CORPORATE ACCOUNT

Q1. Dfine goodwill and explain the various method of its valuation with
suitable example?
ANS 1. Definition: Goodwill is a company’s value that exceeds its assets minus
its liabilities. In other words, goodwill shows that a business has value beyond
its actually physical assets and liabilities. This value can be created from the
excellence of management, customer loyalty, brand recognition, favorable
location, or even the quality of employees. Anything that adds value to the
company beyond its excess assets over liabilities is considered goodwill.
Meaning of Goodwill
Goodwill is the value of the reputation of a firm built over time with respect to
the expected future profits over and above the normal profits. 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 expects that he will be able to earn super profits as
compared to the profits earned by the other firms. Thus, it can be said that
goodwill exists only in case of firms making super profits and not in case of
firms earning normal profits or losses. It is an intangible real asset which
cannot be seen or felt but exists in reality and can be bought and sold.

Factors Affecting the Value of Goodwill

1.Nature of business: A firm that deals with good quality products or has
stable demand for its product is able to earn more profits and therefore has
more value.
2.Location of business: A business which is located in the main market or at a
place where there is more customer traffic tends to earn more profit and also
more goodwill.
3.Owner’s reputation: An owner, who has a good personal reputation in the
market, is honest and trustworthy attracts more customers to the business and
makes more profits and also goodwill.
4.Efficient management: An organization with efficient management has high
productivity and cost efficiency. This gives it increased profits and also high
goodwill.
5.Market situation: The organization having a monopoly right or condition in
the market or having limited competition, enables it to earn high profits which
in turn leads to higher value of goodwill.
6.Special advantages: A firm that has special advantages like import licenses,
patents, trademarks, copyrights, assured a supply of electricity at low rates,
subsidies for being situated in a special economic zones (SEZs), etc. possess a
higher value of goodwill.

Need for the Valuation

In the context of a partnership firm, the need for valuation of goodwill arises at
the time of:
1.Change in the profit sharing ratio amongst the existing partners
2.Admission of a new partner
3.The retirement of a partner
4.Death of a partner
5.Dissolution of a firm where business is sold as going concern.
6.Amalgamation of partnership firms

Methods of Valuation

1] Average Profits Method

i) Simple Average: Under this method, it is valued at agreed number of years’ of

purchase of the average profits of the past years.

Goodwill = Average Profit × No. of years’ of purchase

ii) Weighted Average: Under this method, it is valued at agreed number of years’
of purchase of the weighted average profits of the past years. The weighted
average is used when there exists an increasing or decreasing trend in the profits.
Highest weight is given to the current year’s profit.

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

2] Super Profits Method:

Under this method, valued at agreed number of years’ of purchase of the super
profits of the firm.
 Goodwill = Super Profit × No. of years’ of purchase

Super Profit = Actual/ Average profit – Normal Profit

Normal Profit = Capital Employed * Normal Rate of Return/100

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 a normal rate of return.

Goodwill = Capitalized Average profits – Actual Capital Employed

Capitalized Average profits = Average Profits × 100/Normal Rate of Return

Actual Capital Employed = Total Assets (excluding goodwill) – Outside Liabilities

(ii). Capitalization of Super Profits: Under this method, it is calculated by

capitalizing the super profits directly.

Goodwill = Super Profits × 100/ Normal Rate of Return

Hidden Goodwill

When the value of goodwill is not given at the time of admission of a new
partner, it has to be derived from the arrangement of the capital and the profit
sharing ratio and is known as hidden goodwill.

For example, A and B are partners sharing profits equally with capitals of
Rs.50,000 each. They admitted C as a new partner for one-third share in the
profit. C brings in Rs.60,000 as his capital. Based on the amount brought in by C
and his share in profit, the total capital of the newly constituted firm works out
to be Rs.1,80,000 (Rs. 60,000 × 3). But the actual total capital of A, B and C is
Rs.1,60,000 (50,000 + 50,000+ 60,000). Hence, it can be said that the difference
is on account of goodwill,i.e., Rs.20,000 (1,80,000 – 1,60,000).
Solved Example for You

Q: M/s Mehta and sons earn an average profit of rupees 60,000 with a capital of
rupees 4,00,000. The normal rate of return in the business is 10%. Using
capitalization of super profits method, calculate the value the goodwill of the
firm.

