A business has earned average profits of ₹2,50,000 during the last few years. The firm has assets of ₹25,00,000 and external liabilities of ₹4,50,000. The similar business has a rate of return of 10%. Calculate value of Goodwill by Capitalisation method:
₹4,50,000
Calculating Goodwill by Capitalisation Method
The question requires us to calculate the value of goodwill for a business using the Capitalisation method. This method assesses goodwill by comparing the capital required to earn the average profits at the normal rate of return with the actual capital employed in the business.
Understanding the Given Information
- Average Profit earned by the business: ₹2,50,000
- Total Assets of the firm: ₹25,00,000
- External Liabilities of the firm: ₹4,50,000
- Normal Rate of Return in a similar business: 10%
Steps for Calculation using Capitalisation of Average Profits Method
The Capitalisation of Average Profits method involves the following steps:
- Calculate the Net Assets (Capital Employed) of the business.
- Calculate the Capitalised Value of the business based on the average profit and the normal rate of return.
- Calculate Goodwill by subtracting the Net Assets from the Capitalised Value.
Step 1: Calculate Net Assets (Capital Employed)
Net Assets are calculated as the difference between Total Assets and External Liabilities.
Formula: $\text{Net Assets} = \text{Total Assets} - \text{External Liabilities}$
Calculation:
$\text{Net Assets} = ₹25,00,000 - ₹4,50,000$
$\text{Net Assets} = ₹20,50,000$
Step 2: Calculate Capitalised Value of the Business
The Capitalised Value of the business is the amount of capital required to earn the average profit if invested at the normal rate of return.
Formula: $\text{Capitalised Value} = \frac{\text{Average Profit}}{\text{Normal Rate of Return}}$
Normal Rate of Return = 10% = $\frac{10}{100} = 0.10$
Calculation:
$\text{Capitalised Value} = \frac{₹2,50,000}{0.10}$
$\text{Capitalised Value} = ₹25,00,000$
Step 3: Calculate Goodwill
Goodwill is the excess of the Capitalised Value of the business over its actual Net Assets (Capital Employed).
Formula: $\text{Goodwill} = \text{Capitalised Value} - \text{Net Assets}$
Calculation:
$\text{Goodwill} = ₹25,00,000 - ₹20,50,000$
$\text{Goodwill} = ₹4,50,000$
Alternative Method: Capitalisation of Super Profits
Goodwill can also be calculated using the Capitalisation of Super Profits method. Super Profit is the excess of Average Profit over Normal Profit.
Steps:
- Calculate Net Assets (Capital Employed) - already done: ₹20,50,000.
- Calculate Normal Profit.
- Calculate Super Profit.
- Calculate Goodwill by capitalising Super Profit.
Step 2 Alt: Calculate Normal Profit
Normal Profit is the profit expected from the capital employed at the normal rate of return.
Formula: $\text{Normal Profit} = \text{Net Assets} \times \text{Normal Rate of Return}$
Calculation:
$\text{Normal Profit} = ₹20,50,000 \times 0.10$
$\text{Normal Profit} = ₹2,05,000$
Step 3 Alt: Calculate Super Profit
Formula: $\text{Super Profit} = \text{Average Profit} - \text{Normal Profit}$
Calculation:
$\text{Super Profit} = ₹2,50,000 - ₹2,05,000$
$\text{Super Profit} = ₹45,000$
Step 4 Alt: Calculate Goodwill by Capitalising Super Profit
Formula: $\text{Goodwill} = \frac{\text{Super Profit}}{\text{Normal Rate of Return}}$
Calculation:
$\text{Goodwill} = \frac{₹45,000}{0.10}$
$\text{Goodwill} = ₹4,50,000$
Both methods give the same goodwill value of ₹4,50,000.
Summary of Calculation
| Particulars | Amount (₹) |
|---|---|
| Average Profit | 2,50,000 |
| Total Assets | 25,00,000 |
| Less: External Liabilities | 4,50,000 |
| Net Assets (Capital Employed) | 20,50,000 |
| Normal Rate of Return | 10% |
| Capitalised Value (Average Profit / NRR) | 25,00,000 |
| Less: Net Assets | 20,50,000 |
| Goodwill (Capitalisation of Average Profits) | 4,50,000 |
The calculated value of Goodwill by the Capitalisation method is ₹4,50,000.
Revision Table: Goodwill Calculation Methods
| Method | Key Concept | How Goodwill is Calculated |
|---|---|---|
| Average Profit Method | Future Maintainable Profit | Average Profit × Number of Years' Purchase |
| Super Profit Method (Purchase of Super Profit) | Profit above normal | Super Profit × Number of Years' Purchase |
| Super Profit Method (Capitalisation) | Value of Super Profit | Super Profit / Normal Rate of Return |
| Average Profit Method (Capitalisation) | Capitalised Value vs. Net Assets | (Average Profit / Normal Rate of Return) - Net Assets |
Additional Information: Concepts in Goodwill Valuation
Understanding the terms used in goodwill valuation is crucial:
- Average Profit: The average profit earned by the business over a specified number of past years. It can be simple average or weighted average.
- Normal Rate of Return (NRR): The rate of return that businesses in the same industry and with similar risks usually earn on their capital employed.
- Normal Profit: The profit that the business is expected to earn on its capital employed at the normal rate of return.
- Super Profit: The profit earned by the business over and above the normal profit. It represents the extra earning capacity due to factors like good reputation, location, management, etc.
- Capital Employed (Net Assets): The total capital invested in the business. It is calculated as Total Assets minus External Liabilities. Sometimes, it can also be calculated as Shareholders' Funds plus Long-term Loans.
- Capitalised Value: The value of the entire business calculated by capitalising the average profit at the normal rate of return. It is the theoretical capital needed to earn the average profit at the market rate.
Important Questions from Accounting for Partnership : Goodwill
Consider the following facts about valuation of Goodwill of a partnership firm:
A. Goodwill valuation is done on change in profit sharing ratio among the existing partners.
B. Goodwill is valued on admission of a partner, to know the amount to be paid by him to compensate sacrificing partner(s).
C. Goodwill valuation is done on the retirement of a partner to know the amount to be paid to him as compensation for his sacrifice.
D. Goodwill valuation is done at the time of dissolution of a firm which involves sale of business as a going concern.
E. Goodwill valuation is done during the distribution of profits of the partnership firm.
Choose the correct answer from the options given below:
In the context of a partnership firm, the need for valuation of goodwill arises in the following circumstances.
According to AS-26 on Intangible Assets:
(A) Internally generated goodwill should not be recognised as an asset
(B) Self-generated goodwill is accounted for in the books and shown as an asset
(C) Intangible assets should be written off as early as possible but not exceeding its estimated life
(D) Purchased goodwill is not recognised as an asset
(E) Can be written off even beyond 10 years depending upon the nature of the asset
Choose the correct answer:
Match List I with List II.
List - I List - II (A) Normal Rate of Return (I) Total Assets – Outside Liabilities (B) Number of years purchase (II) Usual return on capital employed (C) Capital Employed (III) Return over and above usual return in similar business (D) Super Profit (IV) Expected period for which returns are anticipated to accrue Choose the correct answer:
Under the capitalisation method of calculating goodwill, the term capital refers to:
