Goodwill is the value of a firm’s reputation and its good brand name in the market. A firm earns goodwill through its hard work. Goodwill helps a firm in winning the trust and faith of the customers by fulfilling their demands in both qualitative and quantitative aspects. It can be said that the goodwill of a firm is a result of the past efforts made by it which helps a firm to earn higher profits in present and in the future as well.
In other words, positive goodwill helps a firm to earn supernormal profits as compared to the other firms that earn only normal profits. Goodwill is considered an intangible asset of the firm. It means it cannot be seen or touched like other assets of the firm. It plays a very crucial role for any firm to survive and compete in the market.
In the words of Lord Eldon, “Goodwill is nothing more than the probability that the old customers will resort to the old place”.
Characteristic of Goodwill
The below mentioned are the characteristics of goodwill.
- It is an intangible asset.
- It is not a fictitious asset.
- It is difficult to ascertain the exact value of goodwill.
- It enhances the present as well as the future earning capacity of a business.
- It helps in earning the supernormal profits against the normal profits.
- It is a basis for winning customers’ trust and faith.
- A positive goodwill not only facilitates a firm to win customers’ trust but also helps the company to excel over its competitors.
Nature of Goodwill
By the very definition of Goodwill, we can figure out that it is something that cannot be touched, seen, or felt but has the potential to generate enormous returns for the firm by creating a positive image in the minds of customers and attracting them. Thus we can classify goodwill as an intangible asset just like patents, trademarks, etc. It, therefore, doesn’t depreciate (i.e. reduce in value due to gradual wear and tear) but rather amortizes over its useful life which is to say that a certain portion of goodwill is written off every year depending on the value derived out of it during the year.
For example, 1/5th of the goodwill is to be written off this year. The accounting treatment of goodwill is covered under Accounting Standard 26(AS-26) according to which, goodwill should not be recorded in the books of accounts unless consideration is paid for it. Also, if goodwill is computed for oneself then such self-generated goodwill should not be recorded because its value cannot be justified by way of the cost incurred to acquire such an asset. Lastly, just like a tangible asset, goodwill can be sold but it happens along with the sale of the business.
Factors Affecting Goodwill
The following are the important factors that affect the goodwill of a firm.
Quality Products: One of the important factors that affect the goodwill of the firm is the quality of the product. Quality product means producing the right and standard featured products and selling them at reasonable prices. A firm that is engaged in producing high-quality goods and services is able to capture the huge demand for its product in the market. This will in turn help the firm to increase its goodwill in the market.
Location: The goodwill of a firm largely depends upon the place where the business of a firm is located. If the business is located at a convenient and easily accessible place, then large numbers of customers get attracted which in turn leads to an increase in sales. It helps the firm to earn higher goodwill.
Management: Efficient management helps the firm to fulfill its customer requirements. It also helps the firm to achieve higher productivity along with cost-efficiency. It means efficient management helps in producing superior quality goods and services at lower costs, which in turn lowers the prices of goods and services in the market as compared to the other firms. Due to this, the firm will be able to earn higher profits resulting in a higher value of goodwill of the firm.
Firm’s Status in the Market: The status of a firm in the market also affects its goodwill. A firm that is not facing huge competition in the market or enjoys the status of monopoly in the market will be able to earn higher profits. This will result in an increase in the value of the goodwill.
Economies of Scales: A firm that enjoys special advantages such as the continuous and easy supply of power, fuel, raw materials, etc., at a reasonable price and producing quality products at a large scale is able to enhance the goodwill of the firm.
Classification of Goodwill
Goodwill can be classified into two broad categories depending, namely:
- Purchased Goodwill
- Self-generated Goodwill
Whenever a firm is sold to another firm generally a consideration is paid in cash or kind because the buyer will enjoy the benefits of the brand image that has been created over the years once the purchase is complete. This kind of goodwill is recorded in the books of accounts since the amount paid can be fairly determined. This goodwill arises when, for instance, the value of assets is greater than the liabilities at the time of purchase and hence, it is a balancing figure. For example, Aman owns a shop that is known for its quality and has a large number of loyal customers and Ravi offers to buy his shop as it is. As a result of this purchase, Ravi will be able to acquire the pool of customers and should therefore pay for it as well apart from the assets.
