1. Goodwill (GW)
GW means reputation of Firm. It can be valued in monetary terms. It is equivalent to the firm’s capacity to earn excess profit over normal profit earned by other Firms. If normal Firms of similar nature are earning a profit of Rs.10,000 and our Firm is earning Rs.15,000, then the excess of Rs.5,000 that we earn can be viewed as GW. Valuation of GW is necessary when:
1. Change in PSR
2. Admission
3. Retirement / Death
4. Dissolution / Sale
2. Four Methods of GW Valuation
1. Average Profit
2. Super Profit
3. Annuity
4. Capitalisation
1. Average Profit
GW = Average Profit of Previous Years X N
N stands for Number of Years (Estimated or assumed. For e.g. 3 or 5 years. Will be given in the question)
For e.g.
Average Profit of past 5 years is Rs.20,000
N is estimated to be 3
GW = 20,000 X 3 = Rs.60,000
If profit is trending (growing OR declining) every year then, weights may be applied to recent years’ profit as they are more close to reality and should carry more weight.
If there are losses, take them as negative numbers for totaling.
If the Question says, partners remuneration was not deducted from the given profits, deduct it from profit.
2. Super Profit
STEPS
1 Compute Actual Capital of the Firm. Say Rs.1,00,000
2 Determine Normal Rate of Return of similar other firms. Say 10%.
3 Compute Normal Profit = Capital X Normal Rate of Return. So, a normal firm would earn Rs.10,000
4 Compute our Firm’s Avg Profit. Say 25,000. So our Firm is earning 2.5 times of that of a normal firm.
5 Super Profit = Normal Profit – Avg Profit. 25,000 minus 10,000 = 15,000. Super profit is 15,000
6 GW = Super Profit X N. If N is 3 Years then GW = 15,000 X 3 = Rs.45,000. In other words:
|
Years
|
Super Profit
|
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YEAR 1
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15,000
|
|
YEAR 2
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15,000
|
|
YEAR 3
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15,000
|
|
GW (Total of Super Profits)
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45,000
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3. Annuity
Under Super Profit method, we assume that Super Profit is earned for N years in future and what is earned in future has “same” monetary value today. But we know that 10 rupees of tomorrow has lesser value compared to today due to inflation, etc. Its present value would be lower. So the future values should be discounted using Discounting Factors.
|
Years
|
Super Profit
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Disc Factor @ 15%
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Disc Value
|
|
YEAR 1
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15,000
|
0.8696
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13,044
|
|
YEAR 2
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15,000
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0.7561
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11,342
|
|
YEAR 3
|
15,000
|
0.6575
|
9,863
|
|
GW (Total of Super Profits)
|
34,248
|
The GW under Annuity will be lower than Super Profit method.
4. Capitalisation
The logic is similar to Super Profit Method, but we compute it backwards
STEPS
1 Determine Normal Rate of Return of similar firms. Say 10%
2 Compute Firm’s Avg Profit. Say Rs.25,000
3 Compute Capital to be employed to earn this Avg Profit. Avg Profit / Normal Rate of Return. Rs.25,000 / 10% = Rs.2,50,000
4 Compute Actual Capital of the Firm. Say 1,00,000
5 GW = Capital to be employed – Capital of the Firm. 2,50,000 minus 1,00,000 = Rs. 1,50,000
3. Need for Valuation of GW
PSR may change due to admission, retirement, death or even by mutual agreement by partners. When PSR changes, some partners may gain and some may lose (sacrifice). So when PSR changes it is important that GW as of that day is valued and gaining partners pay to sacrificing partners for their losses.
4. Valuation of GW in case of Admission
When a new partner is admitted, the existing partners have to sacrifice a portion of their PSR to the new partner. The ratio in which the existing partners sacrifice their PSR is called Sacrificing Ratio (SFR).
Since the new partner acquires his share from existing partners. New partner may be asked to pay premium (on top of Capital) by way of payment of GW to existing partners. This GW is to be paid in the ratio of SFR.