Solution:

Goodwill = Super profits × 100/ Normal Rate of Return

= 20,000 × 100/10

= 2,00,000.

Working notes:

(i). Normal Profit = Capital employed * Normal Rate of Return/100

= 4,00,000 × 10/100

= 40,000

(ii) Super Profit = Average Profit – Normal Profit

= 60,000 – 40,000

= 20,000
Q2. What do you understand by profit prior to incorporation? for what purpose
can this profit be utilized? discuss the various method of determining this profit?

ANS 2Profit of a business for the period prior to the date company into
existence is referred to as Pre-Incorporation profit. Hence prior period item are
those item which is done before incorporation of the company. Profit prior to
incorporation is the profit earned or loss suffered during the period before
incorporation. It is a capital profit and not legally available for distribution as
dividend because a company cannot earn a profit before it comes into
existence.
Profit earned after incorporation is revenue profit, which is available for
dividend. Profit of prior period and post period however divided separately
because the prior period profit and loss hence always credited and charged
from capital reserve A/c. Post period profit and loss thus credited and charged
from Profit & Loss A/c.

It may happen in case of new companies that a running business is taken over
from a certain date, whereas the company may be incorporated at a later date.
The company would be entitled to all profits earned after the date of purchase
of business unless the agreement with the vendors provides otherwise.

But profits up to the date of incorporation of the company have to be treated

as capital profits because these are the profits which have been earned even
before the company came into existence. Such profits are known as profits
prior to incorporation. It should be remembered that a public company cannot
commence business till it receives the certificate of commencement of
business.

Therefore, it would be prudent to treat all profits earned before

commencement of business as capital profits. However, strictly speaking,
“Profit Prior to Incorporation” means only the profits earned up to the date of
incorporation and not up to the date of the certificate of commencement of
business.

For correct allocation of profits, a profit and loss account should be prepared
on the date of incorporation; but this would mean taking stock which is
inconvenient. The usual practice, therefore, is to prepare the profit and loss
account only at the end of the year and then to allocate the profit between the
two periods—up to incorporation and after.

Methods of computing profit and loss prior incorporation

1st Method
One is to close the old books and open new books with the assets and
liabilities as the existed at the date of incorporation. In this way, automatically
the result to that willhowever adjusted.
2nd Method
The second method is to split up the profit for the year of the transfer of the
business to the company between “pre-Incorporation” and “Post-
Incorporation” periods. This also done either on time basis or on turnover basis
or by a method which combines two.

Basis of allocation of items between ‘pre’ and ‘post’ incorporation

period
Time basis
Some type of expense and income which thus divided between pre and post
period item on basis of time ratio.
For example-Depreciation, salary & wages, Rent and trade expenses etc.
Turnover basis
Some type of expense and income thus divided between pre and post period
item on the basis of turnover.
For example-sales promotion expenses,bad debts, sales commission and
selling expenses.
Note:-
1. Some expenses which therefore treated as always pre-Incorporation
period like promoters remuneration, survey report and expenses
regarding articles of association and memorandum of association.
2. Some expenses which however treated as always post-Incorporation
period like directors fees and debenture intere0st.
Debtors & Creditors Suspense Accounts
▪ A company taking over a running business may also agree to collect
its debts as an agent for the vendor and may further undertake to
pay the creditors on behalf of the vendors in such a case, the
debtors and creditors of a vendors will include in the accounts for
the company by debit or credit separate total accounts in the
general ledger to distinguish them from the debtors and creditors of
the business and contra entries will make in corresponding suspense
account. Also details of debtors and creditors balance will thus kept
in separate ledger.
▪ The vendor hence treated as a creditors for the cash received by the
purchasing company in respect of the debts due to the vendor, just
as if he has himself collected cash from his debtors and remitted the
proceeds to the purchasing company.
▪ The vendor thus consider a debtors in respect of cash paid to his
creditors by the purchasing company. The balance of cash collected ,
less paid, will represent the amount due to or by the vendor, arising
from debtors and creditors balances which have taken over, subject
to any collection expenses.
▪ Balance in suspense account will be equal to the amount of debtor
and creditors taken over remaining unadjusted at anytime.