Characteristics of Purchased Goodwill
- This goodwill arises when a business is purchased or acquired for reasons like brand image, customers pool, business connections, etc.
- It is recorded in the books of accounts since its value has been determined in the form of consideration paid.
- Like any other asset, this kind of goodwill is a valuable intangible asset for a firm and hence shall be recorded under the head Assets in the balance sheet of the firm.
- The valuation of goodwill cannot be objectively determined and is based on the seller’s perception.
- The benefit of goodwill can be enjoyed only for a limited period of time owing to the fact that the benefit derived from it cannot be justified in quantitative terms after a certain period. Hence, it should be amortized at the earliest.
Unlike the previous kind, this goodwill is not purchased or bought for consideration but rather generated as a result of the hard work and efforts of the members of the firm. It, therefore, arises because of factors such as consistent quality, satisfied customers, favorable location, etc. Since all these factors are internal to an organization hence the goodwill is an internally generated goodwill boosting the revenues for the firm.
Features of Self-generated Goodwill
- As mentioned above, it arises out of the efforts of a firm over the years and hence is internally generated.
- Since the value of internally generated goodwill cannot be traced back to a cost source hence its accurate and reliable value is very difficult to determine.
- The valuation is based on the perspective of the valuer and hence is completely subjective.
Need for Valuation of Goodwill
The following are the various situations in which the need for the valuation of goodwill arises.
- When there is a change in the profit-sharing ratio of the firm
- When a new partner is admitted to the firm
- When a partner retires or dies
- When a partnership firm is sold
- When a partnership firm is amalgamated with another firm
Methods for Valuation of Goodwill
The below-mentioned methods are used for the valuation of the goodwill of a firm.
- Average Profit Method
- Weighted Average Profit Method
- Super Profit Method
- Capitalisation Method
Method 1: Average Profit Method
Under this method, goodwill is calculated on the average basis of the normal average profits of the last few years. To find out the value of goodwill only the normal profits of the business for specified years are taken into consideration in this method. It means all the abnormal gains or losses and all non-business incomes or expenses are ignored while calculating the profits of a particular year.
The profits so calculated for different years is then added and their average is computed. This average profit is then multiplied by the number of years’ purchases to ascertain the value of goodwill.
The formula for calculating goodwill under this method is Goodwill = Average Profit * Number of years Purchase
Number of years’ of purchase implies the number of years for which the firm expects to earn the same amount of profits.
Steps to Calculate the Goodwill by Average Profit Method
Step 1: Ascertain the total normal profits of the business for the past given years.
Step 2: Add all abnormal losses such as loss by fire, theft, etc., to the normal profits (as mentioned above ). This is because these are not incurred in the normal course of a business.
Step 3: Subtract all abnormal gains such as winnings from lottery, speculation, etc., from the normal profits. This is because these are not earned in the normal course of a business.
Step 4: Add all normal business income that was not previously added to the normal profits and subtract all normal business expenses that are not subtracted previously.
Step 5: Subtract all non-business income, i.e. income earned from outside the business of the firm.
Step 6: Add all the profits for different years after considering all the above steps to find out the total profits of the past given years.
Step 7: Calculate the average profits by dividing the total profits (calculated above) by number of years.
Step 8: Multiply the above calculated average profits by the number of years’ purchases to get the value of goodwill.
Method 2: Weighted Average Profit Method
The weighted Average Profit Method is similar to the Average Profit Method for calculating the goodwill of a firm. Under this method, the only difference is that the weights such as 1, 2, 3, 4…etc. are assigned to the profit of each year.
Generally, the highest weight is assigned to the recent year’s profit and lower weights are assigned to the past year’s profits. The product of the weights and the profit are calculated and then are added to find out the sum total of the products. This total of product is then divided by the total of the weights to compute the weighted average profit. To find out the value of goodwill under this method, the weighted average profit so calculated is multiplied by the number of years’ purchase.
The formula for calculating goodwill by this method is Goodwill = Weighted Average Profit * Number of years’ Purchase
Steps of Calculate Goodwill by weighted Average Profit Method
Step 1: Assign the weights to each year’s profit in ascending order starting from the past year’s profit. It means the lowest weight will be assigned to the most past profits and the highest weight to the most recent profits. For example, if 2012 is the current year preceded by 2011, 2010, 2009, and 2008, then the weights are assigned from 2012 to 2008 as 5, 4, 3, 2, 1.
Step 2: Multiply the weights with the corresponding year’s profit.
Step 3: Calculate the total of the products.
Step 4: Divide the total of the products by the total of the weights in order to calculate the weighted average profit.
Step 5: Multiply the weighted average profit by the number of years purchase to get the value of goodwill.
The superiority of the Weighted Average Profit Method over Average Profit Method
The weighted Average Profit Method enjoys an edge over the Average Profit Method in producing better and reliable results. This is particularly in those scenario, where profits are continuously showing an increasing or decreasing trend over a period of years. This is because the Weighted Average Profit Method assigns more weightage to the recent years’ profits. Therefore, in order to compute a reliable valuation of goodwill one should go for Weighted Average Profit Method.
Method 3: Super Profit Method
A firm earn its profits from the capital employed in the business. Capital employed means the shareholders’ fund. i.e. sum total of share capital and reserves and surplus (i.e. undistributed profits). It can also be defined as the difference between total assets (other than fictitious assets) and external liabilities of a firm.
Under this method, goodwill is calculated on the basis of excess profit earned by a firm over the normal profit earned by its counterparts in the same industry. This excess of profit over the normal profit is termed as super profit. Therefore, to compute the value of goodwill under this method, super profits are multiplied by the number of years’ purchases.
The formula for calculating goodwill by this method is Godwill = Super Profit * Number of years’ purchase
Steps to Calculate Goodwill by Super Profit Method
Step 1: Calculate the Average Profit of the firm
Step 2: Calculate Capital Employed of the firm.
Capital Employed = Total Assets (other than fictitious assets) – External/Outside Liabilities
Or Capital Employed = Share Capital + Free Reserves – Fictitious Assets
Step 3: Calculate Normal Profits on Capital Employed on the basis of Normal Rate of Return
Step 4: Calculate Super Profit by deducting the Normal Profit from the Average Profit. Super Profit = Average Profit – Normal Profit
Step 5: Multiply the Super Profits by the Number of Years’ Purchase to get the value of goodwill.
Method 4: Capitalisation Method
Under this method, goodwill of a firm can be calculated by either of the following two ways.
- Capitalisation of Average Profit
- Capitalisation of Super Profit
Capitalization of Average Profit
Under this method, first of all the capitalised value of the business is calculated. This value is calculated by capitalizing the average profit on the basis of the normal rate of return of a business. To calculate the value goodwill of the firm the actual capital employed of a firm is deducted from the value of the business so calculated.
Therefore,the formula for calculating goodwill by this method is Godwill = Capitalized Value of Average Profit – Actual Capital Employed
Steps to Calculate Goodwill by Capitalisation of Average Profit Method
Step 1: Calculate the average profit of the firm.
Step 2: Calculate Capitalised value of Average Profit on the basis of normal rate of return by the following formula.
Step 3: Ascertain Actual Capital Employed of the firm.
Capital Employed = Total Assets (other than fictitious assets) – External Liabilities
Step 4: Deduct Actual Capital Employed from the Capitalised value of Average Profit to compute the value of goodwill.
Goodwill = Capitalised Average Profit – Actual Capital Employed
Capitalization of Super Profit
Under this method, goodwill is calculated by capitalising the super profits of the firm. It means under this average profit is calculated but instead of capitalisation of average profit, capitalising of super profit is done.
