Study of the methods of valuation of goodwill and accounting

treatment in case of Admission, Retirement or Death of a partner.

INTRODUCTION

Goodwill is the value of reputation of a firm in respect of profits

expected in future over and above the normal rates of profits. It is
goodwill that helps the firm to command a higher price over its
competitors. Goodwill makes the firm stand out and differentiates it
from the competition. It attracts customers to the firm as compared to
its competitors. Such extra earning capacity of a business is because
of its goodwill.

Thus goodwill is the good name, good wishes or reputation of the

business in the minds of all related parties like customers, suppliers,
bankers, workers, etc. The reputation is created by the business due
to many factors like quality of goods, relation with parties, services
provided, consistency, possession of unique patent right, personal
reputation of partner and many other reasons.

Reconstitution of partnership means change in the relationship

between the partners. In other words, it is nothing but a change in the
form of partnership. Such changes can e due to new agreement among
the partners. This may happen on account of

1. Admission of new partner

2. Retirement of existing partner

3. Death of partner

AIMS AND OBJECTIVES

The aims for valuation of goodwill in a firm arise in the following

cases:-
 1. When the profit sharing ratio amongst the partners is changed.

2. When a new partner is admitted.

3. When a partner retires or dies; and

4. When the business is dissolved or sold.

The objectives are as follows:-

1. In case of Admission:-
Admission of partner is a procedure for admitting a new partner
into existing partnership firm as per certain terms and conditions
of partnership deed. Here, incoming partner is benefiting partner
and existing partners are sacrificing partners. So, benefiting
partner should give a share of goodwill to sacrificing as they
sacrifice their share for incoming partner.

2. In case of Retirement:-

From the existing partnership business if a partner wishes to

leave the business, he may do so which will called as Retirement.
In this case, retiring partner retires so his share of profit is
divided into existing partners. That’s why, for his sacrifice it is
obvious to render his share of goodwill.

3. In case of Death of partner:-

When any partner died in the old or existing partnership firm is

called death of a partner. In such a case, deceased partner is
sacrificing and existing partner advantaging partners. So,
existing partner should render deceased partner’s share of
goodwill to his account.

METHOD AND METHODOLOGY:-\

DETAIL REPORT ON PROJECT

Goodwill is the reputation created and enjoyed by firm. It

generates high profits therefore the value of goodwill is calculated on
the basis of profit of the concern, generally the future profit is takes
into account while ascertaining the value of goodwill. The future
profits of the concern are estimated on the past profits so the value of
goodwill is based on future profits estimated with the help of past
profits. The valuation of goodwill of the firm is made on the basis of
certain methods.

There are four methods for valuation of goodwill:-

1. Average Profit Basis,

2. Super Profit Basis,

3. Annuity Basis,

4. Capitalization Basis

1) Average Profit Basis:

Under this method, goodwill is valued/ calculated at certain

number of year’s purchase of the average profit of the firm.
This average profit is to be considered as a base for the
valuation of goodwill because a single year’s performance is
not sufficient basis for judgment. Similarly it is expected that
the firm will earn average profit for the next certain numbers
of years and therefore goodwill is valued of certain number of
year’s purchase of average point.

The steps for average profit method are:-

1. Calculation of Total Profit

 In this step the total profit is to be calculated on the basis
of past few years profits and losses. While calculating the
total profit, the amount of the loss of a particular year is to
be deducted.

Years Amount

I 1,50,000 ( Profit)

II 2,25,000 ( Profit )

III 75,000 ( Loss)

IV 2,00,000 (Profit )

V 2,50,000 ( Profit )

The total profit will be as follows:

Total Profit= (1, 50,000 + 2, 25,000 – 75,000 + 2, 00,000 + 2,

50,000)

(Profits – Loss)

= 8, 25,000 – 75,000

= Rs. 7, 50,000

2. Calculation of Average Profit

Average profit refers to the profit earned by the firm for one
year. It can be calculated by using the following formula.

Average Profit = Total Profit

Number of Years

In the above example the average profit will be calculated

as follows:-
 Average Profit = 7, 50,000

= Rs. 1, 50,000/-

3. Calculation of Goodwill

Under average profit method, goodwill is valued at certain

number of years purchase of average profit. Thus goodwill
can be calculated by using the following formula.

