XII ACCOUNTANCY 2020

ASSIGNMENT - 8

VALUATION OF GOODWILL

Types of Goodwill for accounting point of view

 PURCHASED GOODWILL
 SELF GENERATED/INHERITED GOODWILL

Purchased Goodwill:
The excess amount paid over the net realizable value of assets of a business is called
purchased goodwill in the hands of person who is acquiring the business

Self Generated Goodwill:

The goodwill of the business which has been generated because of certain positive
factors during past years is called self generated goodwill.
Always remember that the business does not bear any cost for self generated goodwill.

The values of self generated goodwill determined in the following cases

 Change in profit sharing ratio
 Admission of a partner
 Retirement/Death of a partner
 When business is sold
Normally the following methods are applied for valuation of goodwill.
a) Average Profit Method
b) Super Profit Method
c) Capitalization Method

ACCOUNTING TREATMENT
As per accounting standard – 26 the self generated goodwill should not appear in the
books. (Thus if it is appearing it should be written off)

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IMPORTANT TERMS
Adjusted Profits:
The profits which are expected to be earn from business operations after adjusting all
abnormalities and future expectation is called adjusted profits.
Net Profit/Loss Amount
Add:  Loss due to fire
 Loss on sale of fixed assets/investments
 Capital Expenditure treated as revenue expenditure (Dr. to P/L
A/c)
 Expenses incurred in past but not be incurred in future
 Overvaluation of Opening Stock
 Undervaluation of closing stock
Less:  Abnormal gain (Profit on sale of fixed assets/investments)
 Non recurring income
 Overvaluation of closing stock
 Undervaluation of opening stock
 Any future expense, like insurance premium

Average Profit:
The average profits which a firm is expected to maintain in future is called average
profits. The average profits are of two types.
1. Simple Average Profit Method
2. Weighted Average Profit Method
SIMPLE AVERAGE PROFIT METHOD
Sum of adjusted profits of given years divided by number of years.
= Sum of Adjusted profits of given years
No. of Years

EXAMPLE:
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The profit for the last five years of a firm were as follows years
1999 Rs. 4,00,000;
2000 Rs. 3,98,000;
2001 Rs. 4,50,000;
2002 Rs. 4,45,000 and year 2003 Rs. 5,00,000.
Calculate goodwill of the firm on the basis of 4 years purchase of 5 years average
profits.
SOLUTION:

Average Profit =Total profit of last 5 years =

No. of years
= 21,93,000
5
= Rs.4,38,600

Goodwill = Average Profits × No. of years purchased

= Rs. 4,38,600 × 4
= Rs. 17,54,400

EXAMPLE:

Calculate the amount of goodwill at three years purchase of the last five years’ average
profit. The firm earned profits during the first 3 years as Rs.25000, Rs. 20000 and
Rs.27000 and suffered losses of Rs.12000 and Rs.7000 in the fourth and fifth year.

Solution:
Average Profit =Total profit of last 5 years
No. of years

= 25000+20000+27000-12000-7000
5
= Rs.10600
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Goodwill = Average Profits × No. of years purchased

= Rs. 10600 × 3

= Rs. 31800

EXAMPLE:

The following were the profits of a firm for the last three years.
Year ending Profit (Rs.)
March 31
2000 4,00,000 (including an abnormal gain of Rs.50,000)
2001 5,00,000 (after charging an abnormal loss of Rs. 1,00,000)
2002 4,50,000 (excluding Rs. 50,000 payable on the insurance of plant
and machinery )

Calculate the value of firm's goodwill on the basis of two years purchase of the average profits for the
last three years.

SOLUTION:
Year Ended Profit [Rs.]

2000 (4,00,000 – 50,000) 3,50,000

2001 (5,00,000 + 1,00,000) 6,00,000
2002 (4,50,000 – 50,000) 4,00,000

Total 13,50,000

Average Profit = Rs.13,50,000

3
= Rs.450000

Goodwill = Average Profits × No. of years purchased

= Rs. 450000 × 2 = Rs. 900000

EXAMPLE:
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From the following calculate average profits of last 4 years.

