METHODS OF GOODWILL VALUATION

ACCOUNTING FOR PARTNERSHIP FIRMS

LESSON - 12

METHODS OF GOODWILL VALUATION

1) AVERAGE PROFIT METHOD

            a) Simple average profit method

                        Under this method the profits earned by the partnership business for a specific number of years are considered for the calculation of goodwill.

FORMULA

                        Goodwill         =     Average profit     *     Number of years purchase

                        Here average profit is the total profit of the number of years upon the specific number of years we have considered for the calculation of goodwill. The number of years purchase means the

years for which the firm is likely to earn the same amount of profit. This method of calculating goodwill is mainly used by the newly purchased business, when a buyer buys the business he calculates the future possibilities of profits by the firm.

PROCEDURE OF CALCULATION OF GOODWILL UNDER SIMPLE AVERAGE PROFIT METHOD

Step 1 : Calculate Normal Profit. Total profit of the firm may have many unexpected and extraordinary items, so first normal profit of the business should be calculated by adjusting those extraordinary items.

             Profit/loss before adjustments                                                                                                XXX

           

              ADD:

                        - Abnormal losses                                                                                    XXX

                        - Loss on sale of fixed asset                                                                    XXX

                        - Overvaluation of  opening stock                                                            XXX

                        - Undervaluation of closing stock                                                            XXX

                        - Expenses which are not expected to arise in future                                XXX

                        - Any capital expenditure wrongly charged as revenue expenses            XXX                    

Note : All the above items are unexpected situations which had reduced the normal

profit of the firm.

            LESS:

                        - Abnormal gains                                                                                    XXX

                        - Overvaluation of closing stock                                                            XXX

                        - Undervaluation of opening stock                                                          XXX

                        - Incomes that are not expected in the future                                          XXX

                        - Partner's remuneration not deducted                                                    XXX                      

Note : All the above items are unexpected items which had increased the normal

profit of the firm so it has to be deducted.

                                                                                                    ADJUSTED PROFIT             TOTAL        

Step 2 : Find Average profit of the business

FORMULA

                    Average profit         =         Total profit of number of years       

                                                                            Number of years

Step 3 : Determine the number of years purchase. The number of the years the partnership firm is expected to earn the same amount of profit.

Step 4 : Calculate the value of goodwill by applying formula

FORMULA

                  Goodwill                 =         Average profit         *        Number of years purchase

b) Weighted average profit method

            

                The method of calculation is similar to the simple average profit method. Under this method a value (weight) is allotted for every year, the profit of the particular year is multiplied to the weight assigned to that year to get the product, then the total of products are divided by the total of the weights (value) assigned for every year to get the average profit. Usually more values (weights) are assigned to the recent years.

PROCEDURE FOR CALCULATING GOODWILL UNDER WEIGHTED AVERAGE PROFIT METHOD 

Step 1 : Calculate Normal Profit. Total profit of the firm may have many expected and extraordinary items, so normal profit of the business should be calculated first by adjusting those extraordinary items.

            The process is same as the previous method

                    - consider each years profit

                    - Deduct abnormal gains

                    - Deduct recurring expenses

                    - Add abnormal losses

Step 2 : Weights (values) are to be assigned for every year

Step 3 : Find average profit

                    - Each years profit is multiplied by its weight assigned

                    - Calculate total products and the total weights

FORMULA

            Weighted Average            =               Total profit or product        

                        Profit                                         Total of weights

Step 4 : Calculate goodwill by applying the formula

FORMULA

                    Goodwill = Weighted average profit         *        Number of years purchased

2) SUPER PROFIT METHOD

            

            Why some business earn more profit and other similar businesses don't ? Imagine if similar business of same resources (investment, workings etc.) are operating why are they not earning the same amount of profit ?

                    Every business earns profit but some business earn more profit than normal amount of profit than that of the other similar business with same investments etc. This excess amount of profit 

earned than the normal profit of the other similar business is called "super profit".

