₹25,000 × 4 = ₹1,00,000; ₹18,000 × 5 = ₹90,000. Total of products = ₹3,48,000; total of weights = 15.

Weighted average profit = ₹3,48,000 ÷ 15 = ₹23,200. Goodwill = ₹23,200 × 3 = ₹69,600.

How are profits adjusted before averaging?

The profits of past years are rarely ready to use as printed. Abnormal items of income and expense, errors of the past, and charges that will not recur must be corrected first, so that the average reflects the maintainable profit of the business. The following adjustments are commonly made.

1. Deduct an annual charge for management cost, if the partners are to be paid for managing the business.
2. Add back capital expenditure wrongly charged to revenue, and deduct the depreciation that should have been charged on it.
3. Correct the effect of overvaluation or undervaluation of closing stock: deduct the excess from the year in which the closing stock was overvalued, and add it back to the next year, where it becomes the opening stock.
4. Add back abnormal losses such as loss by theft, and deduct abnormal gains.
5. Deduct depreciation that has been omitted, and add any income that has been left out.

Worked example 3. The profits of the last four years were: 2012 ₹20,200; 2013 ₹24,800; 2014 ₹20,000; 2015 ₹30,000, with weights 1, 2, 3 and 4.

On 1 September 2014 a major plant repair of ₹6,000 was charged to revenue; it is to be capitalised, subject to depreciation of 10% per annum on the reducing balance method. The closing stock for 2013 was overvalued by ₹2,400.

An annual charge of ₹4,800 is to be made to cover management cost. Calculate goodwill at three years' purchase of the weighted average profits.

Answer: Deduct ₹4,800 from each year: ₹15,400; ₹20,000; ₹15,200; ₹25,200. Add back the capital expenditure of ₹6,000 in 2014: ₹21,200.

Depreciation: for 2014, 10% of ₹6,000 for 4 months = ₹200; for 2015, 10% of ₹5,800 for one year = ₹580. Adjusted: ₹15,400; ₹20,000; ₹21,000; ₹24,620.

Deduct the overvaluation of closing stock of ₹2,400 from 2013, and add it back to 2014 as overvalued opening stock: adjusted profits ₹15,400; ₹17,600; ₹23,400; ₹24,620. Products: ₹15,400; ₹35,200; ₹70,200; ₹98,480; total ₹2,19,280 with total weights 10.

Weighted average profit = ₹21,928. Goodwill = ₹21,928 × 3 = ₹65,784.

How is goodwill valued by the super profit method?

The basic assumption of the average profit method is that a new business will earn no profits in its first few years, so the buyer pays for the total profits he is likely to receive.

It is contended, however, that the buyer's real benefit does not lie in total profits; it is limited to such amounts of profits as are in excess of the normal return on capital employed in a similar business.

It is therefore desirable to value goodwill on the basis of excess profits and not actual profits.

The steps involved under the method are:

1. Calculate the average profit;
2. Calculate the normal profit on the firm's capital on the basis of the normal rate of return;
3. Calculate the super profit by deducting normal profit from the average profit;
4. Calculate goodwill by multiplying the super profit by the given number of years' purchase.

Normal profit = Firm's capital × Normal rate of return ÷ 100

Super profit = Average profit − Normal profit

Goodwill = Super profit × Number of years' purchase

Suppose an existing firm earns ₹18,000 on a capital of ₹1,50,000 and the normal rate of return is 10%. Normal profit works out at ₹15,000 (₹1,50,000 × 10/100), and super profit at ₹3,000 (₹18,000 − ₹15,000).

If the benefit of super profits is likely to be available for 5 years, goodwill will be ₹15,000 (₹3,000 × 5).

Worked example 4. The firm's capital employed on 31 December 2015 was ₹5,00,000. The profits for the last five years were: 2011 ₹40,000; 2012 ₹50,000; 2013 ₹55,000; 2014 ₹70,000; 2015 ₹85,000. The normal rate of return is 10%.

Find the value of goodwill based on 3 years' purchase of super profits.

Answer: Normal profit = ₹5,00,000 × 10/100 = ₹50,000. Total profit = ₹3,00,000; average profit = ₹3,00,000 ÷ 5 = ₹60,000. Super profit = ₹60,000 − ₹50,000 = ₹10,000. Goodwill = ₹10,000 × 3 = ₹30,000.

What if partners' salaries are also to be covered?

