CHAPTER 8 – PARTNERSHIP ACCOUNTS – UNIT 2 – TREATMENT OF GOODWILL

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Chapter 8 – Partnership Accounts

Unit 2 – Treatment of Goodwill in Partnership

Accounts

Meaning of Goodwill Goodwill means reputation.

Need for Valuation of Goodwill 1. When a running business organisation is sold as a going concern; and

2. When there is a change in the constitution of a partnership firm.

Methods of Valuation of Goodwill

Average Profit Method 𝐺𝑜𝑜𝑑𝑤𝑖𝑙𝑙 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 × 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠′𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒

Average Profit Average Profit could either by Simple Average or Weighted Average.

Following steps are followed to calculate the weighted average:

1. Every year is assigned a weight.

2. Profit of every year is multiplied by the weight assigned to it.

3. The sum of the products as calculated above is divided by the sum of the weights.

Year (a)

Profit/(Loss) (b)

Weight (c)

Product (d) = (b) × (c)

1 1,00,000 1 1,00,000 2 2,50,000 2 5,00,000 3 4,00,000 3 12,00,000

Total 6 18,00,000

𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 =18,00,000

6= 3,00,000

Number of Years’ Purchase Number of year’s purchase means the number of years for which the firm can expect to earn the same

amount of profit after the change in ownership because of the efforts put in the past.

Algorithm for Calculation of Goodwill Step 1 – Calculation of Normal Business Profit/Adjusted Profit for each year.

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In order to calculate the Normal Business Profit or the Adjusted Profit, the following table is made for as

many years as are given in the question:

Particulars Year 1

Year 2

Year 3

Reason

Given Profit/(Loss)

Add:

Abnormal Losses (e.g. Loss by fire, loss by theft, etc.)

Abnormal Losses are not normal business activities. Since the profit gets adversely affected when such losses are debited to the Profit & Loss A/c, they should be added back in order to ascertain the correct, or the normal profit.

Loss on Sale of Fixed Assets

Loss on Sale of Fixed Assets is not a normal business activity. Since the profit gets adversely affected when such losses are debited to the Profit & Loss A/c, they should be added back in order to ascertain the correct, or the normal profit.

Overvaluation of Opening Stock

Overvaluation of Opening Stock results in reduced profit. Therefore, it should be added to ascertain the correct, or the normal profit.

Undervaluation of Closing Stock

Undervaluation of Closing Stock results in reduced profit. Therefore, it should be added to ascertain the correct, or the normal profit.

Non-recurring Expenses

An expense which is non-recurring would not reduce the profit of every year in the future. Therefore, it should be added to ascertain the correct, or the normal profit.

Capital Expenditure charged as Revenue Expenditure

Capital Expenditures are not charged to profit and loss account while revenue expenditures are charged to profit and loss account. If capital expenditure is charged as a revenue expenditure, this means that the profit is reduced to the extent of the capital expenditure. Therefore, it should be added to ascertain the correct, or the normal profit.

Less:

Abnormal Gains Abnormal Gains are not normal business activities. Since the profit increases when such gains are credited to the Profit & Loss A/c, they should be reduced in order to ascertain the correct, or the normal profit.

Overvaluation of Closing Stock

Overvaluation of Closing Stock results in increased profit. Therefore, it should be reduced in order to ascertain the correct, or the normal profit.

Undervaluation of Opening Stock

Undervaluation of opening stock results in increased profit. Therefore, it should be reduced to ascertain the correct, or the normal profit.

Non-Recurring Incomes

An income which is non-recurring would not increase the profit of every year in the future. Therefore, it should be reduced to ascertain the correct, or the normal profit.

Partners’ Remuneration (if it is not deducted)

Partners’ Remuneration, if not deducted, needs to be deducted in order to ascertain the correct, or the normal profit.

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Any other future expense

Any other future expense will reduce the profit, and hence, it is deducted in order to ascertain the correct, or the normal profit.

Step 2 – Find out the simple average or the weighted average of the adjusted profits as calculated in step

1 for all the years.

Step 3 – Determine the Number of Years’ Purchase.

Step 4 – Goodwill = Average Profit × Number of Years’ Purchase.

Super Profit Method

Determination of Capital Employed Balance Sheet

Liabilities ₹ Assets ₹

Capital A/cs: Land 2,00,000 A 50,000 Building 5,00,000 B 1,50,000 Plant 1,00,000 C 3,00,000 Stock 45,000 General Reserve 4,50,000 Debtors 50,000 Bank Loan 5,00,000 Cash 2,00,000 Creditors 45,000 Bank 4,00,000

14,95,000 14,95,000

The boxed portion in the above balance sheet, i.e. the capital accounts of A, B, and C, and the General

Reserve is the capital employed. Capital employed is basically what belongs to the owners.

There are two ways of calculating the capital employed:

1. Liabilities Side Approach

2. Asset Side Approach

Average Capital Employed

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 =𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

2

OR

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + (1

2 × 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟′𝑠 𝐷𝑟𝑎𝑤𝑖𝑛𝑔𝑠)

CHAPTER 8 – PARTNERSHIP ACCOUNTS – UNIT 2 – TREATMENT OF GOODWILL

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− (1

2 × 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟′𝑠 𝑃𝑟𝑜𝑓𝑖𝑡)

Annuity Method Question

A firm of A, B, and C has a total capital investment of ₹4,50,000. The firm earned net profits during the last

four years as I – ₹70,000; II – ₹80,000; III – ₹1,20,000 and IV – ₹1,00,000. The reasonable expected return

is 15% having regard to the risk involved. Find out the value of goodwill of the business if it is based on 3

years’ purchase of the average super profits of the past four years. Also, calculate the goodwill using the

Annuity method.

(ICAI Study Material – Modified)

Solution

Normal Profit =

=

= ₹ 67,500

Super Profit =

=

Goodwill =

=

= ₹ 75,000

Calculation of Goodwill using Super Profit Method

Capital Employed × Normal Rate of Return

₹4,50,000 × 15%

=₹70,000 + ₹80,000 + ₹1,20,000 + ₹1,00,000

– ₹ 67,5004

₹ 25,000

Super Profit × Number of Years' Purchase

₹25,000 × 3

Average Profits – Normal Profit

1

1.15

1

(1.15)2

1

(1.15)3

57,080.63

1 25,000 = 0.8696 21,739.13

Calculation of Goodwill using Annuity Method

Year Super ProfitDiscounting

Factor @ 15%Present Value

16,437.91

18,903.59

3 25,000 = 0.6575

2 25,000 = 0.7561

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Capitalisation Method