Methods of Valua�on of Goodwill

ILLUSTRATION 1

Problem: Lee and Lawson are equal partners. They decide to admit Hicks as a one-fourth partner.

They want to calculate goodwill using the following data:

Year Profit (`)

2016 1,20,000

2017 1,25,000

2018 1,30,000

2019 1,50,000

• Capital Employed (as on 31.12.2019) = ₹5,00,000

• Normal Profit Rate = 20%

• Required: Value of Goodwill under different methods

Method 1: Average Profit Method (Weighted)

Year Profit (`) Weight Weighted Profit (`)

2016 1,20,000 1 1,20,000

2017 1,25,000 2 2,50,000

2018 1,30,000 3 3,90,000

2019 1,50,000 4 6,00,000

Total 10 13,60,000

Weighted Average Profit = ₹13,60,000 ÷ 10 = ₹1,36,000

Goodwill = ₹1,36,000 × 3 years = ₹4,08,000

Method 2: Super Profit Method

Average Profit = ₹1,36,000

Normal Profit = 20% of ₹5,00,000 = ₹1,00,000
Super Profit = ₹1,36,000 – ₹1,00,000 = ₹36,000
Goodwill = ₹36,000 × 3 = ₹1,08,000

Method 3: Annuity Method

Assump�ons:

• Super Profit = ₹36,000

• Number of years = 3

• Interest rate = 20%

• Annuity factor for 3 years at 20% = 2.1065

Goodwill = ₹36,000 × 2.1065 = ₹75,834

Method 4: Capitaliza�on Method

Average Profit = ₹1,36,000

Normal Rate = 20%

Capitalized Value of Business =

₹1,36,000 × 100 / 20 = ₹6,80,000

Less: Capital Employed = ₹5,00,000

Goodwill = ₹6,80,000 – ₹5,00,000 = ₹1,80,000

Summary of Goodwill Values

Method Value of Goodwill (`)

Average Profit Method ₹4,08,000

Super Profit Method ₹1,08,000

Annuity Method ₹75,834

Capitaliza�on Method ₹1,80,000

ILLUSTRATION 2

Given:

Par�culars Amount (`)

Capital Invested 1,50,000

Market Rate of Interest 10%

Risk Return on Business Capital 2%

Total Normal Return Rate (10% + 2%) 12%

Alterna�ve Employment Income (Proprietor’s Remunera�on) 6,000 p.a.

Profits/Losses of the Business:

Year Result

2016 Profit 40,000

2017 Profit 36,000

2018 Loss 6,000

2019 Profit 50,000

Step 1: Calculate Total Profits (excluding the loss)

2016 = 40,000

2017 = 36,000

2019 = 50,000

Total = 1,26,000

Less: Loss in 2018 = 6,000

Net Total = 1,26,000 – 6,000 = ₹1,20,000

Step 2: Calculate Average Profit

Average Profit=1,20,000/4=₹ 30,000

Step 3: Deduct Proprietor's Alterna�ve Income

Maintainable Profit=₹ 30,000−₹ 6,000=₹24,000

Step 4: Calculate Normal Profit

Normal Profit=12% of ₹ 1,50,000=₹ 18,000

Step 5: Calculate Super Profit

Super Profit=₹ 24,000−₹ 18,000=₹ 6,000

Step 6: Value of Goodwill (5 years’ purchase)

Goodwill=₹ 6,000×5=₹ 30,000

Admission of a Partner
ILLUSTRATION 3: Goodwill Adjusted Through Capital Accounts

Ques�on:

The following is the Balance Sheet of Yellow and Green as at 31st December 2019:

Balance Sheet (Before Admission)

Liabili�es Assets

Trade Payables 20,000 Cash at Bank 10,000

Capital: Sundry Assets 55,000

Yellow – 25,000

Green – 20,000 65,000

Total 85,000 Total 85,000

Yellow and Green share profits in the ra�o 3:2. Black is admited as a partner, bringing in ₹20,000 as
capital. Goodwill is valued at 3 years’ purchase of the average of the last 4 years’ profits:

Profits: 2016 - ₹9,000; 2017 - ₹14,000; 2018 - ₹12,000; 2019 - ₹13,000

New profit-sharing ra�o is 6:5:5.