Year Profit/Loss
2016 33,000
2017 8000 (Loss)
2018 44000
2019 69000
Additional Information:
a) During the year 2017 there was loss due to fire of Rs. 25,000.
b) In the year 2018 a repair of Rs. 15,000 carried out on 1 July, 2018 was Dr. to revenue A/c for
the purpose of valuation of goodwill these are to be capitalized and depreciation is to be
charged @ 20% p.a. on written down value method. The opening stock of 2019 was
undervalued by Rs. 8,000
Now the machinery is to be insured and expected premium p.a. is Rs. 5,000
15000 * 20/100 * 6/12 = 1500
15000 – 1500 = 13500 * 20/100
SOLUTION:
ADJUSTED PROFIT
2016 2017 2018 2019
Profit & Loss (Given) 33,000 (8,000) 44,000 69,000
Add: Loss due to fire 25,000
Add: Repair to be Capitalised (15,000)
Less: Depreciation 1,500 2700
Add: Undervaluation of Closing Stock 8,000
Less: Undervaluation of Opening stock (8,000)
Less: Insurance Expenses (5,000) (5,000) (5,000) (5,000)
Adjusted Profit 28,000 12,000 60,500 53,300

Average Profit = Total profit of last 4 years

No. of years

= 28,000 + 12,000 + 60,500 + 53,300

4
= 38,450

WEIGHTE AVERAGE PROFIT METHOD

This method is a modified version of the earlier method. Under this method each year's
profit is multiplied by the respective number of weights i.e. 1,2,3,4 etc., in order to find
out value of product and the total of products is then divided by the total of weights in
order to ascertain the weighted average profits. Thereafter, the weighted average profit
is multiplied by the agreed number to find out the value of goodwill.
Steps to Compute weighted average profits

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1. Compute Adjusted Profit
2. Allot Weights (normally given in questions)
3. Find product of adjusted profit & weights 1 * 2
4. Find total of weights and product
5. Compute Weighted Average Profit = Total of Products of Profits
Total of Weights

Goodwill = Weighted Average Profits × Agreed Number of years'(Purchase)

EXAMPLE:

The profits of a firm for the year ended 31st March for the last five years were as follows :
Year Profit (Rs.)
2009 19,000
2010 23,000
2011 30,000
2012 22,000
2013 18,000
Calculate the value of goodwill on the basis of three years' purchase of weighted average profits after
weights 1,2,3,4 and 5 respectively to the profits for 2009, 2010, 2011, 2012 and 2013.

SOLUTION:
Year Adj Profit Weight Product (a *
(a) (b) b)
2009 19000 1 19000
2010 23000 2 46000
2011 30000 3 90000
2012 22000 4 88000
2013 18000 5 90000

Total 15 333000

∑ 𝑷𝒓𝒐𝒅𝒖𝒄𝒕
Weighted Average Profit = ∑ 𝑾𝒆𝒊𝒈𝒉𝒕𝒔

𝟑𝟑𝟑𝟎𝟎𝟎
= 𝟏𝟓

= 22,200

Goodwill = 22200 × 3 = 66600

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SUPER PROFIT METHOD

Super profit is the excess of actual profit over the normal profit.

Goodwill = Super Profit × No. of years of purchase

STEPS:

1) Calculate the average profit.

2) Ascertain the normal profit on the capital employed
Normal profit = Capital employed × Normal Rate
100
3) Super Profit = Average Profit – Normal Profit
4) Calculate goodwill

Capital Employed:
The money of the promoter employed in the business activities is called capital employed. There are
two different approaches of computing Capital Employed
Asset Approach Liability Approach
Fixed Assets (excluding self generated goodwill) Capital + Accumulated Profits (Reserve, P/L Cr.)
+ Investments (excluding Non Trade – Accumulated Losses (Adv Exp, P/L Dr./ Prel.
Investments) Exp.)
+ Current Assets – External Liabilities – Self Generated Goodwill
– Non-Trade Investments
NOTE:
 If in the balance sheet only goodwill term is there and nothing else is mentioned, it will be
assumed as self generated goodwill.

If on asset side in the balance sheet, investments are appearing & question is silent weather
investments trade/ non-trade investment. We will assume it as non-trade investments.