The formula for calculating goodwill by this method is Goodwill = Super Profit * ( 100 divided by Normal Rate of Return)
Steps to Calculate Goodwill by Capitalisation of Super Profit
Step 1: Calculate Capital Employed of the firm as:
Capital Employed = Total Assets – External Liabilities
Step 2: Calculate Normal Profit of the firm as:
Step 3: Calculate Average Profit.
Step 4: Calculate Super Profit of the firm by deducting Normal Profit from Average Profit, as:
Super Profit = Average Profit – Normal Profit
Step 5: Calculate goodwill of the firm by the following formula:
Treatment of Goodwill
As per the Accounting Standard 26 of ICAI, goodwill is recorded in the books only when some consideration in money or money’s worth has been paid for it. This practice is mandatory to follow. In the case of admission, retirement, death, or change in profit sharing ratio among existing partners, Goodwill Account cannot be raised as no consideration is paid for it. This implies that the goodwill of a partnership firm is self-generated goodwill, that is, the firm itself evaluates the value of the goodwill. The AS-26 standard specifies that goodwill should be immediately written off after it has been raised. That is, as per this accounting standard, goodwill has to be adjusted through Partners’ Capital Account
There are various cases for treatment of the goodwill in the books of accounts on the eve of admission of a new partner.
Various cases for treatment of the goodwill
- Goodwill Privately Paid
- Goodwill Brought in Cash and Retained in the business
- Goodwill Brought in Cash and Withdrawn by the old Partners
- Only a Part of Goodwill is Brought in
- Unable to Bring Goodwill in Cash at all
- When Goodwill is Brought in Kind
However; an important point that is to be taken care of is that irrespective of any case of goodwill, if goodwill already appears in the Balance Sheet of the Old Firm, then first of all this goodwill is to be transferred (i.e. written-off) to the old Partners’ Capital A/c in their old profit sharing ratio. It is done by debiting the old partners’ capital account and crediting the goodwill account in their old profit sharing ratio.
Cases of Goodwill
Case 1: When the new partner pays his share of goodwill privately to the old partners
No accounting entry is recorded in the books of account in this case.
Case 2: When Share of Goodwill is brought in Cash and retained in the Business
When the new partner brings his/her share of goodwill in cash, it is transferred to sacrificing Partner’s Capital Account in their sacrificing ratio. In short, it can be said that the existing partners share the amount of goodwill brought in by the new partner in their sacrificing ratio.
Case 3: When the Goodwill is brought in by the New Partner and is Withdrawn by the Old Partners (fully or partly)
In Case 2, we learned that the premium for goodwill brought in by the new partner is retained in the business. That is, the old partners are not withdrawing this amount of premium of goodwill. But, in case, if the old partners decide to withdraw the premium either fully or partly, then an additional Journal entry is passed.
Case 4: When Only a Part of Premium or Goodwill is brought in by the New Partner in Cash
There may be a situation when the new partner is not able to bring the whole amount of his/her share of goodwill in cash. In such a case, the premium for the goodwill account is credited with the amount of premium which is brought in by the new partner. At the time of the transfer of the premium amount to the sacrificing partners’ capital account, the new partner’s capital account is to be debited with the unpaid amount of premium (i.e. the amount which he/she is unable to bring).
Case 5: When the New Partner is not able to bring his Share of Goodwill or Premium in Cash at all
At the time of admission, when the new partner is not able to bring his/her whole share of goodwill, then the New Partner’s Capital Account is debited and old Partners’ Capital A/c will be credited in their sacrificing ratio with the amount of goodwill that is not brought by the new partner.
Case 6: When the Premium for Goodwill is brought in Kind
There may be a situation when on admission, the new partner does not bring his share of goodwill in cash. Instead he/she brings his/her share of goodwill in kind (usually in form of the assets). In such a case, all the assets brought in by the new partner are debited and a share of the premium for goodwill is credited.