When Partners Sacrifice is in the ratio of Existing PSR
Normally partners sacrifice their PSR in the ratio of their existing PSR. For e.g., if existing PSR is 1:1 and new partner’s PSR is 1/3, then this 1/3 is to be sacrificed by the existing partners in their existing PSR which is 1:1. So each partner will sacrifice 1/6 + 1/6 which totals to 1/3. We see that partners shares SFR equally.
When the partners sacrifice is in the ratio of existing PSR, we find that SFR = Old PSR.
When Partners Sacrifice is NOT in the ratio of Existing PSR
SFR Computation steps are
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Name of Partners –à
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A
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B
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C is New
|
|
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STEP 1
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Find Existing PSR
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1/2
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1/2
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NA
|
|
STEP 2
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Find New PSR
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4/9
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2/9
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3/9
|
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STEP 3
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Compute Old PSR minus New PSR
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1/2 – 4/9 = 1/18
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1/2 – 2/9 = 5/18
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NA
|
|
STEP 4
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SFR is
|
1
|
5
|
NA
|
|
CHECK1
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Total of SFR = New Partner’s PSR
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1/18
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5/18
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3/9 (same as 6/18)
|
Only for Reference: It is to be noted that 1/18 and 5/18 are in the ratio of 1:5 as explained below.
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STEP 4
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Compute SFR (Ratio or Ratio)
SFR is
|
1/18 / (1/18 + 5/18) =
1/6
1
|
5/18 / (1/18 + 5/18) =
5/6
5
|
NA
|
5. A/cg Treatment of GW in case of Admission
GW to be recorded in BS only when it is purchased and paid for (payment by money or money’s worth)
In case of admission, Firm is receiving GW and not paying. Hence GW A/c needs to be closed as we cannot show it in BS. GW to be closed by transferring it to existing partners Capital A/c. This is done at SFR.
In summary. GW received is credited to old partners at SFR.
If the Firm’s GW is estimated to be Rs.1,20,000, then new partner needs to his portion only. If his PSR is 1/3, then he has to bring Rs.40,000 only and not entire 1,20,000.
Negative SFR
After admission, old partners PSR should go down. So old PSR (1/2) is higher than new PSR (1/3). SFR = Old PSR – New PSR. Ideally SFR should always be positive.
But in some rare cases, it may by agreed that one partner may not sacrifice, or even gain. In that case new PSR of that partner will be same as old PSR or higher. In that case SFR of that partner will be negative. Partner with negative SFR will not get a portion of GW. Partners with positive SFR is only eligible for share of GW.
Example 3 – If there 2 existing partners and only 1 partner is sacrificing and the other not, then the entire GW should be credited to the sacrificing partner only.
GW Adj through Book Entries
If new partner is unable to bring GW in cash, it can be adjusted through Capital A/cs as this is money equivalent
Private Payment of GW
If partners pay GW privately, it is recorded in their personal books and in Firm’s books
Example 2
6. A/cg Treatment of GW in case of change in PSR
Partners can mutually agree to change their PSR. In that one partner may gain and another lose (sacrifice). The losing partner will have a positive SFR and gaining partner will have a negative SFR, called Gaining Ratio (GNR).
A valuation of GW needs to be carried out to compensate the sacrificing partner. Normally no cash is brought in and entries are done through Capital A/cs
7. A/cg Treatment of GW in case of retirement or death
In case of retirement or death, the continuing partners will gain and has to pay GW to the retiring partners. The gaining partners have to pay GW in the ratio of GNR.
or Partners can mutually agree to change their PSR. In that one partner may gain and another lose (sacrifice). The losing partner will have a positive SFR and gaining partner will have a negative SFR (called Gaining Ratio).
A valuation of GW needs to be carried out to compensate the sacrificing partner. Normally no cash is brought in and entries are done through Capital A/cs