Where the partners are to be paid salaries, the normal profit must cover both the interest on capital and the salaries, because these are the minimum returns the partners expect before any super profit arises. The normal profit is then the sum of interest on capital and partners' salaries.

Worked example 5. The capital of the firm of Anu and Benu is ₹1,00,000 and the market rate of interest is 15%. Annual salary to partners is ₹6,000 each.

The profits for the last 3 years were ₹30,000; ₹36,000 and ₹42,000. Goodwill is to be valued at 2 years' purchase of the last 3 years' average super profits. Calculate the goodwill.

Answer: Interest on capital = ₹1,00,000 × 15/100 = ₹15,000. Partners' salaries = ₹6,000 × 2 = ₹12,000. Normal profit = ₹15,000 + ₹12,000 = ₹27,000.

Average profit = (₹30,000 + ₹36,000 + ₹42,000) ÷ 3 = ₹1,08,000 ÷ 3 = ₹36,000. Super profit = ₹36,000 − ₹27,000 = ₹9,000. Goodwill = ₹9,000 × 2 = ₹18,000.

How is goodwill valued by the capitalisation method?

Under this method goodwill can be calculated in two ways: by capitalising the average profits, or by capitalising the super profits.

Capitalisation of average profit

Under this method the value of goodwill is ascertained by deducting the actual firm's capital in the business from the capitalised value of the average profits on the basis of the normal rate of return. The steps are:

1. Ascertain the average profits based on the past few years' performance.
2. Capitalise the average profits on the basis of the normal rate of return, to get the capitalised value of average profits.
3. Ascertain the actual firm's capital (net assets) by deducting outside liabilities from the total assets, excluding purchased goodwill, non-trade investments and fictitious assets.
4. Compute the value of goodwill by deducting net assets from the capitalised value of average profits.

Capitalised value = Average profit × 100 ÷ Normal rate of return

Goodwill = Capitalised value − Net assets

Worked example 6. A business has earned average profits of ₹1,00,000 during the last few years and the normal rate of return in a similar business is 10%. The value of net assets of the business is ₹8,20,000. Ascertain the value of goodwill by the capitalisation of average profits method.

Answer: Capitalised value of average profits = ₹1,00,000 × 100/10 = ₹10,00,000. Goodwill = ₹10,00,000 − ₹8,20,000 = ₹1,80,000.

Capitalisation of super profit

Goodwill can also be ascertained by capitalising the super profit directly. Under this method there is no need to work out the capitalised value of average profits. The steps are:

1. Calculate the capital of the firm, which is total assets excluding purchased goodwill, non-trade investments and fictitious assets, minus outside liabilities.
2. Calculate normal profit on capital employed.
3. Calculate the average profit for the past years, as specified.
4. Calculate super profit by deducting normal profit from average profit.
5. Multiply the super profit by 100 and divide by the normal rate of return.

Goodwill = Super profit × 100 ÷ Normal rate of return

In other words, goodwill is the capitalised value of super profits. The amount of goodwill worked out by this method will be exactly the same as calculated by capitalising the average profits.

Using the data of the previous example, normal profit is ₹82,000 (10% of ₹8,20,000), super profit is ₹18,000 (₹1,00,000 − ₹82,000), and goodwill is ₹18,000 × 100/10 = ₹1,80,000.

Worked example 7. Rama Brothers earn an average profit of ₹30,000 with a capital of ₹2,00,000. The normal rate of return in the business is 10%. Using the capitalisation of super profits method, work out the value of the goodwill of the firm.

Answer: Normal profit = ₹2,00,000 × 10/100 = ₹20,000. Super profit = ₹30,000 − ₹20,000 = ₹10,000. Goodwill = ₹10,000 × 100/10 = ₹1,00,000.

How is capital employed worked out from a balance sheet?

In examination questions the capital employed is usually given, but sometimes the balance sheet must be read to find it. The rule is to take the assets that actually work in the business and deduct the outside liabilities.

1. Start with the total assets shown in the balance sheet.
2. Deduct purchased goodwill, because it is not a working asset.
3. Deduct non-trade investments, unless they are specified as trade investments.
4. Deduct fictitious assets such as a debit balance of the Profit and Loss Account or advertisement suspense.
5. Deduct outside liabilities, both long-term and short-term.

The same figure can be built up from the liabilities side: partners' capitals, adjusted for their current accounts, plus reserves and surplus, less fictitious assets and goodwill.