In the case of Hidden Goodwill, the value of goodwill is not mentioned at the time of admission of a new partner. It can be considered as one of the methods for calculating the value of goodwill of the firm. This is more prominent in cases, where the new partner does not bring his/her share of goodwill in cash. In such cases, the goodwill of the firm remains hidden and the value of the firm’s goodwill is determined by taking the difference between the capitalized value of the firm and the net worth of the firm. The capitalized value of the firm is ascertained by capitalizing the new partner’s capital on the basis of his/her share of profits.
The following formula is used to ascertain the value of the firm’s goodwill.
Value of Firm’s Goodwill = Capitalised Value of the Firm – Net Worth
Where Capitalized Value of the Firm = Capital of New Partner × Reciprocal of New Partner’s Share
Net Worth = Total Capital of New Firm (including New Partner’s Capital) + Accumulated Profits and Reserves (if any)
OR Net Worth = Total Assets – External Liabilities
Steps to Calculate Value of Firm’s Goodwill
Step 1: Calculate the capitalized value of the firm as:
Capitalized Value of the Firm = Capital of New Partner × Reciprocal of New Partner’s Share
Step 2: Calculate the net worth of the firm as:
Net Worth = Total Capital of New Firm (including New Partner’s Capital) + Accumulated Profits and Reserves (if any)
OR Net Worth = Total Assets – External Liabilities
Step 3: Subtract the value ascertained in step 2 from the value ascertained in step 1 to compute the value of goodwill of the firm. That is, Value of Firm’s Goodwill = Capitalised Value of the Firm – Net Worth
Step 4: The share of goodwill of the new partner is calculated by multiplying the value of goodwill of the firm (as calculated in step 3) by his/her share in profits. New Partner’s Share of Goodwill = Value of Firm’s Goodwill × New Partner’s Share
Adjustment of Accumulated Profits and Losses
If there are any accumulated profits or losses appearing in the books of the old firm at the time of admission of a new partner, then these are distributed among the old partners in their old profit sharing ratio. Such accumulated profits or losses are generally in the form of reserves such as Reserve Fund, General Reserve, Profit and Loss Account, Investment Fluctuation Reserves, Workmen’s Compensation Reserves, etc. The new partner is not entitled to any share of such accumulated profits as all these reserves and losses are accrued to the hard work and past efforts of the old partners.
Revaluation of Assets and Reassessment of Liabilities
Sometimes the value of the assets and liabilities of a firm does not appear at its current value in the books of account. With the passage of time, their values in the books may differ from their current values. It means there could be an increase or decrease in the values. Therefore, at the time of admission of a new partner, it is desirable to ascertain the true current value of all the assets and liabilities. There may also be a situation when some assets or liabilities of a firm are not recorded in the books of account. So, in order to reveal the assets and liabilities of a firm at their current values, an account in the name of a Revaluation Account is prepared. This account may sometimes be called a Profit and Loss Adjustment Account. Any increase in the value of assets and decrease in the value of liabilities is credited to the revaluation account. This is because it is a profit or gain for a firm. On the other hand, any decrease in the value of assets and increase in the value of liabilities are debited to this account. This is because it is a loss to the firm. Also, any unrecorded assets of the firm will be credited and unrecorded liability of the firm will be debited to this account. If the credit side of the revaluation account is more than its debit side then it reveals the profit. On the other hand, if the debit side is more than its credit side it will be considered as a net loss. Any profit or loss from this account will be transferred to the old partner’s capital in their old profit sharing ratio.
Procedure to Prepare Revaluation Account
The following are the various steps involved in the preparation of the Revaluation Account.
- First of all, any decrease in the value of assets and increase in the value of liabilities are recorded on the Debit side of the Revaluation Account.
- Secondly, any increase in the value of assets and decrease in the value of liabilities is recorded on the Credit side of the account.
- If there is any Unrecorded Asset of the firm then it is shown on the Credit side of the account.
