NOTES

CHAPTER 3: Goodwill: Nature and Valuation

Goodwill: is an intangible asset which places an enterprise at an advantageous position due to which the enterprise is able to earn higher profits without putting extra efforts.

Characteristics or features of goodwill

1. It is an intangible asset.
2. It does not have an existence separate from that of an enterprise.
3. It helps in earning higher profits.
4. It is the context of the partnership.

Methods of valuation of Goodwill

1. Average profit method:
1. simple average profit method
2. Weighted average profit method
2. Super profit method
3. Capitalization method:
1. Capitalization of average profit method
2. Capitalization of super profit

Example 1:

A Ltd. acquired the business of S for the purchase consideration of Rs. 5,00,000 payable by cheque. The assets acquired and liabilities taken over are:-

Assets	Rs.	Liabilities	Rs.
Furniture Inventory Debtors	10,000 7,50,000 1,50,000	Creditors Salaries payable Outstanding Expenses	5,20,000 75,000 15,000

Pass the journal entries.

Solution:

Date	Particulars	L.F.	Debit	Credit
	Furniture A/c Dr. Inventory A/c Dr. Debtors A/c Dr. Goodwill A/c (bal fig) Dr.  To creditors A/c  To salaries payable A/c  To outstanding expenses A/c  To S		10,000 7,50,000 1,50,000 2,00,000	5,20,000 75,000 15,000 5,00,000
	S A/c. Dr.  To Bank A/c		5,00,000	5,00,000

Example 2:

Amen purchased B’s business with effect from 1^st April 2019. It was agreed that the firm’s goodwill will be valued at two year’s purchase of average normal profit of the last three years. Profits of B business for last three years ended 31^st march were:-

 2017: Rs. 1,00,000 (including an abnormal gain of Rs. 10,000)
 2018: Rs. 1,10,000 (after charging an abnormal loss of Rs. 20,000)
 2019: Rs. 85,000 (including interest of 5,000 from non-trade investment)

Calculate value of the firm’s goodwill.

Solution:

	Adjustments	Normal profit
Profit for the year ended 31st March 2017 Profit for the year ended 31st March 2018 Profit for the year ended 31st March 2019	(1,00,000 − 10,000) (1,10,000 + 20,000) (85,000 − 5,000)	90,000 1,30,000 80,000
Average profit: total numbers profit	= 3,00,000	= 1,00,000

Average profit:

$$\frac{\text{Total Numbers Profit}}{\mathrm{Number\; of\; years}}=\frac{\mathrm{3,00,000}}{3}=\mathrm{1,00,000}$$

Goodwill:

 Average Profit × No. of year’s purchase

 = 1,00,000 × 2 = 2,00,000

Example 3:

Profits of the firm for the last 5 years were:-

Year ended	31st March 2015	31st March 2016	31st March 2017	31st March 2018	31st March 2019
Profits	40,000	48,000	60,000	50,000	36,000

Calculate the value of goodwill on the basis of three year’s purchase of the weighted average profit after assigning weights 1, 2, 3, 4 and 5 respectively to the profits for the year ended 31^st march 2015, 16, 17, 18 and 19.

Solution:

Year Ended A	Profit B	Weight C	Weighted profit D = B × C
31st March 2015 31st March 2016 31st March 2017 31st March 2018 31st March 2019	40,000 48,000 60,000 50,000 36,000	1 2 3 4 5	40,000 96,000 1,80,000 2,00,000 1,80,000
Total		15	6,96,000

Weighted average profit = $\frac{\text{Total of Weighted Profit}}{\text{Total of Weights}}=\frac{6,96,000}{15}=46,400$

Difference between Super profit and Average profit

Basis	Average Profit	Super Profit
Meaning	It is average of the profits of past agreed years.	It is excess of average profit over normal profit.
Normal rate of return	Is not relevant in the calculation of average profit.	Is considered while calculating the super profit.
Average capital employed	Is not considered while calculating average profit.	Is taken into account while calculating the super profit.
Relevance of valuing goodwill	Is relevant for average profit method, super profit method or capitalization method of valuation of goodwill.	Is relevant for super profit method and capitalization of super profit method of valuation of goodwill.