Worked example 8. A firm's balance sheet shows: Akshay's Capital ₹1,20,000; Baldev's Capital ₹1,00,000; Akshay's Current Account ₹20,000; Baldev's Current Account (debit) ₹10,000; General Reserve ₹20,000; Advertisement Suspense ₹10,000. Calculate the capital employed.

Answer: Capitals and current accounts: ₹1,20,000 + ₹1,00,000 + ₹20,000 − ₹10,000 = ₹2,30,000. Add General Reserve ₹20,000 = ₹2,50,000. Deduct Advertisement Suspense ₹10,000, a fictitious asset = ₹2,40,000. Capital employed is ₹2,40,000.

What are the advantages and limitations of each method?

Merits and limitations of the average profit method

The average profit method is simple to apply and uses figures that are readily available in the books. It suits a firm whose profits are steady.

Its weakness is that it ignores the capital employed altogether: a firm that earns ₹1,00,000 on a capital of ₹20,00,000 is treated better than a firm that earns ₹80,000 on a capital of ₹2,00,000, although the second firm is far more efficient.

Merits and limitations of the super profit method

The super profit method is logically sound because it pays only for the excess over the normal return, which is the real reason a buyer pays for goodwill.

Its limitation is that it depends on two estimates, the normal rate of return and the number of years' purchase, and a small change in either alters the answer sharply.

Merits and limitations of the capitalisation method

The capitalisation method links goodwill directly to the capital employed and the normal rate of return, and the two versions of it agree exactly. Its limitation is that it requires a reliable valuation of net assets; if assets are overstated, goodwill is understated, and the reverse if they are understated.

How do the valuation methods compare, and which should a firm choose?

The three methods do not give the same figure for the same firm, and each answers a different question. The average profit method asks what the buyer would pay for the whole stream of past profits for a few years.

The super profit method asks what the buyer would pay for the excess over a normal return. The capitalisation method converts a profit stream into the capital sum that would produce it at the normal rate of return.

Note: The two capitalisation methods give the same answer. Capitalising average profit and then deducting net assets is the same as capitalising only the excess of average profit over normal profit.

The choice of method is a matter of agreement between the partners, and in an examination the question names the method to be used.

The simple average profit method is the easiest to apply when profits are steady. The super profit and capitalisation methods are more logical, because they pay only for earnings above a normal return, but they need a reliable figure for capital employed and an agreed normal rate of return.

Worked example 9. A firm has average profit of ₹1,20,000, capital employed of ₹9,00,000 and a normal rate of return of 10%.

Value the goodwill by the simple average profit method at 3 years' purchase, by the super profit method at 3 years' purchase, and by capitalisation of super profit, and compare.

Answer: Average profit method: ₹1,20,000 × 3 = ₹3,60,000. Normal profit = ₹9,00,000 × 10/100 = ₹90,000. Super profit = ₹1,20,000 − ₹90,000 = ₹30,000. Super profit method: ₹30,000 × 3 = ₹90,000.

Capitalisation of super profit: ₹30,000 × 100/10 = ₹3,00,000. The three figures differ widely, so the partners should agree the method in advance.

How is goodwill treated in the books when a partner is admitted?

The incoming partner who acquires a share in the profits of the firm from the existing partners brings in an additional amount to compensate them for loss of their share in super profits.

This amount is his share of goodwill, also called premium for goodwill. The amount of premium brought in by the new partner is shared by the existing partners in their ratio of sacrifice.

If the amount is paid to the old partners directly by the new partner, no entry is passed in the books of the firm.

When the amount is paid through the firm, the bank account is debited and the premium for goodwill account is credited; the premium for goodwill account is then debited and the sacrificing partners' capital accounts are credited individually in their sacrificing ratio.

If the partners decide to retain the amount in the business, no further entry is passed; if they withdraw it in full or in part, their capital accounts are debited and the bank account is credited.

Worked example 10. Sunil and Dalip share profits in the ratio 5:3. Sachin is admitted for 1/5 share and brings ₹20,000 as capital and ₹4,000 as his share of goodwill by cheque. The partners decide to retain the goodwill in the business. Give the journal entries.

Answer: (i) Bank A/c Dr. ₹24,000; To Sachin's Capital A/c ₹20,000; To Premium for Goodwill A/c ₹4,000. (ii) Premium for Goodwill A/c Dr. ₹4,000; To Sunil's Capital A/c ₹2,500; To Dalip's Capital A/c ₹1,500.