- Similarly, any Unrecorded Liabilities are shown on the Debit side of the Revaluation Account.
- Then, Outstanding expenses of the firm are recorded on the Debit side and Prepaid expenses are recorded on the Credit side of the Revaluation Account.
- Similarly, any income that is received in advance is shown on the Debit side and Prepaid expenses (i.e. expenses incurred in advance) are recorded on the Credit side of the Revaluation Account.
- Lastly, if the total of the debit side exceeds the total of the credit side, then it is regarded as Revaluation Loss and is transferred to the Debit Side of the Partners’ Capital Account in their old profit sharing ratio. On the other
- hand, if the total of the debit side is short of the total of the credit side, then it is regarded as Revaluation Profit and is transferred to the Credit Side of Partners’ Capital Account in their old profit sharing ratio.
Partners’ Capital Account
Partners’ Capital Account is prepared to ascertain the closing capital balances of the partners of a firm. These capital balances are shown on the Liabilities side of the New Balance Sheet. Below given is the comprehensive format of the Partners’ Capital Account.
Procedure to Prepare Partners’ Capital Account
The following are the various steps involved in the preparation of Partners’ Capital Account.
- First of all, the opening balance of capital is shown on the credit side of the Partners’ Capital Account as ‘Balance b/d’. In case, if the capital balance of any of the partners appears on the Assets side of the Balance Sheet (in the
question), then it is shown on the debit side of the Capital Account as ‘Balance b/d’.
- Then, Revaluation Profit is transferred to the Credit side and in case of Loss, it is transferred to the Debit side of the capital account.
- Thirdly, we need to transfer reserves such as, General Reserve, Reserve Fund, Investment Fluctuation Fund, Workmen Compensation Fund and Contingency Reserve (see NOTE), Credit Balance of P & L etc. are transferred
to the credit side of the capital account in the old profit sharing ratio of old partners.
- Similarly, on the debit side, losses such as Debit Balance of P & L, Deferred Revenue Expenditure, Advertisement Suspense Account, etc. are transferred to the debit side of the capital account in the old profit sharing ratio of
- Goodwill already appearing in the old balance sheet is transferred to the debit side of the capital account in the old profit sharing ratio of old partners.
- Also, at the time of admission, any amount brought in cash by the new partner as his/her Capital contribution and Premium for Goodwill is recorded on the credit side of the Partners’ Capital Account.
- Premium for goodwill brought in by the new partner is also transferred to the credit side of the Partners Capital Account in the sacrificing ratio of the old partners. In case any partner gains, then his/her gaining share is
recorded is recorded on the debit side of the account.
- If any share of premium credited to the old partners is withdrawn by them, then it is recorded on the debit side of the Partners’ Capital Account.
- If any of the partners has taken-over any of the assets, then it is shown on the Debit side and if any liability is paid-off by any partner, then it is shown on the credit side of the capital account.
- Finally, if the total of the credit side exceeds the total of the debit side, then the final capital balance of the partners is shown ‘Balance c/d’ on the Debit side. On the contrast, if the total of the debit side exceeds the total of the
credit side, then the final capital balance of the partners is shown as ‘Balance c/d’ on the Credit side.
- If the Partners’ Capital Account shows a credit balance (Cr. Side > Dr. Side), then it is also shown on the Liabilities side of the Balance Sheet. On the other hand, if the Partners’ Capital Account shows a debit balance (Dr. Side Cr. Side), then it is shown on the Assets side of the Balance Sheet.
- Also, often there exists some reserves in the form Employees Provident Fund, Provision for Tax, Taxation Reserve, Joint Life Policy (JLP) Reserve and Depreciation Reserve (such as Machinery Replacement Reserve) in the
Old Balance Sheet. It should be noted that such items are not distributed among the partners and are shown on the Liabilities side of the New Balance Sheet of the new firm.
A profit and Loss Account is the second financial statement prepared by an organization. This account is prepared to ascertain the net results of a firm in form of net profit earned or net loss incurred during an accounting period.
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