Required: Pass journal entries and prepare the new Balance Sheet assuming goodwill is adjusted through
capital accounts.
Answer:

Working Notes:

1. Average Profit = (9,000 + 14,000 + 12,000 + 13,000) / 4 = ₹12,000

2. Goodwill of the Firm = ₹12,000 × 3 = ₹36,000

3. Black’s Share = (5/16) × 36,000 = ₹11,250

4. Sacrificing Ra�o:

Partner Old Share New Share Sacrifice

Yellow 3/5 6/16 3/5 - 6/16 = 18/80

Green 2/5 5/16 2/5 - 5/16 = 7/80

Sacrificing Ra�o = 18:7

Journal Entries:

Date Par�culars L.F. Dr. (₹) Cr. (₹)

1 Bank A/c Dr. 20,000

To Black’s Capital A/c 20,000

(Capital brought in by Black)

2 Black’s Capital A/c Dr. 11,250

To Yellow’s Capital A/c 8,100

To Green’s Capital A/c 3,150

(Goodwill adjusted in sacrificing ratio 18:7)

New Balance Sheet

Liabili�es ` Assets `

Trade Payables 20,000 Cash at Bank 30,000

Capital: Sundry Assets 55,000

Yellow – 33,100

Green – 23,150

Black – 20,000 76,250

Total 96,250 Total 96,250

ILLUSTRATION 4: Goodwill Brought in Cash

Ques�on:

Con�nue Illustra�on 3 assuming Black brings in goodwill in cash.

Answer:

Journal Entry:

Par�culars Dr. (₹) Cr. (₹)

Bank A/c Dr. 31,250

To Black’s Capital A/c 20,000

To Yellow’s Capital A/c 8,100

To Green’s Capital A/c 3,150

(Capital and goodwill brought in cash)

New Balance Sheet

Liabili�es ` Assets `

Trade Payables 20,000 Cash at Bank 41,250

Capital: Sundry Assets 55,000

Yellow – 33,100

Green – 23,150

Black – 20,000 76,250

Total 96,250 Total 96,250

ILLUSTRATION 5: Goodwill Brought in Cash but Withdrawn

Ques�on:

Same as Illustra�on 4, but Yellow and Green withdraw their goodwill share.

Answer:

Addi�onal Journal Entry:

Par�culars Dr. (₹) Cr. (₹)

Yellow’s Capital A/c Dr. 8,100

Green’s Capital A/c Dr. 3,150

To Bank A/c 11,250

(Goodwill amount withdrawn by old partners)

New Balance Sheet

Liabili�es ` Assets `

Trade Payables 20,000 Cash at Bank 30,000

Capital: Sundry Assets 55,000

Yellow – 25,000

Green – 20,000

Black – 20,000 65,000

Total 85,000 Total 85,000

ILLUSTRATION 6: Goodwill Paid Privately

� Ques�on:

Same as Illustra�on 3, but Black pays goodwill privately to Yellow and Green. Capital is s�ll brought in
cash.

Answer:

Journal Entry:

Par�culars Dr. (₹) Cr. (₹)

Bank A/c Dr. 20,000

To Black’s Capital A/c 20,000

(Capital brought in; goodwill paid privately)

New Balance Sheet

Liabili�es ` Assets `

Trade Payables 20,000 Cash at Bank 30,000

Capital: Sundry Assets 55,000

Yellow – 25,000

Green – 20,000

Black – 20,000 65,000

Total 85,000 Total 85,000

ACCOUNTING TREATMENT OF GOODWILL IN CASE OF CHANGE IN
PROFIT SHARING RATIO
ILLUSTRATION 7

Ques�on:

A, B, and C are equal partners. They decided to change their profit-sharing ra�o to 4:3:2. The goodwill of
the firm is valued at ₹90,000.
Pass the necessary journal entry for the adjustment of goodwill.