The sacrificing ratio is taken as the old ratio 5:3, so Sunil gets ₹4,000 × 5/8 = ₹2,500 and Dalip ₹4,000 × 3/8 = ₹1,500.

When the new partner does not bring his share of goodwill in cash, the amount not brought is debited to his current account and the sacrificing partners' capital accounts are credited for their respective shares.

Goodwill already appearing in the books is written off by debiting the old partners' capital accounts in their old profit sharing ratio.

Worked example 11. Ram and Rahim share profits in the ratio 3:2. Rahul is admitted for 1/3 share. He brings ₹10,000 as capital but cannot bring any amount for his share of goodwill, which is valued at ₹30,000. No goodwill appears in the books. Give the journal entries.

Answer: (i) Bank A/c Dr. ₹10,000; To Rahul's Capital A/c ₹10,000. (ii) Rahul's Current A/c Dr. ₹30,000; To Ram's Capital A/c ₹18,000; To Rahim's Capital A/c ₹12,000.

Rahul's share of goodwill is credited to the old partners in their sacrificing ratio, which is the old ratio 3:2, so Ram gets ₹30,000 × 3/5 = ₹18,000 and Rahim ₹30,000 × 2/5 = ₹12,000.

What is hidden goodwill, and how is it inferred?

Sometimes the value of goodwill is not given at the time of admission of a new partner. In such a situation it has to be inferred from the arrangement of the capital and the profit sharing ratio.

The capital brought in by the new partner, divided by his share, gives the total capital of the newly constituted firm.

The actual total capital of all the partners is then compared with this figure, and the difference is taken as goodwill.

1. Divide the new partner's capital by his share of profits to get the total capital of the new firm.
2. Add the capitals of all the partners, old and new, to get the actual total capital.
3. Deduct the actual total capital from the total capital of the new firm; the difference is the goodwill of the firm.
4. Multiply the goodwill by the new partner's share to get his share of goodwill.
5. Credit the sacrificing partners' capital accounts in their sacrificing ratio and debit the new partner's current account if he does not bring the amount.

Worked example 12. Hem and Nem share profits in the ratio 3:2, with capitals of ₹80,000 and ₹50,000. Sam is admitted for 1/5 share and brings ₹60,000 as capital. Calculate the goodwill of the firm and Sam's share of it.

Answer: Total capital of the firm = ₹60,000 × 5 = ₹3,00,000. Actual capital of Hem, Nem and Sam = ₹80,000 + ₹50,000 + ₹60,000 = ₹1,90,000. Goodwill of the firm = ₹3,00,000 − ₹1,90,000 = ₹1,10,000.

Sam's share = ₹1,10,000 × 1/5 = ₹22,000, credited to Hem ₹13,200 and Nem ₹8,800 in the ratio 3:2.

Going beyond the syllabus

Accounting Standard 26, Intangible Assets, applies to expenditure incurred on intangible items in accounting periods commencing on or after 1 April 2003.

It defines an intangible asset as identifiable, non-monetary, without physical existence, and held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.

Internally generated goodwill should not be recognised as an asset, and intangible assets should be written off as early as possible but not beyond their estimated life, which normally should not exceed 10 years.

Purchased goodwill may be shown as an asset and written off within that limit. This is why, when a firm is reconstituted, goodwill already appearing in its balance sheet is written off.

Glossary

• Goodwill: the monetary value of a firm's good name and reputation, being the present value of its anticipated excess earnings.
• Intangible asset: an asset that has value but no physical existence, such as goodwill, patents or trademarks.
• Super profit: the excess of the actual average profit of a firm over the normal profit on its capital employed.
• Normal profit: the profit a similar business would earn on its capital at the normal rate of return.
• Normal rate of return: the rate of return generally earned by businesses of a similar type and risk.
• Capital employed: total assets excluding purchased goodwill, non-trade investments and fictitious assets, less outside liabilities.
• Net assets: another name for capital employed, being the assets actually at work in the business.
• Fictitious assets: items such as a debit balance of the Profit and Loss Account or advertisement suspense, which have no realisable value.
• Years' purchase: the number of years for which the profit or super profit is expected to continue, used as a multiplier.
• Average profit: the total profit of the given years divided by the number of those years.
• Weighted average profit: the total of each year's profit multiplied by its weight, divided by the total of the weights.
• Capitalisation: converting a stream of profit into a capital sum by multiplying it by 100 and dividing by the normal rate of return.
• Non-trade investments: investments held for income rather than for the business, which are excluded from capital employed.

