TREATMENT OF GOODWILL

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Savita Mahendru

Asst Lecturer in Commerce�HRMMV

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Goodwill

• When partners carry on business with their firm for a long time, they earn a reputation for it. This reputation translates in monetary terms into expected future profits above normal profits. We commonly refer to this excess profit as the firm’s goodwill. Let’s understand the concept of goodwill in detail.
• Goodwill is nothing but the reputation of a partnership firm. It is computed on the basis of expected profits in excess of normal profits. It denotes the firm’s capacity to earn a greater profit in the future based on its track record.
• All firms functioning in a geographical area and working in the same business can expect to earn similar profits. If one firm earns excess profits than it expects, this is due to its goodwill. This can happen because of various factors. For example, it offers better customer service or its partners have a greater market reputation.

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• For example, two partners have owned a popular bakery since 2000. The bakery’s total worth (assets-liabilities) is Rs. 30 lakhs. The partners decided to sell their bakery in 2015. A prospective buyer offers Rs. 32 lakhs for their entire business. The excess of Rs. 2 lakhs is the goodwill they earned over 15 years.

Nature of Goodwill

We have to treat goodwill in accounting terms as an asset. It is not a physical asset because we cannot see or touch it. Despite this, we treat it as an intangible asset because we derive some value from it.

According to Accounting Standards, an intangible asset must contain the following features. Since goodwill contains all these characteristics, we can conclude that it is an intangible asset.

• It must have characteristics of assets. This means that it must have some clearly identifiable value.
• The asset must have future economic benefits. The firm must be able to expect and predict what value they will get from it.
• Its value must be measurable. It is not an asset if we cannot measure its value in monetary terms.

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Calculation of Goodwill

According to Accounting Standards, partners have to compute their firm’s goodwill for the following purposes:

• A new partner joins a firm
• An existing partner retires or dies
• Partners want to dissolve the firm
• Partners change their profit sharing ratio

In all these cases, partners have to first calculate and distribute existing goodwill before taking further steps.

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Factors Affecting Goodwill

There is no exhaustive list of factors affecting goodwill. The following factors, however, commonly affect a firm’s goodwill:

• Partners’ ability to attract customers due to their reputation
• Quality of goods or services
• Customer satisfaction
• Location of business
• Possession of intellectual property rights like trademarks
• Monopoly rights like exclusive license to sell the product
• Possession of special contracts to make goods available easily
• Good managerial skills
• How much the company has spent on R&D

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Methods of Goodwill Valuation

• 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 for Goodwill expects that he will be able to earn super profits as compared to the profits earned by the other firms. Thus, goodwill exists only in the case of firms making super profits and not in the case of firms earning normal profits or losses.
• Goodwill is recorded in the books only when some consideration in money or money’s worth is paid for it. Thus, in the context of a partnership firm, the need for valuation of goodwill arises at the time of:

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• 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

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Methods of Valuation of Goodwill

1. Average Profits Method

• i] Simple Average: Under this method, the goodwill is valued at the agreed number of years’ of purchase of the average profits of the past years. Goodwill = Average Profit x No. of years’ of purchase
• ii] Weighted Average: Under this method, the goodwill is valued at an agreed number of years’ of purchase of the weighted average profits of the past years. We use the weighted average when there exists an increasing or decreasing trend in the profits giving the highest weight to the current year’s profit.

Goodwill = Weighted Average Profit x No. of years’ of purchase

Weighted Average Profit = Sum of Profits multiplied by weights/ Sum of weights

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2. Super Profits Method

(i) The Number of Years Purchase Method: Under this method, the goodwill is valued at the agreed number of years’ of purchase of the super profits of the firm.

• Goodwill = Super Profit x No. of years’ of purchase
• # Super Profit = Actual or Average profit – Normal Profit
• # Normal Profit = Capital Employed x (Normal Rate of Return/100)

(ii) Annuity Method: This method considers the time value of money. Here, we consider the discounted value of the super profit.

• Goodwill = Super Profit x Discounting Factor

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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 the normal rate of return.

• Goodwill = Normal Capital – Actual Capital Employed
• # Normal Capital or Capitalized Average profits = Average Profits x (100/Normal Rate of Return)
• # Actual Capital Employed = Total Assets (excluding goodwill) – Outside Liabilities

(ii) Capitalization of Super Profits: Under this method, Goodwill is calculated by capitalizing the super profits directly.

• Goodwill = Super Profits x (100/ Normal Rate of Return)

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Accounting Treatment of Goodwill in case of Admission of Partner

The incoming partner brings in some amount as his share of Goodwill or Premium to compensate the existing partners for the loss of their share in the future profits of the firm. Thus, at the time of admission of a partner, there are following two ways to treat goodwill.

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1] Premium Method

• Under this method, when the incoming partner brings his share of goodwill in cash, the existing partners share it in the sacrificing ratio. However, when the amount of goodwill is paid privately by the new partner to old partners privately in cash, no entry is passed in the books of the firm.
• Alternatively, we can credit the share of goodwill that the new partner brings in cash to the new partner’s capital account and then adjust existing partners’ capital accounts in their sacrificing ratio. The following are the Journal Entries:

B. When Goodwill already exists in the books:

(b) Goodwill continues to appear in the books:

• When the partners decide that goodwill continues to appear in the books, the new partner will bring his proportionate share of goodwill only in respect of the difference between the new value and the book value. All the journal entries in this respect are the same.

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2] Revaluation Method

• We use this method when the new partner decides not to bring his share of goodwill in cash. Thus, we need to raise the goodwill account in the books by debiting Goodwill account and crediting old partners’ capital accounts in the old profit-sharing ratio.

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