Answer:

Calcula�on of Gain/Loss:

Partner Old Share New Share Difference (Gain/Loss)

A 1/3 4/9 Gain = 1/9

B 1/3 3/9 No Change

C 1/3 2/9 Loss = 1/9

A gains and C sacrifices, so A should compensate C.

Goodwill Adjustment:

1/9 × ₹90,000 = ₹10,000

Journal Entry:

Par�culars Debit (₹) Credit (₹)

A’s Capital A/c 10,000

To C’s Capital A/c 10,000

(Being goodwill adjusted due to change in ratio)

ILLUSTRATION 8

Ques�on:

A, B, and C share profits and losses in the ra�o 4:3:3. They decide to change the ra�o to 7:7:6.
The goodwill of the firm is valued at ₹20,000.
Calculate sacrifice/gain by each partner and pass the journal entry.

Answer:

Calcula�on of New and Old Shares:

Partner Old Share New Share Difference (Gain/Loss)

A 4/10 7/20 Loss = 1/20

B 3/10 7/20 Gain = 1/20

C 3/10 6/20 No Change

B gains and A sacrifices.

Goodwill Adjustment:

1/20 × ₹20,000 = ₹1,000

Journal Entry:

Par�culars Debit (₹) Credit (₹)

B’s Capital A/c 1,000

To A’s Capital A/c 1,000

(Being goodwill adjusted due to change in ratio)

ILLUSTRATION 9

Ques�on:

A, B, C, and D share profits and losses equally. They decide to change the profit-sharing ra�o to 3:3:2:2.
Goodwill of the firm is valued at ₹20,000.
Pass the journal entry for adjustment of goodwill.

Answer:

Old Ra�o: 1/4 each = 25%

New Ra�o: A = 3/10, B = 3/10, C = 2/10, D = 2/10

Calcula�on of Gain/Loss:

Partner Old Share New Share Difference (Gain/Loss)

A 1/4 = 0.25 3/10 = 0.30 Gain = 1/20

B 1/4 = 0.25 3/10 = 0.30 Gain = 1/20

C 1/4 = 0.25 2/10 = 0.20 Loss = 1/20

D 1/4 = 0.25 2/10 = 0.20 Loss = 1/20

A & B gained, C & D sacrificed.

Goodwill Adjustment:

1/20 × ₹20,000 = ₹1,000 (each)

Journal Entry:

Par�culars Debit (₹) Credit (₹)

A’s Capital A/c 1,000

B’s Capital A/c 1,000

To C’s Capital A/c 1,000

To D’s Capital A/c 1,000

(Being goodwill adjusted due to change in profit-sharing ratio)

ACCOUNTING TREATMENT OF GOODWILL IN CASE OF RETIREMENT OR
DEATH OF A PARTNER
ILLUSTRATION 10

Ques�on:

Antoo, Bantoo, and Chintoo were in partnership sharing profits and losses in the ra�o 3:4:3 respec�vely.
The accounts are prepared annually as on 31st March. As per partnership terms:

• On re�rement of a partner, goodwill is to be valued at 3 years' purchase of average profits of

past 4 years, a�er deduc�ng:

o 12% interest on capital employed, and

o Remunera�on of ₹2,000 per month per partner.

• Capital employed is ₹6,50,000.

• On 1st April 2020, Antoo re�red. Goodwill was to be adjusted through capital accounts.

• Bantoo and Chintoo would share profits equally going forward.

Profits for the last 4 years (before charging salary and interest):

Year Profit (₹)

2016–17 2,60,000

2017–18 2,75,000

2018–19 2,65,000

2019–20 2,80,000

You are required to calculate goodwill and pass journal entry.