While calculating super profit three things are to be considered

        a) Average profit - the profit that is adjusted after all extraordinary and non-business activities

        b) Normal rate of return - The rate of return (profit) normally earned by the other similar type of business

        c) Capital employed - The money invested for running the business

Capital employed can be found using two ways

1) Liabilities side approach

            Using the information form the liabilities side we can calculate the amount of money invested in the business.

FORMULA 

                    Capital employed     =     Capital     +     Reserves     -     Fictitious asset     -     non-trade investments

2) Asset side approach

            Using the information given in the asset side we can calculate the amount of money invested in the business. 

FORMULA

                    Capital employed     =         All assets ( except goodwill, fictitious asset and non-trade investments)     -     outside liabilities

Note: As capital employed fluctuates time to time average capital employed should be calculated  

FORMULA

             Average capital employed       =     Opening capital employed  +  Closing capital employed

                                                                                                                        2

PROCEDURE FOR CALCULATING GOODWILL UNDER SUPER PROFIT METHOD

Step 1: Calculate average capital employed

Step 2: Calculate adjusted profit

Step 3: Calculate normal profit

FORMULA

                                Normal profit         =         Average capital     *        Normal rate of return    

                                                                                     employed                            100

Step 4: Calculate super profit

FORMULA

                Super profit            =            Average profit    -    Normal profit

Step 5: Calculate goodwill by applying the formula

FORMULA

                Goodwill                 =          Super profit        *        number of years purchase  

3) CAPITALIZATION METHOD

a) Capitalization of average profit

            

                In capitalization method goodwill is calculated by deducting capital employed from capitalized value of average profit on the basis of normal rate of return (profit).

FORMULA

                        Capitalized average     =        Average profit     *        100  

                                        profit                              Normal rate of return

PROCEDURE FOR CALCULATING GOODWILL UNDER CAPITALIZATION OF AVERAGE PROFIT METHOD 

Step 1: Calculate average profit

Step 2: Find the capitalized value of average profit by applying the formula

Step 3: Calculate the value of net assets

Step 4: Calculate goodwill by applying the formula

FORMULA

            Goodwill         =        Capitalized value of average profit    -    net asset

b) Capitalization of super profit

           

                The process of capitalizing the super profit is similar to the process of capitalization of average profit. Goodwill is calculated by capitalizing super profit

PROCEDURE FOR CALCULATING GOODWILL UNDER CAPITALIZATION OF SUPER PROFIT METHOD

Step 1: Find super profit same as by the super profit method (by finding normal and average profit)

Step 2: Capitalize super profit to get the amount of goodwill by directly applying the formula

FORMULA

            Goodwill        =        Super profit         *                  100       

                                                                                        Rate of return

ACCOUNTING TREATMENT OF GOODWILL

ACCOUNTING FOR PARTNERSHIP FIRMS 

LESSON - 11

ACCOUNTING TREATMENT OF GOODWILL

            Goodwill is an intangible asset which means it cannot be seen like other physical assets Example: Furniture, machinery etc. It is called an asset because it places the firm at an advantageous position so that the firm may earn higher amount of profits than the other similar firms. Goodwill cannot be formed overnight, is has to be earned by the efforts made by the firm over the past years.

            Goodwill will allow the firm to earn more profits than normal in the future with the same amount of efforts. There are many factors that contribute towards goodwill of a firm. Example location of the firm, brands, trademarks, patents, regular customer, reputation of the firm and its partners etc.

CLASSIFICATION OF GOODWILL:

1) PURCHASED GOODWILL

            A goodwill is said to be purchased goodwill if it is acquired by the firm by paying cash or any equivalent kind for it. This situation happens during purchase of new businesses. Purchased goodwill is to be recorded in the book of accounts.

2) SELF-GENERATED GOODWILL

            Self generated goodwill is earned by the efforts of the business. It depends upon the efforts and commitment the business has made all these years.

            According to ACCOUNTING STANDARD - 26 goodwill should be recorded in the books of accounts only if consideration in money is paid for it. Self generated good will will not be recorded in the books of accounts unless it is sold or purchased or any cash/equivalent is paid for it.