Common errors and misconceptions

• Misconception: Goodwill can be calculated only one way. Correct: Goodwill calculated by one method may differ from that calculated by another, so the method is usually agreed between the existing partners and the incoming partner.
• Misconception: A firm earning normal profit has some goodwill. Correct: Goodwill exists only when the firm earns super profits; a firm earning normal profits or incurring losses has no goodwill.
• Misconception: Weighted average is always better. Correct: Weighted average should be used only if it is specified.
• Misconception: Fictitious assets count in capital employed. Correct: Purchased goodwill, non-trade investments and fictitious assets are excluded from total assets.
• Misconception: All investments are excluded. Correct: Investments are treated as non-trade unless specified as trade investments.
• Misconception: Only long-term liabilities are deducted. Correct: Outside liabilities include both long-term and short-term liabilities.
• Misconception: Partners' salaries are ignored in normal profit. Correct: Where salaries are payable, normal profit includes interest on capital plus partners' salaries.
• Misconception: Goodwill already in the books is kept when a partner is admitted. Correct: Goodwill appearing in the books is written off by debiting the old partners' capital accounts in their old profit sharing ratio.

Exam-style questions with model answers

Q1. State any two factors that affect the value of goodwill of a firm. [2 marks]

1. Nature of business: a firm that produces high value added products, or has 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.

Q2. A firm earned average profit of ₹60,000. Its capital employed is ₹4,00,000 and the normal rate of return is 12%. Calculate the super profit. [2 marks]

1. Normal profit is the profit a similar business would earn on the same capital at the normal rate of return: ₹4,00,000 × 12/100 = ₹48,000.
2. Super profit is the excess of average profit over normal profit: ₹60,000 − ₹48,000 = ₹12,000.

Q3. Explain the meaning of capital employed and state what is excluded from total assets while computing it. [3 marks]

1. Capital employed, or net assets, is the capital actually at work in the business.
2. It is total assets less outside liabilities, where outside liabilities include both long-term and short-term liabilities.
3. Total assets exclude purchased goodwill, non-trade investments and fictitious assets. Investments are treated as non-trade unless specified as trade investments.

Q4. The profits of a firm for the last four years were ₹40,000; ₹50,000; ₹60,000 and ₹70,000. Calculate goodwill at three years' purchase of the average profit. [3 marks]

1. Under the simple average profit method, the profits of the given years are first added: ₹40,000 + ₹50,000 + ₹60,000 + ₹70,000 = ₹2,20,000.
2. Average profit = Total profit ÷ Number of years = ₹2,20,000 ÷ 4 = ₹55,000.
3. Goodwill = Average profit × Number of years' purchase = ₹55,000 × 3 = ₹1,65,000. The buyer pays for three years of the average profit that the firm's reputation is expected to bring.

Q5. Distinguish between the average profit method and the super profit method of valuing goodwill. [4 marks]

1. Base: the average profit method uses the average of past profits; the super profit method uses the excess of average profit over normal profit.
2. Capital employed: the average profit method ignores it; the super profit method needs it, because normal profit is calculated on it.
3. Formula: goodwill is average profit × years' purchase under the first, and super profit × years' purchase under the second.
4. Suitability: the average profit method suits a firm with steady profits, while the super profit method is more logical because a buyer pays only for excess earning capacity.

Q6. A firm's average profit is ₹90,000, its capital employed is ₹6,00,000 and the normal rate of return is 10%. Calculate goodwill by (a) capitalisation of average profit and (b) capitalisation of super profit, and show that the two agree. [5 marks]

1. (a) Capitalisation of average profit. Capitalised value of average profit = Average profit × 100 ÷ Normal rate of return = ₹90,000 × 100/10 = ₹9,00,000. This is the capital that would earn ₹90,000 at the normal rate of 10%.
2. Goodwill = Capitalised value − Capital employed = ₹9,00,000 − ₹6,00,000 = ₹3,00,000.
3. (b) Capitalisation of super profit. Normal profit = ₹6,00,000 × 10/100 = ₹60,000.
4. Super profit = Average profit − Normal profit = ₹90,000 − ₹60,000 = ₹30,000.
5. Goodwill = Super profit × 100 ÷ Normal rate of return = ₹30,000 × 100/10 = ₹3,00,000.
6. Both methods give ₹3,00,000, because deducting capital employed from the capitalised average profit leaves exactly the capitalised value of the super profit.

