Chapter 3 Valuation of Goodwill
Chapter 3 Valuation of Goodwill
Accoutancy
Chapter 1 Introduction to Partnership
1. Select the correct answer for each questions :
1. ‘Goodwill’ is which type of asset ?
(A) Tangible asset
(B) Intangible asset
(C) Current asset
(D) Fictitious asset
2. Goodwill depends on which aspect ?
(A) On employee of business enterprise
(B) On management of business enterprise
(C) On assets of business enterprise
(D) On future maintainable profit
3. Goodwill is a financial value of ………………….
(A) Investment
(B) prestige of business enterprise
(C) fixed assets
(D) competition
4. Goodwill is ………………. where individual skill is important.
(A) more
(B) less
(C) zero
(D) negative
5. Which method is appropriate for the computation of goodwill when every year profit is increasing ?
(A) simple average
(B) weighted average
(C) annual growth rate
(D) compound growth rate
6. Expected profit = ……………….
(A) Capital employed × Expected rate of return
(B) Average profit × Expected rate of return
(C) Weighted average × Expected rate of return
(D) Assets × Expected rate of return
7. Super profit means ……………..
(A) Capital employed – Expected profit
(B) Expected profit – Capital employed
(C) Average profit – Expected profit
(D) Expected profit – Average profit
Chapter 1 Introduction to Partnership
2. Answer the following questions in one sentence :
(1) What is goodwill ?
Answer:
“Goodwill is an intangible asset which shows the reputation of a firm in the market.”
OR
‘ “Goodwill is the value of the reputation of a firm in respect to the profit earning over and above the expected profit.”
(2) What is revaluation of goodwill ?
Answer:
At the time of reconstruction of partnership, with revaluation of assets and liabilities, new value of goodwill is determined. This is called revaluation of goodwill.
(3) Which type of asset is goodwill ?
Answer:
Goodwill is an intangible asset which cannot be seen but it has a value in the market.
(4) Under which head goodwill is shown in the balance sheet ?
Answer:
Goodwill is shown in the balance sheet on the assets side under the head of non-current assets as intangible asset.
(5) What is capitalized profit ?
Answer:
Capitalized profit means capitalized value of average profit on the basis of the expected rate of return.
(6) What is super profit ?
Answer:
When a business earns excess profit over average profit then the amount of excess profit is called super profit.
(7) What is average profit ?
Answer:
When total profit of some last years is divided by number of years then the value received is known as average profit.
(8) What is weighted average profit ?
Answer:
When profit of the last years is given weighted (i.e. 1, 2, 3 ….) and then average profit is found out then it is known as weighted average profit.
Chapter 1 Introduction to Partnership
3. Answer the following questions in brief :
(1) Give the meaning of goodwill and explain the factors affecting to its valuation.
Answer:
“A company’s goodwill is an intangible asset that demonstrates its standing in the marketplace.” Factors influencing goodwill valuation include:
(i) Business nature: We can describe a company as having goodwill when it generates greater profit because of consistent sales, other factors, exceeding profit projections, or producing high-value products.
(ii) Business location: A business may be able to make more money if it is situated in a busy area or at a central location for customers. Such a business may place a high value on goodwill due to its prominent location.
(iii) Length of operation: Generally speaking, a company’s reputation in the market increases with age. The bulk of clients are well-known to the business and have maintained close relationships with it over time, thus the goodwill of such a business is undoubtedly high.
(iv) Market conditions: A monopoly or little competition allows the affected firm to make a large profit. As a result, in this kind of business, goodwill is highly valued.
(v) Managerial efficiency: A company’s cost and productivity both go down when its managers are effective. Profit rises as a result, which eventually raises the value of goodwill.
(vi) Additional unique advantages: A company’s goodwill is highly valued when it obtains a license, patent, trademark, or has been making more money. In addition to the previously mentioned elements, a company’s historical successes, positive labor relations, services after sales, etc., can also be factors in increasing profit. Under these conditions, the company’s goodwill is once more quite high.
(2) Explain the nature of the goodwill.
Answer:
When a partnership firm reconstructs its assets and liabilities, goodwill must also be determined at the time of revaluation.
(i) Goodwill for a business is an intangible asset that belongs to the non-current asset category.
(ii) Intangible assets are invisible but have value in the market over time. A well-established company gains a reputation, good name, and extensive network of business contacts that are advantageous to the company. The primary driver of the goodwill is the advantage’s monetary worth.
(iii) Businesses that make a regular profit or lose money don’t have goodwill.
(iv) Goodwill is shown as an intangible asset within the noncurrent assets section of the balance sheet’s assets section.
(3) Explain the simple average method for the valuation of goodwill.
Answer:
The average profit over a specific period of time is taken into account when valuing goodwill using the simple average technique. Next, in order to value goodwill, this average profit must be multiplied by a specific number of years. Here, it is expected that a new company will need to operate for a specific number of years in order to turn a profit. As a result, the buyer of the business is willing to pay goodwill valued at the number of years of average profit.
Goodwill is often defined as the product of the average profit and the number of years during which the forecasted profit is expected.
Illustration : Profit of a firm for last four years is 40,000; ₹ 45,000; ₹ 35,000 and ₹ 60,000 respectively. Value of the goodwill to be determined on the basis of 3 year purchase of last 4 years average profit.
Total profit = ₹ 40,000 + ₹ 45,000 + ₹ 35,000 + ₹ 60,000 = ₹ 1,80,000
Goodwill = Average profit × No. of years of purchase
(4) Explain the weighted average method for the valuation of goodwill.