           As goodwill is recorded only when consideration in money is paid for it. So at the time of admission or retirement or death or change in profit-sharing ratio, goodwill is mostly not raised, it is adjusted through the capital accounts of the partners. During these times when the agreements are revised, when there is a change in the profit sharing ratio among the partners the gaining partner should compensate the sacrificing partners in the form of goodwill.

FORMULA:

                                Amount of compensation       =    Value of firm's  * Share of profit

                                                    payable                           goodwill                  gained

JOURNAL ENTRIES

1) WHEN FOLLOWING FLUCTUATING CAPITAL METHOD:

            Gaining partner's capital a/c                 Dr.             XXX

                To sacrificing partner's capital a/c                                    XXX

            (being adjustment made for goodwill)

2) WHEN FOLLOWING FIXED CAPITAL METHOD:

            Gaining partner's current a/c                 Dr.             XXX

                To sacrificing partner's current account                           XXX

            (being adjustment made for goodwill)

WHEN IS VALUATION OF GOODWILL DONE ?

        - Change in profit sharing ratio among partners

        - Any new partner is admitted to the firm

        - Any partners dies or retires from the firm

        - When partnership firm is sold

        - When two or more partnership firms joins together

METHODS OF VALUATION OF GOODWILL

1) AVERAGE PROFIT METHOD

a) Simple average profit method

b) Weighted average profit method

2) SUPER PROFIT METHOD

3) CAPITALIZATION METHOD

a) Capitalization of average profit

b) capitalization of super profit

Note: These methods of valuation of goodwill will be discussed individually in detail.

CHANGE IN PROFIT SHARING RATIO

 ACCOUNTING FOR PARTNERSHIP FIRMS

LESSON - 10

CHANGE IN PROFIT SHARING RATIO

   

           As discussed in the previous lesson, we have understood that the partnership deed is to be prepared new when certain major changes take place among the partners agreement. Each and every major change that leads for preparation of new partnership deed has to be discussed in detail. Lets start with the first change in this lesson.

PROFIT SHARING RATIO AMONG PARTNERS  

           When the partnership is formed the partners would have already decided about their profit or loss sharing ratio (the percentage of sharing among each partners). This ratio may be changed due to some reasons like capital contribution, increase in responsibilities, new partners admission etc. This makes them to prepare a new deed according to the changes they have made. When the ratio among the partners is changing then there are two possibilities that may arise 

        a) A partner may get more percentage of profit share than his previous share or 

        b) He may get less percentage of profit share than his previous share.

            When a partner is getting more percentage of share than his previous share then he is gaining more percentage of share, as his profit ratio is gaining it is called 'gaining ratio'. If the partner is getting less percentage of share than his previous share then his share has decreased from his previous share of profit, as his profit ratio is sacrificed it is called 'sacrificing ratio'. Based on this two situations Sacrificing ratio and Gaining ratio is calculated.

FORMULA:

Sacrifice Share Ratio = Old Share Ratio - New Share Ratio

Gaining Share Ratio = New Share Ratio - Old Share Ratio

          

              

            As a partner's gain in profit share is because of an another partner's sacrifice made in his profit share. In other words, if share of one or more partners increases then the share of other one or more partners decreases. What is the benefit for the sacrificing partner?  The partner who has sacrificed his share in favor of the gaining partner should be compensated by the gaining partner in the form of 'goodwill'.

            Formulas should be used to find the sacrificing and the gaining partners and the amount of compensation. The reason for finding the sacrificing and the gaining partner is to find the amount of compensation the gaining partner has to pay to the sacrificing partner for the sacrifice he has made in his share of profit. The gaining partner will pay the compensation amount according to the share gained by him.

