T.S grewal Accountancy chapter-2 goodwill: solutions, nature and valuation
1.what is goodwill
A goodwill is the value of Reputation, good name and wide business connections of a firm which enables it to earn higher profits in compare to the normal profit earned by the other firms in the same trade,
2: features of goodwill
features of goodwill are as under:
- it is valuable, Intangible Asset
- it helps in earning excess profit
- it is valuable only when entire business is sold.
3: factors affecting the value of goodwill
- nature of business:
- location
- efficiency of management
- market situations
- special advantages like low rate and assured supply of electricity , long term contacts for supply of materials, well known collaborators, patents, trademarks , import licences etc, enjoy higher value of goodwill
4; Need for valuation of goodwill
- change in the profit sharing ration among the existing partners
- Admission of a new partner
- Retirement of a partner
- Death of a partner
- Dissolution of a firm involving sale of business as a going concern
- Amalgamation of a partnership firm
5; categories of goodwill
- purchased goodwill
- self generated goodwill
6; meaning and features of purchased goodwill
goodwill for which a consideration in money or money’s worth has been paid is called purchased goodwill, (features)
- it arises on purchase of a business or brand
- shown in balance sheet as an asset
- it is amortised (depreciated)
7; meaning and features of self-generated goodwill
it is an internally generated goodwill which arises from a number of factors that a running business possess: (features)
- it is generated over the years,
- according to AS-26, it is not recorded in books of accounts,
- it is also known as inherent goodwill
8: methods of valuation of goodwill
- Average profit method
- super profit method
- capitalisation method
(a) capitalisation of Average profit (b) capitalisation of super profit
How to calculate goodwill
1.Average profit method; under this method the goodwill is valued at agreed number of year’s purchase of the average profits of the few years, it is based on the assumption that a new business will not be able to earn any profits during the first few years of its operation. stepwise procedure to calculate goodwill under this method.
step 1: calculate Normal profit or loss for each of the past year, after adjusting any abnormalities,
| calculation of Adjusted profit: profit or loss (given) of the past year (before adjustments) Add: (i) Abnormal losses (like loss by fire, theft, earthquake, etc) (ii) loss on sale of fixed assets (as sale of fixed assets is not a business Activity) (iii) under valuation of closing stock( as it would have reduced profit) (iv) over valuation of opening stock (as it would have reduced profit) (v) capital expenditure treated as an expense (like purchase of machinery treated as an revenue expense) less: (i) Abnormal gains (like profit from speculative activities) (ii) Income from non-Trade investments (as it is not related to normal business activities (iii) profit on sale of fixed assets (as sale of fixed is not a normal business activity) (iv) over valuation of closing stock (as it would have increased the profits) (v) under valuation of opening stock (as it would have increased profit) (vi) Remuneration to partners, if it is already not deducted ( as it is to be paid in future years) |
Adjusted profits
step:2 calculate Total profits by adding past profits of each year,
step;3 calculate Average profit as follow; —Average profit-Total profit/number of year
step:4 goodwill = Average profits X No of years purchase
2. super profit method; The goodwill is valued at agreed number of years’ purchase of the super profits of the past few years, if a firm earns higher profit in compariosn to normal profit (profit generally earned by the other firms of same industry) then the difference is called super profit. goodwill is calculated on the basis of super profits due to future expectations of earning capacity of the firm,
stepwise procedure to calculate goodwill under this method;
- calculate the average profit (as par average profit method)
- calculate the normal profit on capital employed on the basis of the normal rate return
- Formula of Normal profit = capital Employed X Normal Rate of Return/100.[capital employed will be calculated as under;, liabilities side approach:, capital employed (investment) = capital +Reserves -fictitions Assets ( if any)-goodwill-Non-trade investments,
Assets side approach
capital employed = All assets (except goodwill, fictitious assets and Non-trade investments)-outsider’s liabilities
4. super profit = Average profit-Normal profit
5. goodwill = super profit x number of Year’s purchase
3. capitalisation method; under this method the goodwill can be calculated in two ways: (a) by capitalizing the average profits, or (b) by capitalizing the super profits: (a) capitalisation of average profits; under this method, the value of goodwill is ascertained by deducting the actual employed (net assets) in the business from the capitalised value of the average profit on the basis of normal rate of return . this involves the following steps:
step;1 capitalised value of the firm = Average profit X 100 / Normal rate of return
step:2 Net Assets/ capital employed = All Assets (except goodwill), fictitious Assets and Non-Trade -Trade investments )-outsider’s liabilities
step;3 goodwill = capitalised value -capital employed ,
capitalisation of super profits ; goodwill can also be ascertained capitalising the super profit directly.