Answer:
If the profit in the weighted average profit method is increasing steadily, we should give the profits from recent years more weight and the earnings from earlier years relatively less weight. Typically, the profit weights of various years are numbered 1, 2, 3,…
Weighted average profit is the result of averaging weightage with profit after it has been determined. When precise instructions are provided or the business’s profit shows a consistent upward or downward trend, goodwill must be determined using the weighted average profit method.
Illustration : Profit of a firm for last 3 years is ₹ 22,000; ₹ 25,000 and ₹ 30,000 respectively. Determine the value of goodwill on the basis of 2 years purchase of last 3 year weighted average profit.
Goodwill = Weighted average profit × No. of years of purchase = ₹ 27,000 × 2 = ₹ 54,000
(5) Explain the super profit method for the valuation of goodwill.
Answer:
The capital used by the company, the expected rate of return, the expected profit, the average profit, etc. are used in the super profit technique of goodwill valuation.
The term “super profit” refers to the amount of excess profit that a business achieves over typical profit, defined as the excess of average profit over the predicted profit.
It is important to consider the following factors when determining goodwill using the super profit method.
(6) Explain the profit capitalization method for the valuation of goodwill.
Answer:
In the capitalization of profit method, average profit of the business is computed and it is used to determine its capitalized value on the basis of normal/expected rate of return of the business. Thus, profit arrived at is known as capitalization of profit.
Capitalized profit means capitalized value of average profit on the basis of the expected rate of return.
Goodwill = Capitalized profit – Capital employed
If capitalized amount is equal to the capital employed or less, then there is no goodwill of the business.
Illustration : From the following information of a firm, determine the value of goodwill on the basis average profit capitalization method.
Total Assets ₹ 10,00,000; Total liabilities ₹ 2,00,000; Expected rate of return 10%; last three years profit of the firm is ₹ 1,10,000; ₹ 1,30,000 and ₹ 1,20,000 respectively.
Chapter 1 Introduction to Partnership
4. From the following information of Bhavesh and Vipul’s firm, compute the value of goodwill on the basis of 4 years purchase of last five years average profit. Information of last five years profit is as under :
Answer:
Statement showing computation of average profit :
| Year | Profit (₹) |
|---|---|
| 2011-12 | 1,00,000 |
| 2012-13 | 1,10,000 |
| 2013-14 | 1,80,000 |
| 2014-15 | 2,00,000 |
| 2015-16 | 1,50,000 |
| Total | 7,40,000 |
Goodwill = Average profit × No. of years purchased
= ₹ 1,48,000 × 4 = ₹ 5,92,000
∴ Goodwill = ₹ 5,92,000
Chapter 1 Introduction to Partnership
5.Mahendra and Pravin are partners of a firm sharing profit and loss in the ratio of 3 : 2. They want to change their profit-loss sharing ratio to 1 : 1. Therefore, they decided to make valuation of goodwill. As per partnership agreement, value of goodwill to be determine on the basis of 5 years purchase of last 4 years average profit.
Answer:
Statement showing computation of average profit :
Chapter 1 Introduction to Partnership
6.From the following information find out weighted average profit.
Answer:
Statement showing computation of weighted profit :
Chapter 1 Introduction to Partnership
7. From the following information of Babulal and Kantilal’s firm, determine the value of goodwill on the basis of 3 years purchase of last five years weighted average profit :
Answer:
Chapter 1 Introduction to Partnership
8. Pushapa, Pratibha and Bhavna are partners of a partnership firm. They decided to change their profit-loss sharing ratio from 3 : 2 : 1 to 1 : 1 : 1. Therefore they decided to make the valuation of goodwill. On the basis of partnership firm’s profit and other information, determine the value of goodwill on the basis of three years purchase of super profit. Assets : ₹ 6,00,000; Liabilities : ₹ 2,50,000; Expected rate of return : 10% Actual Profit:
| Year | Profit (₹) |
|---|---|
| 2013-14 | 60,000 |
| 2014-15 | 80,000 |
| 2015-16 | (20,000) |
| 2016-17 | 30,000 |
| Total | 1,50,000 |
Answer:
Chapter 1 Introduction to Partnership
9. Capital of Meena and Manju’s firm is ₹ 4,00,000 and expected rate of return is 10%. Last three year’s profits are ₹ 1,20,000 ₹ 1,10,000 and ₹ 1,00,000 respectively. Compute the value of goodwill two times of super profit on the basis weighted average method.
Answer:
Chapter 1 Introduction to Partnership
10. From the following information of Nairutva and Rutvik’s firm determine the value of goodwill of partnership firm on the basis of capitalization of weighted average profit method.
Additional information : (1) Business assets : ₹ 6,00,000. (2) Business liabilities : ₹ 1,70,000. (3)Normal expected return of business is 10%.
Answer:
Chapter 1 Introduction to Partnership
11. Determine the value of goodwill of Prabha and Prabhu’s firm on the basis of capitalized super profit method. (1) Capital employed : ₹ 9,00,000 (2) Expected rate of return : 12 % (3) Last five years profit :
Answer:
Chapter 1 Introduction to Partnership
12. Rajesh and Harish are partners of a partnership firm. On the basis of their partnership firm’s profit and other information, determine the value of goodwill on the basis of two years purchase of super profit. (1) Capital employed : ₹ 8,00,000 (2) Expected rate of return : 12 % (3) Previous year’s profit :
Answer:
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- Chapter 2 Final Accounts (Financial Statements) of Partnership Firm
- Chapter 4 Reconstruction of Partnership
| Year | Profit (₹) |
|---|---|
| 2014-15 | 80,000 |
| 2015-16 | 70,000 |
| 2016-17 | 90,000 |