Goodwill= Average X Number of year’s purchase

Average profit as calculated in step no. 2 is Rs. 1, 50,000/-

and of goodwill is valued at three years purchase of
average profit hen goodwill will be as under:

Goodwill = Average Profit X No. of year’s purchase

Goodwill = Rs. 1, 50,000 X 3

Goodwill = Rs. 4, 50,000

2) Super Profit Basis:

In case of average profit basis, goodwill is calculated on the

basis of average profit multiplied by certain number of years. On
the other hand, super profit means, excess profit that can be
earned by a firm over and above the normal profit usually earned
by similar firms under similar circumstances. Under this method,
the partner who gains in terms of profit sharing ratio has to
contribute only for excess profit because normal profit he can
earn by joining any partnership firm. Under this method, what
excess profit a partnership firm can earn is to be determined
first.

To value the goodwill under this method the following 4 steps

are to be taken.

1. Calculation of Average profit:-

The procedure for the calculation of average profit is

already explained above.

2. Calculation of Normal Profit:-

Normal profit refers to a reasonable expected profit to be

earned by a business concern after meeting all its business
expenses. It is ascertained by using the following formula:

Normal Profit = Capital Employed X NRR

100

NRR = Normal Rate of Return

Capital Employed:-

Amount of capital used by the firm to run and manage

its business activities, is called capital employed. The term
“Capital Employed “is made – up of fixed assets (other than
goodwill) plus current assets minus current liabilities.

Normal Rate of Return:-

Normal rate of return is the return of profit normally

expected by the investors on the capital employed by
considering the returns or profit actually earned by other
firm in the same industry. Normal rate of return depends
upon the nature of business and element of risk is involved
therein.
 3. Calculation of Super Profit:-

Super profit is the profit earned by the business concern

over and above the normal profit on capital employed. It
denotes extra earning of the firm. In other words, it is
nothing but the excess of average profit over the normal
profit.

Eg. The normal earning rate of Amar & company is 155 on

capital employed of Rs. 4,00,000/- therefore the normal
profit or earning is Rs. 60,000/- If its actual profit or earning
is Rs. 1,00,000/-, Amar & company has earned super profit
of Rs.40,000 (1,00,000- 60,000)

Thus super profit is calculated as per the following

formula.

Super Profit= Average profit – Normal Profit

4. Calculation of goodwill:-

Under super profit method, goodwill is valued at certain

number of year’s purchase of super profit. It is calculated as per
the following formula.

Goodwill = Super profit X Number of year’s purchase

(Obviously if there is no super profit, the firm will have no

goodwill)

 TREATMENT OF GOODWILL IN CASE OF ADMISSION

Goodwill means extra premium brought by new partner.

There are two methods of recording goodwill in the books
of accounts while admitting new partner in the existing
partnership firm.
A) Extra Premium Method :-

Under this method incoming partner his proportionate share

of goodwill in cash and it may be retained in the business
or withdrawn by old partners from the business.

i) When a new partner brings his share of goodwill in cash and it

is retained in the business

The following two journal entries are to be passed:-

a) Cash/ Bank A/c………………………………………….Dr.

To Goodwill A/c

(Being goodwill brought by new partner in cash)

b) Goodwill A/c………………………………………………Dr.

To Old partner’s capital/current A/c (sacrifice Ratio)

(Being goodwill retained in the business)

ii) When goodwill is brought by new partner and it is withdrawn

by old partners:

The following three journal entries are to be passed:-

a) Cash/Bank A/c…………………………………………..Dr.

To Goodwill A/c

(Being goodwill brought in cash by new partner)

b) Goodwill A/c……………………………………………...Dr.

To Old partner’s capital/ current A/c (Sacrifice Ratio)

(Being goodwill credited to old partners)

c) Old partner’s capital/current A/c ………Dr. (Actual amount

. withdrawn)
 To Cash/Bank A/c

(Being goodwill withdrawn by old partners)

iii) When new partner bring his share of goodwill in cash & if it is
paid to old partners privately:-

In this case no entry is required to be passed in the books of

the firm, as it is a private agreement between the partners.

B) Valuation Method:-

Under this method new partner does not bring the amount
of goodwill in cash. So old partners create/raise the Goodwill A/c
in the books of the firm at the time of admission of partner. The
following is the accounting treatment of goodwill as per this
method.

i) When the new partner does not bring the goodwill in cash
and it is raised in the books of the firm:

The following journal entry is passed.

d) Goodwill A/c……………………………………………...Dr.

