Book-Keeping and Accountancy · Ch 3 — Reconstitution of Partnership (Admission of Partner)
Goodwill — Meaning, Factors Affecting Value, and Methods of Valuation
Goodwill — Meaning, Factors Affecting Value, and Methods of Valuation
A firm that has been trading successfully for several years usually enjoys advantages a brand-new firm does not — an established customer base, a trusted name, favourable supplier relationships. This extra earning capacity has real money value, and when a new partner is admitted to share in the firm's FUTURE profits, that value has to be recognised and accounted for.
Goodwill
Goodwill is the value of the reputation of a firm, built up over time, which enables it to earn higher profits than a similar new firm without such reputation would earn from the same volume of business.
Why goodwill is valued on admission of a partner
The firm's existing goodwill has been built up entirely through the efforts, capital and reputation of the OLD partners, over the years before the new partner joined. Once admitted, the new partner will share in the firm's future profits — profits that are higher partly because of this pre-existing goodwill. Fairness therefore requires that the new partner compensate the old partners, in their sacrificing ratio, for the share of this built-up goodwill that he will now enjoy without having contributed to building it.
Factors affecting the value of goodwill: favourable location of the business; quality and reputation of the product or service; efficiency and stability of management; nature of the business and the degree of competition it faces; long-standing, favourable contracts and customer relationships; the amount of capital required to start a similar business; and the general market and economic conditions the firm operates in.
Methods of valuation of goodwill
| Method | Formula | When typically used |
|---|---|---|
| Average Profit Method | Goodwill = Average Profit of past years × Number of years' purchase | When profits of past years are fairly steady |
| Super Profit Method | Normal Profit = Capital Employed × Normal Rate of Return; Super Profit = Average Profit − Normal Profit; Goodwill = Super Profit × Number of years' purchase | When the firm's capital employed and a normal industry rate of return are known |
| Capitalisation of Average Profit Method | Capitalised Value of the business = Average Profit × 100 ÷ Normal Rate of Return; Goodwill = Capitalised Value − Capital Employed | When the true "worth" of the whole business is to be estimated first |
| Capitalisation of Super Profit Method | Goodwill = Super Profit × 100 ÷ Normal Rate of Return | Gives goodwill directly, without first finding the capitalised value of the whole business |
The value of a firm's reputation, built up over time, that enables it to earn higher profits than a similar new firm would earn from the …
The excess of a firm's average profit over the normal profit its capital employed should earn at the normal rate of return for …