step:1 calculate Average profit (as par average profit method)
step:2 calculate Normal profit. Normal profir = capital employed X Normal rate of return/ 100
step:3 calculate super profit, ;: super profit = average profit-Normal profit
step:4 goodwill = super profits X 100/ Normal Rate of return
QUESTION:1 (Average profit method)
| Year | Amount |
| 2012 | 96,000 |
| 2013 | 60,600 |
| 2014 | 62,400 |
| 2015 | 84,400 |
Calculate the value of goodwill
solution:
Formula, Average profit = Total profits/ No. of years
Goodwill = average profit X number of years purchase
Average profit = 3,03,400/4 = 75,850,
Goodwill = 75,850 X 2 = 151,700
QUESTION:2 The capital investment of the firm is Rs, 1,20,000. A fair return on the capital having regard to the risk involved is 10%. calculate the value of goodwill on the basis of three years purchase of the super profit for the last three years, profit for the last three years was Rs, 44000,Rs, 40000. Rs, 36000 respectively.
solution:
| Average profit: = 36,000+40,000+44,000 = 40,000 divide 3 Normal profit = capital employed X Normal rate of return 100 Normal profit = 1,20,000 X 10 = Rs, 12,000 divide 100 super profit = Average profit-Normal profit =Rs, 40,000-12,000 =Rs, 28,000 goodwill = super profit X number of years purchased = Rs, 28,000 X 3 = Rs, 84,000 |
QUESTION:3 (capitalisation method): A firm earns Rs, 1,20,000 as its annual profits the rates of normal profit being 10% The assets of the firm amounted to Rs, 14,40,000 and liabilities to Rs, 4,80,000. find out the value of goodwill by capitalisation method.
solution:
| capitalised value of the firm average profit X 100 Normal rate of return = Rs, 1,20,000 X 100 = Rs, 12,00,000 divide 100 capital employed = Total assets-liabilities , Rs 14,40,000-4,80,000 = Rs, 9,60,000 goodwill = capitalised value-capital employed = Rs, 12,00,000-9,60,000 = Rs, 2,40,000 |
QUESTION:4 (Average profit method)‘ A and B are partners in a firm. they admit C into the firm The goodwill for the purpose is to be calculated at 2 years purchase of the average normal profits of the three years which were Rs, 10,000, Rs, 15,000 and Rs, 30,000 respectively. second years, profit included profit on sale of machinery Rs, 10,000 find the value of goodwill of the firm on C’;s Admission
solution;
| calculation of average profit | |
| year ended | Amount |
| 1st year | 10,000 |
| 2nd year(15,000-10,000) | 5,000 |
| 3rd year | 30,000 |
| Total profits | 45,000 |
| Average profit = Total profit = 45, 000 = Rs, 15,000 No. of years 3 goodwill = average profit X No. of years of purchase = Rs, 15,000 X 2 = Rs, 30,000 |
QUESTION;5 (super profit method): The average net profits expected of a firm in future are Rs, 68,000 per year and capital invested in the business by the firm is Rs, 3,50,000. The rate of interest expected from capital invested in this class of business is 12%. the remuneration of the partners is estimated to be Rs, 8,000 for the year you are required to find out the value of goodwill on the basis of two year’s purchase of super profits.
solution:
| Average profit = average net profit-partner’s remuneration (i) Average profit = Rs, 68,000-Rs, 8,000 = Rs, 60,000 (ii) Normal profit = capital employed X Normal rate of return divide 100 =Rs,3,50,000 X 12=Rs, 42,000 100 (iii) super profit = average profit-Normal profit 60,000-42,000 = Rs, 18,000 (iv) value of goodwill = super profit X No. of years’ purchase = Rs, 18,000 X 2 = Rs, 36,000 |
QUESTION:6 (super profit method): on april 1st , 2014 an existing firm had assets of Rs, 75,000 including cash of Rs, 5,000 The partners capital accounts showed a balance of Rs, 60,000 and reserves constituted the rest, if the normal rate of return is 20% and the goodwill of the firm is valued at Rs, 24,000 at 4 years purchase of super profits find the average profits of the firm,
solution:
| (1) calculation of Normal profit = capital employed X Normal rate 100 = 75,000 X 2 = Rs, 15.000 100 (2) calculation of super profit: goodwill = super profit X no. of yaers purchase Rs 24,000 = super profit X 4 super profit = 24,000 = Rs, 6,000 divide 4 (3) calculation of average profit: super profit = average profit-Normal profit 6000 = average profit- 15,000 average profit = Rs, 6,000+Rs 15,000 = Rs, 21,000 |
QUESTION:7 M/S Aradhya having the assets of Rs, 10,00,000 and liabilities of Rs, 4,20,000 The firm earn the annual profit of Rs, 90,000. the rate of interest expected from the capital having regard to the risk involved is 15%. calculate the amount of goodwill by capitalisation of super profit method.
solution:
| super profit = average / Actual profits-Normal profits Actual profits = Rs, 90,000 Normal profit = capital employed X Normal rate of return 100 capital employed = Total Assets-outsider’s liabilities = 10,00,000-4,20,000 = Rs, 5,80,000 Normal profit = Rs, 5,80,000 X 15 = Rs, 87,000 divide 100 super profit = Rs 90, 000-87,000 = Rs, 3,000 goodwill = super profits X 100 Normal rates of return = Rs, 3000 X 100 15 goodwill = Rs, 20,000 |