To Old partner’s capital/ current A/c (In old Ratio)

(Being goodwill credited to old partners)

ii) When Goodwill is raised and written off:

The following two journal entries are passed.

a) Goodwill A/c……………………………………………...Dr.

To Old partner’s capital/ current A/c (In old Ratio)

(Being goodwill rose in the books of the firm)

 b) All partners’ capital/current A/c ………Dr. (in New profit sharing
. ratio)

To goodwill A/c

(Being goodwill written off)

iii) When goodwill already appears in the books of the firm:

In such case, if the goodwill is revalued, the entry is

passed for the amount of difference either through
capital/current a/c or revaluation a/c.

TREATMENT OF GOODWILL IN CASE OF RETIREMENT AND DEATH

The goodwill is shown, valued, raised or adjusted in the books at

the time of retirement and death of partner in the following different
way.

i) If goodwill is raised to its full value and retained in the

business

Goodwill A/c…………………………………………………Dr.

To All Partner’s capital A/c

(Being full value of goodwill is distributed to all the partners in

old profit sharing ratio)

ii) If goodwill is fully raised and then written off

a) Goodwill A/c…………………………………………………Dr.

To All Partner’s capital A/c

(Being goodwill created and credited to all partner’s capital

account in their old ratio)

B continuing partner’s capital A/c………………Dr.

 To goodwill A/c

(Being raised goodwill written off and debited to continuing

partner’s capital account in their new ratio)

iii) If goodwill is raised to the extent of retiring partner’s share

only and retained in business

Goodwill A/c………………………………………Dr.

To Retiring partner’s capital A/c

(Being share of goodwill of retiring partner to the credited to

his capital A/c)

iv) If goodwill raised equal to the retiring partner share earlier

and now written off:

Goodwill A/c………………………………………Dr.

To Retiring partner’s capital A/c

(Being share of goodwill of retiring partner to the credited to

his capital A/c)

Continuing partner’s capital A/c……………..Dr.

To Goodwill A/c

(Being the share of goodwill of retiring partner is to be written

off in gain ratio)

OR

Continuing partner’s capital A/c……………..Dr.

To Goodwill A/c
 (Being the share of goodwill of retiring partner is to be written
off by continuing partners in gain ratio)

V) If goodwill is given in the old balance sheet. The net result of its
revaluation may be shown either in profit and loss adjustment account
or shown in partner’s capital account.

CONCLUSION

When a new partner is admitted into a partnership, certain

adjustments in accounts become necessary. Chiefly, this is because
the new partner will acquire a share in the profits of the firm and
because of this; the old partners will stand to lose.

Goodwill is compensation to old partners for their sacrifice in

connection with admission of a new partner. So it is to be credited to
the partners according to their profit sacrificing ratio. Whatever
shares the new partner is getting, it may be sacrificed by the old
partners in proportion to their old profit sharing ratio or in different
proportion.

In case of Retirement of a partner, the continuing partners will

gain in terms of profit sharing ratio. Therefore, they have to pay to
retiring partner for his share of goodwill in the firm in the gaining ratio.
Similarly, in case of death of the partner, the continuing partner should
bear the share of goodwill due to the heirs of the deceased partner.
For this purpose, the goodwill is valued on the date of the retirement
or death and adjusted through the capital accounts of the partners.

YOUR OPINION AND SUGGESTION

Whatever there is any change in the existing relationship of the

partners inter se, some partners have to sacrifice their future profit
and some others would gain. Those who are sacrificing future profit
should be compensated by the others who are gaining. This
adjustment of the partnership rights may arise due to admission of a
new partner, change in the profit sharing ratio, retirement or death of
a partner and dissolution of the partnership. The partners, who gain in
terms of profit sharing ratio, have to pay for such gain as a proportion
to the value of goodwill. The partners, who lose in terms of profit
sharing ratio, receive payments for the sacrifice as a proportion to the
value of goodwill.

REFERENCES

1) Book-keeping and Accountancy standard XII

Maharashtra State Board of Secondary and Higher Secondary

Education

2) Fundamentals of Accounting

Board of Studies,

The Institute of Charted Accounts of India