Q7. The profits of a firm for five years were ₹30,000; ₹36,000; ₹42,000; ₹48,000 and ₹54,000, with weights 1, 2, 3, 4 and 5. Calculate goodwill at two years' purchase of the weighted average profit. [5 marks]

1. Each year's profit is multiplied by its weight: ₹30,000 × 1 = ₹30,000; ₹36,000 × 2 = ₹72,000; ₹42,000 × 3 = ₹1,26,000; ₹48,000 × 4 = ₹1,92,000; ₹54,000 × 5 = ₹2,70,000.
2. Total of products = ₹30,000 + ₹72,000 + ₹1,26,000 + ₹1,92,000 + ₹2,70,000 = ₹6,90,000; total of weights = 1 + 2 + 3 + 4 + 5 = 15.
3. Weighted average profit = Total of products ÷ Total of weights = ₹6,90,000 ÷ 15 = ₹46,000.
4. Goodwill = Weighted average profit × Number of years' purchase = ₹46,000 × 2 = ₹92,000.
5. The weighted average (₹46,000) is higher than the simple average (₹2,10,000 ÷ 5 = ₹42,000) because the profits show a rising trend and the recent years carry the higher weights.

Q8. The capital of a firm is ₹5,00,000 and the normal rate of return is 12%. The average profit for the last five years is ₹80,000, and the partners are to be paid salaries of ₹5,000 each to two partners. Calculate goodwill at three years' purchase of super profit. [6 marks]

1. Where partners are to be paid salaries, normal profit must cover both a normal return on capital and the salaries.
2. Return on capital at the normal rate = ₹5,00,000 × 12/100 = ₹60,000.
3. Partners' salaries = ₹5,000 × 2 = ₹10,000.
4. Normal profit = ₹60,000 + ₹10,000 = ₹70,000.
5. Super profit = Average profit − Normal profit = ₹80,000 − ₹70,000 = ₹10,000.
6. Goodwill = Super profit × Number of years' purchase = ₹10,000 × 3 = ₹30,000.
7. If the salaries were ignored, super profit would be ₹20,000 and goodwill ₹60,000, which would overstate the value of the firm's reputation, because the salaries are a minimum return the partners expect before any super profit arises.

Key takeaways

• Goodwill is the value of a firm's reputation in respect of future profits over and above normal profits, and it is an intangible asset.
• Goodwill exists only when a firm earns super profits; a firm earning normal profits or incurring losses has none.
• Nature of business, location, efficiency of management, market situation and special advantages are the main factors affecting goodwill.
• Capital employed is total assets excluding purchased goodwill, non-trade investments and fictitious assets, less outside liabilities.
• Simple average profit multiplies average profit by years' purchase; weighted average gives higher weightage to recent years and is used only if specified.
• Super profit is average profit minus normal profit, and goodwill is super profit multiplied by the years' purchase.
• Capitalisation of average profit deducts net assets from the capitalised value of average profit.
• Capitalisation of super profit multiplies super profit by 100 divided by the normal rate of return, and gives the same answer.
• Where partners' salaries are payable, normal profit includes interest on capital plus the salaries.

Test yourself

Define goodwill in one sentence.

Goodwill is the value of the reputation of a firm in respect of the profits expected in future over and above the normal profits, and is an intangible asset.

When does a firm have no goodwill?

A firm that earns only normal profits, or is incurring losses, has no goodwill, because goodwill exists only when the firm earns super profits.

What is the formula for normal profit?

Normal profit = Firm's capital × Normal rate of return ÷ 100. The firm's capital includes partners' capital and reserves and surplus but excludes fictitious assets and goodwill.

Average profit is ₹50,000 and goodwill is valued at four years' purchase. What is the goodwill?

Goodwill = ₹50,000 × 4 = ₹2,00,000.

Capital employed is ₹3,00,000 and the normal rate of return is 15%. What is the normal profit?

Normal profit = ₹3,00,000 × 15/100 = ₹45,000.

Why is weighted average used only if specified?

Because the weights are a matter of judgement; the partners must agree on them, so the weighted average is applied only when the question or the agreement specifies the weights.

State the formula for goodwill by capitalisation of super profit.

Goodwill = Super profit × 100 ÷ Normal rate of return. It is the capitalised value of the super profits of the firm.

Name any three occasions on which goodwill must be valued in a partnership firm.

Change in the profit sharing ratio among existing partners, admission of a new partner, and retirement or death of a partner. Dissolution involving sale of the business and amalgamation of firms are other occasions.