Accountancy · Ch 2 — Reconstitution of a Partnership Firm — Admission of a Partner
Methods of Valuation of Goodwill
Methods of Valuation of Goodwill
Goodwill is an intangible asset, and its exact value is inherently difficult to determine. Because different methods can produce different values, the partners — both existing and incoming — must agree in advance on which method will be used. The textbook presents three standard methods for valuing goodwill in a partnership.
1. Average Profits Method
Under this method, goodwill is valued at an agreed number of years' purchase of the average profits of the past few years. The logic is that a buyer (the incoming partner) is paying for the right to earn a stream of future profits, and the past average is the best estimate of that stream.
Steps:
- Calculate the total profits (or adjusted profits) for a given number of past years.
- Find the average profit:
Average Profit = Total Profits / Number of Years - Multiply the average profit by the agreed number of years' purchase.
Goodwill = Average Profit × Number of Years' Purchase
Example: If average profit is ₹1,00,000 and the partners agree on 3 years' purchase, goodwill = ₹1,00,000 × 3 = ₹3,00,000.
2. Super Profits Method
This method recognises that goodwill exists only when a firm earns more than the normal profit expected from its capital employed. The excess of actual profit over normal profit is called super profit.
Steps:
- Calculate the Capital Employed in the business (usually total assets minus outside liabilities).
- Determine the Normal Rate of Return (the rate typically earned by similar businesses in the industry).
- Calculate Normal Profit:
Normal Profit = Capital Employed × (Normal Rate of Return / 100) - Calculate Average Profit (as in the Average Profits Method).
- Find Super Profit:
Super Profit = Average Profit – Normal Profit - Multiply the super profit by the agreed number of years' purchase.
Goodwill = Super Profit × Number of Years' Purchase
Example: Capital employed = ₹10,00,000; Normal rate of return = 10%; Average profit = ₹1,50,000.
- Normal profit = ₹10,00,000 × 10/100 = ₹1,00,000
- Super profit = ₹1,50,000 – ₹1,00,000 = ₹50,000
- If 3 years' purchase is agreed, goodwill = ₹50,000 × 3 = ₹1,50,000.
A common mistake is to forget that super profit can be zero or negative. If average profit equals or is less than normal profit, there is no super profit — and therefore no goodwill under this method.
3. Capitalisation Method
This method values the entire business as a capitalised value of its average profits, and then subtracts the actual capital employed to arrive at goodwill. It answers the question: "How much extra capital would be needed to earn the same profit at the normal rate?"
There are two approaches:
(a) Capitalisation of Average Profits
- Calculate Capitalised Value of the Business:
Capitalised Value = (Average Profit × 100) / Normal Rate of Return - Calculate Net Assets (or Capital Employed).
- Goodwill = Capitalised Value – Net Assets
Goodwill = (Average Profit / Normal Rate of Return × 100) – Net Assets
Example: Average profit = ₹1,50,000; Normal rate = 10%; Net assets = ₹12,00,000.
- Capitalised value = ₹1,50,000 × 100/10 = ₹15,00,000
- Goodwill = ₹15,00,000 – ₹12,00,000 = ₹3,00,000
(b) Capitalisation of Super Profits …