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54 views

NOTES

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agrasenhardware16
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CHAPTER 2

Goodwill: Nature and Valuation

Meaning:It is an Intangible asset which places an enterprise at an advantageous


position due to which the enterprise is able to earn higher profits without extra
efforts.

When Valuation of Goodwill Is done

 When there is change in PROFIT SHARING RATIO


 When a new partner is ADMITTED
 When a partner RETIRES or DIES
 When partnership Firm is SOLD
 When TWO or MORE firms AMALGAMATE

METHOD OF VALUATION OF GOODWILL

AVERAGE PROFIT SUPER PROFIT CAPITALISATION

AVERAGE PROFIT METHOD

SIMPLE AVERAGE PROFIT WEIGHTED AVERAGE PROFIT


SIMPLE AVERAGE PROFIT METHOD

GOODWILL : Average profit * No of years Purchased

AVERAGE PROFIT = *Normal profit for all the years


** No. of Years

*Calculation of NORMAL BUSINESS PROFIT

PROFIT /LOSS of PAST YEARS ------------

ADD:
 Abnormal loss (Loss by Theft of Fire) ------
 Loss on sale of Fixed assets ------
 Overvaluation of Op . Stock ------
 Undervaluation of Closing Stock ------
 Non-Recurring Expenses ------
 Capital Expenditure ------ -------

LESS:
 Abnormal Gains ------
 Profit on sale of Fixed Assets ------
 Undervaluation of Op.Stock ------
 Overvaluation of Closing Stock ------
 Non Recurring Income ------
 Partners Remuneration ------
 Income from Non Trade Investments ------
 Future Expenses (Insurance Premium) ------ -------

**No of years purchase means the number of years for which the firm is likely to earn same
amount of profit in future.

Drawbacks of Simple Average Method

1. Trend of profitability is not considered since each year’s profits are given equal
weightage.
2. Distinction is not made between a business that has rising profits and one that has
falling profits.
 This gave rise to a new method that is Weighted Average method.
WEIGHTED AVERAGE METHOD

 This method is used when profits shows rising trend or falling trend.
 This method is preferred as it gives more weightage to latest profit, which is
likely to be maintained in the future by the firm.
 Under this method weights are assigned to each year. If the profits show
increasing trend then highest weight is assigned to current year, like 1,2,3,4 ….
 If profit shows decreasing trend then lowest weight is assigned to the current
year’s profit like …4,3,2,1.

STEPS INVOLVE IN CALCULATING GOODWILL BY WEIGHTED AVERAGE METHOD

1.Calculation of NORMAL PROFIT (i.e. adjusting abnormalities in NET PROFIT)

2. Calculation of WEIGHTED PROFIT by multiplying NORMAL PROFIT with their respective


weight.

3.Calculate the total of WEIGHTS and total of WEIGHTED PROFITS.

4. Calculate WEIGHTED AVERAGE PROFITS with the help of the following formula:

WEIGHTED AVERAGE PROFITS = TOTALS OF WEIGHTED PROFITS


TOTALS OF WEIGHTS

5. Calculation of GOODWILL with the help of following formulas:

GOODWILL = WEIGHTED AVERAGE PROFITS *NUMBER OF YEARS’ PURCHASE


SUPER PROFIT METHOD
In this method GOODWILL is calculated on the basis of ‘Excess Profit’ earned by the firm in
comparison to the competitor firm. This ‘EXCESS PROFIT’ is termed as ‘SUPER PROFIT’. Thus
Super Profit is Excess of ACTUAL PROFIT over the NORMAL PROFIT.

FORMULA:GOODWILL = SUPER PROFIT * NO of PURCHASE YEARS

SUPER PROFIT = AVERAGE PROFIT –NORMAL PROFIT

NORMAL PROFIT = AVERAGE CAPITAL EMPLOYED * NORMAL RATE OF RETURN/100

STEPS in calculating Goodwill by Super profit method

1. Calculation of CAPITAL EMPLOYED by Asset approach or Liabilities approach method:

ASSET APPROACH

CAPITAL EMPLOYED = Total assets – (Goodwill + Non Trade Investments+Ficticious Assets)


- External Liabilities

LIABILITY APPROACH

CAPITAL Employed = SHARE CAPITAL/ PARTNERS CAPITAL +RESERVE and SURPLUS –


(GOODWILL+ NON TRADE INVESTMENT +FICTICIOUS ASSETS)

2. CALCULATION OF AVERAGE CAPITAL EMPLOYED:

A.C.E = Opening capital employed +Closing Capital employed


2

3. CALCULATION OF NORMAL PROFIT

N.P = Average capital employed * Normal Rate of return


100

4. CALCULATION OF SUPER PROFIT:

S. P= ACTUAL PROFIT –NORMAL PROFIT

5. CALCULATION OF GOODWILL:

G.W = Super profit *No of year’s purchased


CAPITALISATION METHOD

CAPITALISATION OF AVERAGE PROFIT CAPITALISATION OF SUPER PROFIT

Steps in calculating GOODWILL by Capitalisation of Average


profit

1. Calculate AVERAGE NORMAL PROFIT.

2. Calculate capitalized value of the firm with the help of the given formula:

Capitalized value of business = Average profit *100


Normal rate of return

3. Calculate the value of NET ASSET / CAPITAL EMPLOYED

NET ASSETS = All Assets -(Goodwill + Non Trade Investments + Fictitious assets +
Outside Liabilities)

4. GOODWILL = CAPITALISED value of Business – NET Assets

*This method is useful when Average Profit is less than Normal Profit.

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