When admitting a new partner to a partnership a lot of accounting adjustments need to be made. One such major adjustment is the valuation and the treatment of goodwill. Let us take a look.
Meaning of Goodwill
Goodwill is the value of the reputation of a firm built over time with respect to the expected future profits over and above the normal profits. A well-established firm earns a good name in the market, builds trust with the customers and also has more business connections as compared to a newly set up business. Thus, the monetary value of this advantage that a buyer is ready to pay is termed as Goodwill.
The buyer who pays expects that he will be able to earn super profits as compared to the profits earned by the other firms. Thus, it can be said that goodwill exists only in case of firms making super profits and not in case of firms earning normal profits or losses. It is an intangible real asset which cannot be seen or felt but exists in reality and can be bought and sold.
Factors Affecting the Value of Goodwill
- Nature of business: A firm that deals with good quality products or has stable demand for its product is able to earn more profits and therefore has more value.
- Location of business: A business which is located in the main market or at a place where there is more customer traffic tends to earn more profit and also more goodwill.
- Owner’s reputation: An owner, who has a good personal reputation in the market, is honest and trustworthy attracts more customers to the business and makes more profits and also goodwill.
- Efficient management: An organization with efficient management has high productivity and cost efficiency. This gives it increased profits and also high goodwill.
- Market situation: The organization having a monopoly right or condition in the market or having limited competition, enables it to earn high profits which in turn leads to higher value of goodwill.
- Special advantages: A firm that has special advantages like import licenses, patents, trademarks, copyrights, assured a supply of electricity at low rates, subsidies for being situated in a special economic zones (SEZs), etc. possess a higher value of goodwill.
Need for the Valuation
In the context of a partnership firm, the need for valuation of goodwill arises at the time of:
- Change in the profit sharing ratio amongst the existing partners
- Admission of a new partner
- The retirement of a partner
- Death of a partner
- Dissolution of a firm where business is sold as going concern.
- Amalgamation of partnership firms
Methods of Valuation
1] Average Profits Method
i) Simple Average: Under this method, it is valued at agreed number of years’ of purchase of the average profits of the past years.
Goodwill = Average Profit × No. of years’ of purchase
ii) Weighted Average: Under this method, it is valued at agreed number of years’ of purchase of the weighted average profits of the past years. The weighted average is used when there exists an increasing or decreasing trend in the profits. Highest weight is given to the current year’s profit.
Goodwill = Weighted Average Profit × No. of years’ of purchase
2] Super Profits Method:
Under this method, valued at agreed number of years’ of purchase of the super profits of the firm.
Goodwill = Super Profit × No. of years’ of purchase
Super Profit = Actual/ Average profit – Normal Profit
Normal Profit = Capital Employed * Normal Rate of Return/100
3] Capitalization Method:
(i) Capitalization of Average Profits: Under this method, the value of goodwill is calculated by deducting the actual capital employed from the capitalized value of the average profits on the basis of a normal rate of return.
Goodwill = Capitalized Average profits – Actual Capital Employed
Capitalized Average profits = Average Profits × 100/Normal Rate of Return
Actual Capital Employed = Total Assets (excluding goodwill) – Outside Liabilities
(ii). Capitalization of Super Profits: Under this method, it is calculated by capitalizing the super profits directly.
Goodwill = Super Profits × 100/ Normal Rate of Return
When the value of goodwill is not given at the time of admission of a new partner, it has to be derived from the arrangement of the capital and the profit sharing ratio and is known as hidden goodwill.
For example, A and B are partners sharing profits equally with capitals of Rs.50,000 each. They admitted C as a new partner for one-third share in the profit. C brings in Rs.60,000 as his capital. Based on the amount brought in by C and his share in profit, the total capital of the newly constituted firm works out to be Rs.1,80,000 (Rs. 60,000 × 3).
But the actual total capital of A, B and C is Rs.1,60,000 (50,000 + 50,000+ 60,000). Hence, it can be said that the difference is on account of goodwill,i.e., Rs.20,000 (1,80,000 – 1,60,000).
Solved Example for You
Q: M/s Mehta and sons earn an average profit of rupees 60,000 with a capital of rupees 4,00,000. The normal rate of return in the business is 10%. Using capitalization of super profits method, calculate the value the goodwill of the firm.
Goodwill = Super profits × 100/ Normal Rate of Return
= 20,000 × 100/10
(i). Normal Profit = Capital employed * Normal Rate of Return/100
= 4,00,000 × 10/100
(ii) Super Profit = Average Profit – Normal Profit
= 60,000 – 40,000