Answer:

� Step 1: Average Profit

Total Profit = 2,60,000 + 2,75,000 + 2,65,000 + 2,80,000 = ₹10,80,000

Average Profit = ₹10,80,000 / 4 = ₹2,70,000

� Step 2: Adjusted Average Profit

• Interest on Capital @12% of ₹6,50,000 = ₹78,000

• Salaries: 3 × ₹2,000 × 12 = ₹72,000

Adjusted Average Profit = 2,70,000 – 78,000 – 72,000 = ₹1,20,000

� Step 3: Goodwill of the Firm

Goodwill = 3 × ₹1,20,000 = ₹3,60,000

Antoo’s Share = 3/10 × 3,60,000 = ₹1,08,000

� Step 4: Gain/Sacrifice Ra�o

Partner Old Share New Share Difference (Gain/Loss)

Antoo 3/10 0 -3/10 (Re�red)

Bantoo 4/10 1/2 +1/10 (Gain)

Chintoo 3/10 1/2 +2/10 (Gain)

Gaining Ra�o = Bantoo : Chintoo = 1:2

� Journal Entry:

Par�culars Dr. (₹) Cr. (₹)

Bantoo’s Capital A/c 36,000

Chintoo’s Capital A/c 72,000

To Antoo’s Capital A/c 1,08,000

(Being goodwill adjusted through gaining partners)

ILLUSTRATION 11

Ques�on:

Cu and Au share profits and losses in the ra�o 5:3. On 1st April 2020, Ag was admited with ¼ share
under the following terms:

1. Ag brings ₹2,00,000 as capital.

2. New ra�o: Cu : Au : Ag = 2:1:1

3. Cu's salary increased from ₹2,000 p.m. to ₹3,000 p.m. from Oct 1, 2018

4. Interest on Capital: 8% p.a.

5. Capitals (unchanged for 4 years): Cu ₹4,00,000; Au ₹3,00,000

6. Goodwill to be valued at 3 years purchase of weighted average adjusted profit of last 4 years.

7. Ag to bring goodwill in cash.

Profits (before salary & interest):

Year Profit (₹)

2016–17 2,10,000

2017–18 2,60,000

2018–19 2,10,000

2019–20 3,05,000

Adjustments to Profits:

• (a) Machine cos�ng ₹40,000 (purchased 01/10/2018) wrongly debited to revenue. Deprecia�on:
20% WDV

• (b) Stock overvalued on 31/03/2018 by ₹20,000

• (c) Loss by fire of ₹10,000 (2016-17) not adjusted in Trading A/c

• (d) Bad debts ₹5,800 (2020) to be writen off

Answer:

� Step 1: Adjusted Profits

Year Calcula�on Adjusted Profit (₹)

16–17 2,10,000 – 24,000 (salary) – 56,000 (interest) + 10,000 (fire loss added) 1,40,000

17–18 2,60,000 – 24,000 – 56,000 – 20,000 (stock overvalua�on) 1,60,000

18–19 2,10,000 – 30,000 – 56,000 + 40,000 (machine) – 4,000 (depr.) + 20,000 1,80,000

19–20 3,05,000 – 36,000 – 56,000 – 7,200 (depr.) – 5,800 (bad debts) 2,00,000

� Step 2: Weighted Average Profit

Year Adjusted Profit (₹) Weight Product (₹)

2016–17 1,40,000 1 1,40,000

2017–18 1,60,000 2 3,20,000

2018–19 1,80,000 3 5,40,000

2019–20 2,00,000 4 8,00,000

Total 10 18,00,000

Weighted Average Profit = 18,00,000 / 10 = ₹1,80,000

Goodwill = 3 × 1,80,000 = ₹5,40,000

Ag’s Share = 1/4 × 5,40,000 = ₹1,35,000

� Step 3: Sacrificing Ra�o

Partner Old Share New Share Difference (Sacrifice)

Cu 5/8 2/4 1/8

Au 3/8 1/4 1/8

Ag – 1/4 –

Sacrificing Ra�o: Cu : Au = 1:1

� Journal Entry:

Par�culars Dr. (₹) Cr. (₹)

Bank A/c 1,35,000

To Cu’s Capital A/c 67,500

To Au’s Capital A/c 67,500

(Ag’s goodwill credited to sacrificing partners)