JOURNAL ENTRY

        Gaining partner capital a/c Dr.                         XXX

            To sacrificing partner's capital a/c                              XXX

       (being gaining partner compensated the sacrificing partner)

OTHER FACTORS RELATED TO PROFIT SHARING RATIO:

            There are certain things which are interlinked with the profit sharing ratio of the partners so a change in profit sharing ratio might bring a change in the following things also. While changing the profit ratio of the partners look for the changes in the following things.

a) Gaining or Sacrificing ratio will be determined

b) Goodwill has to be treated

c) Treatment of Reserves, accumulated profits or losses

d) Assets and liabilities should be revalued

e) Partner's capital accounts should be adjusted

            Each of these headings will be discussed individually in detail in the further lessons.

PREPARATION OF NEW PARTNERSHIP DEED

 ACCOUNTING FOR PARTNERSHIP FIRMS

LESSON - 9

PREPARATION OF NEW PARTNERSHIP DEED

            Partnership firm operates according to the agreement (partnership deed) the partners have made when the partnership firm was formed, all the terms and conditions that the partners have agreed has been mentioned in the agreement and they work accordingly. When ever there is any change or alteration upon their agreements then the partners have to modify the partnership deed accordingly. In this situation the old partnership deed comes to an end and a new partnership deed begins. 

The major reason for a change in the partnership deed is :

1) Change in the profit sharing ratio among the partners

2) A new partner is admitted to the firm

3) Retirement of a partner from the firm

4) Death of a partner from the firm

5) Joining of two or more partnership firms

1) CHANGE IN THE PROFIT SHARING RATIO AMONG THE PARTNERS:

            When the partnership is formed the partners would have already decided about their profit or loss sharing ratio (the percentage of sharing among each partners). This ratio may be changed due to some reasons like capital contribution, increase in responsibilities etc. When the ratio among the partners is changing then there are two possibilities that may arise 

        a) A partner may get more percentage of profit share than his previous share or 

        b) He may get less percentage of profit share than his previous share.

            When a partner is getting more percentage of share than his previous share then he is gaining his share of profit as his profit ratio is gaining it is called 'gaining ratio'. If the partner is getting less percentage of share than his previous share then he is sacrificing his share of profit as his profit ratio is sacrificed it is called 'sacrificing ratio'.

2) A NEW PARTNER IS ADMITTED TO THE FIRM:

            When all the partners mutually agree then a new partner may be appointed to the firm. When a new partner is appointed then there are many new changes that might take place along the admission. Example: The new partner has to be given a share among the profit, he will bring his share of capital etc.

            As there are changes taking place the old agreement becomes void

and a new partnership deed has to be prepared. In this situation the old agreement comes to an end and a new deed will be prepared according to the new changes that happened as new partner is admitted.

3) RETIREMENT OF A PARTNER FROM THE FIRM:

            A partner may voluntarily or as a reason of age may leave the partnership firm. When a partner leaves the partnership firm there happens a certain changes like the retired partner's share of profit will be taken by other partners, his settlements has to be made etc.

            As there are changes taking place a new partnership deed has to be prepared accordingly. In this situation the old agreement comes to an end and a new deed will be prepared according to the new changes that happened as a the partner retires.

4) DEATH OF A PARTNER FROM THE FIRM:

            A partner may die suddenly, in that situation the terms and agreements will have a change.

Example: The dead partner's share of profit will be taken by other partners, his accounts will come to an end etc. As there are changes taking place in their agreement a new partnership deed has to be prepared. In this situation the old agreement comes to an end and a new partnership deed will be prepared according to the changes occur after the death of the partner.

            The process of accounting terms for both retirement of a partner and death is same but the only difference between them is a retirement can be pre planned so the accounting process can be arranged accordingly but in case of death it happens suddenly so accounting process has to be prepared according to the incident of the death of a partner.

5) JOINING OF TWO OR MORE PARTNERSHIP FIRMS:

            A partnership firm having an intention of expanding or to increase their performance may join with other partnership firms. Joining of two or more partnership firms is called Amalgamation. When more than a firm joins together then their terms and conditions has to be refreshed. As the firms mutually agree to their new terms and conditions. A new partnership deed among the firms has to be prepared accordingly.