Example:
Calculate Capital Employed in following cases:
a) Fixed Assets Rs. 2,15,000 including goodwill Rs. 25,000; Current assets Rs. 44,000; Investments
Rs. 20,000; Liabilities Rs. 84,000

CE = Fixed Assets (2,15,000 – 25,000) = 1,90,000

+ Current Assets = 44,000
- Liabilities = (84,000)
1,50,000
b) Capital of Partners = Rs. 1,38,000; General Reserve Rs. 22,000; Preliminary Expenses Rs.
20,000

CE = 1,38,000 + 22,000 – 20,000 = 1,40,000

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c) Total Assets = Rs. 3,92,000 including goodwill Rs. 48,000 (out of which purchased goodwill is
Rs. 18,000) and advertisement Exp. Rs. 15,000; Liabilities of the business Rs. 1,27,000

Total Assets = 3,92,000

- Self Generated G/W = (30,000)
- Adv. Exp. = (15,000)
- Liability = (1,27,000)
Capital Employed = 2,20,000

Example:
The books of business showed that the capital employed on December 31,2001, Rs.5,00,000 and the
profits for the last five years were: 1997-Rs. 40,000; 1998- Rs. 50,000; 1999-Rs. 55,000; 2000-Rs.
70,000 and 2001-Rs. 85,000. You are required to find out the value of goodwill based on 3 years
purchase of the super profits of the business, given that the normal rate of return is 10%.

Sol.
Average Profit = Rs. 3,00,000/5 = Rs. 60,000
Normal Profit = Capital Employed × Normal Rate of Return
100
= 5,00,000 ×10
100
= Rs. 50,000
Super Profit = Rs. 60,000 – Rs. 50,000 = Rs. 10,000
Goodwill = Rs. 10,000 × 3 = Rs. 30,000

CAPTALISATION METHOD

a) Capitalization of Average Profit

In this method, the value of goodwill is ascertained by deducting the actual capital
employed (net assets) in the business from the capitalized value of the average
profits on the basis of normal rate of return.
This involves the following steps :

1. Adjusted
2. Ascertain the average profits based on the past few years' performance.
3. Capitalize the average profits on the basis of the normal rate of return as
follows :
𝟏𝟎𝟎
Normal Capital Employed = Average Profits ×
𝐍𝐨𝐫𝐦𝐚𝐥 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧

This will give the total value of business.

4. Ascertain the actual capital employed (net assets) by deducting outside

liabilities from the total assets (excluding goodwill).
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Capital Employed = Total Assets (excluding goodwill) – outside liabilities

(Net Tangible Assets)

5. Compute the value of goodwill by deducting net assets from the total value of
business, i.e. (2) – (3).

Goodwill = Capitalized Value of Average Profit – Actual Capital Employed

Example:
A business has earned average profits of Rs. 1,00,000 during the last few years and the
normal rate of return in a similar type of business is 10%. Ascertain the value of
goodwill by capitalization method, given that the value of net assets of the business is
Rs. 8,20,000.

Sol. Capitalized Value of Average Profits = 100000 × 100

10
= Rs 10,00,000
Goodwill = Capitalized Value – Net Assets
= 10,00,000 – 8,20,000

= Rs. 1,80,000

(b) Capitalization of Super Profits

Under this method following steps are involved :

STEPS:
1) Calculate the average profit.
2) Ascertain the normal profit on the capital employed
Normal profit = Capital employed × Normal Rate
100
3) Super Profit = Average Profit – Normal Profit

4) Calculate goodwill Multiply the super profits by the required rate of return multiplier,
that is,
𝟏𝟎𝟎
Goodwill = Super Profits ×
𝑵𝒐𝒓𝒎𝒂𝒍 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏

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AVERAGE PROFIT
Goodwill = W.Average Profit × No. of years purchase

Super Profit
Goodwill = Super Profit × No. of years purchase

Capitalisation of Average Profit

Goodwill = Capitalized Value of Average Profit – Actual Capital Employed

Capitalisation of Super Profit

𝟏𝟎𝟎
Goodwill = Super Profits ×
𝑵𝒐𝒓𝒎𝒂𝒍 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏

Example:
Following relates to the profit earned by a firm for the last four year; Rs.15000,
Rs.25000, Rs.65000 and Rs.75000. the total assets of the firm are Rs.640000and outside
liabilities Rs.140000. normal rate of return is 6%. Calculate goodwill of the firm under
capitalization of super profit method.

Sol. Average Profit = 15000+25000+65000+75000

4
= 45000

Capital Employed = Total Assets – Outside Liabilities

= 640000 – 140000 = 500000

Normal profit on Capital Employed = 500000 × 6/100 = 30000

Super Profit = AP – NP = 45000 – 30000 = 15000

Goodwill = 15000 × 100 / 6 = 250000

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