Partnership: Fundamental - 2

Goodwill

A well-established business develops an advantage of good name, reputation and wide business connections. This helps the business to earn more profits as compared to a newly set up business, the monetary value of such advantage is known as “Goodwill”. In other words, goodwill is the value of the reputation of a firm in respect of the profits expected in future over and above the normal profits.

Goodwill in Partnership

Goodwill is also one of the special aspects of partnership accounts which requires adjustment (also valuation if not specified) at the time of reconstitution of a firm viz., a change in the profit-sharing ratio, the admission of a partner or the retirement or death of a partner.

Factors Affecting the Value of Goodwill
The main factors affecting the value of goodwill are as follows:
1. Nature of business: A firm which has stable demand for its products or when demand for its products is higher than the supply, then the firm is able to earn more profits In such a case, firm enjoys good reputation and has more goodwill.
2. Location: If the business is centrally located or is at a place having heavy customer traffic, the goodwill tends to be high.
3. Efficiency of management:  A well-managed firm usually enjoys the advantage of high productivity and cost efficiency. This leads to higher profits and so the value of goodwill will also be high.
4. Market situation:  The monopoly condition or limited competition enables the concern to earn high profits which leads to higher value of goodwill.
5. Special advantages:  The firm that enjoys special advantages like import licenses, low rate and assured supply of electricity, long-term contracts for supply of materials, well-known collaborators, patents, trademarks, etc. enjoy higher value of goodwill.
6. Quality of Product: If the firm produces better quality of products or firm enjoys good reputation or popularity for the quality of its products, then the firm will have more value of its goodwill.
7. Favourable Contracts: If the firm has favourable contracts with other reputed firms or the firm has received bulk orders from big business houses, then its goodwill will
8. Time Factor or Longevity of Business or Age of Business: The period for which the business has been in the market also influences the value of goodwill.
9. Risk Involved in the Business: If more risk is involved in the business, then value of firm's goodwill will be less. However, if the business faces lower risks, then value of its goodwill will be more.
10. Increasing Trend of Profit: If profit of the business is continuously increasing, then goodwill of the firm will be high. However, if profit is continuously decreasing over the years, then there will be less value for goodwill.
Classification of Goodwill
Goodwill can be classified into two categories: Purchased Goodwill; and Self-Generated Goodwill.
Purchased Goodwill
Purchased goodwill arises when a business unit is purchased by another business concern and the purchase price paid is in excess (If the value of net assets (i.e. Assets - Liabilities) acquired.

According to AS-26: Intangible Assets, the depreciable amount of an intangible asset (like goodwill) should be allocated on a systematic basis over the best estimate of its useful life. In simple words, Purchased Goodwill should be amortized (written off) over the best estimate of its useful life.
Self-Generated Goodwill
It is an internally generated goodwill which arises from a number of attributes that a running business possesses. This Goodwill is earned over a period of years on account of many favourable factors that increase the value of business. As no consideration is paid for this goodwill, no cost can be placed on it. So, such goodwill is not shown in the Balance Sheet of the business.

As per Accounting Standard 26 - Intangible Assets, "Internally generated goodwill is not recognized as an asset because it is not an identifiable resource controlled by the entity that can be measured reliably at cost". So, it is not to be recorded in the books of accounts.

Need for Valuation of Goodwill
Normally, the need for valuation of goodwill arises at the time of sale of a business. But, in the context of a partnership firm it may also arise in the following circumstances:
            1. Change in the profit-sharing ratio amongst the existing partners;
            2. Admission of new partner;
            3. Retirement of a partner;
            4. Death of a partner; and
            5. Dissolution of a firm involving sale of business as a going concern.
            6. Amalgamation of partnership firms.

Methods of Valuation of Goodwill

The important methods of valuation of goodwill are as follows:
1. Average Profits Method       2. Super Profits Method       3. Capitalization Method
1. Average Profit Method – It is sub-categorized as follows:
1A. Simple Average Profit Method; 1B. Weighted Average Profit Method

1A. Simple Average Profit Method:

Steps for calculation of G/W under Simple Average Profit Method:
            (a) Average Profits = (Total Profits or Losses) / No. of years
            (b) Goodwill = Average Profits × No. of years purchase
Note:  Abnormal losses are added back to that year’s profits and Abnormal gains are deducted.

1B. Weighted Average Profit Method:
Steps for calculation of G/W under Weighted Average Profit Method:
            (a) Calculation of Total Product of Weighted Profits –

Year (a)	Profits / Losses after adjustments (b)	Weights (c)	Product (b × c)
		Total Weights	Total Product

            (b) Weighted Average Profits = Total Product / Total Weights

            (c)  Goodwill = Weighted Average Profits × No. of years purchase

2. Super Profits Method:
The excess of actual profits over the normal profits is termed as super profits.
            Steps for calculation of G/W under Super Profit Method:
            (a) Average Profits = (Total Profits or Losses) / No. of years
            (b) Normal Profit = Capital Employed × Normal Rate of Return/100
                        Capital Employed (Net Assets) = Total Assets (excluding G/W) – Outside Liabilities
                        Or, Partners’ Capital + Reserves, Profits etc.
            (c) Super Profits = Average Profits – Normal Profit
            (d) Goodwill = Super Profits × No. of years purchase
3. Capitalization Methods –
            Under this method the goodwill can be calculated in two ways:
            3A. Capitalization of Average Profits; 3B. Capitalization of Super Profits.

3A. Capitalization of Average Profits: 
Steps for calculation of G/W: 
(a) Average Profits = (Total Profits or Losses) / No. of years.
(b) Capitalized value of Average Profits = Average Profits × 100/Normal Rate of Return.
(c) Actual Capital Employed (Net Assets) = Total Assets (excluding G/W) – Outside Liabilities.
(d) Goodwill = Capitalized value of Average Profits – Actual Capital Employed (Net Assets).

3B. Capitalization of Super Profits:

Steps for calculation of G/W:
(a) Average Profits = (Total Profits or Losses) / No. of years
            (b) Normal Profit = Capital Employed × Normal Rate of Return/100
                        Capital Employed (Net Assets) = Total Assets (excluding G/W) – Outside Liabilities
                        Or, Partners’ Capital + Reserves, Profits etc.
(c) Super Profits = Average Profits – Normal Profit
(d) Goodwill = Super Profits × 100/Normal Rate of Return
            In other words, goodwill is the capitalized value of super profits. 

Change in Profit Sharing Ratio among the Existing Partners
Sometimes, the partners of a firm decide to change their existing profit-sharing ratio without any admission or retirement of a partner. This results in a gain of additional share in future profits of the firm for some partners while a loss of a part thereof for other partners. In such a situation, the partner who gain by change in profit effecting amounts to one partner buying the share of profit from another partner. Apart from the payment for compensation, the change in profit sharing ratio also necessitates adjustment in partner’s capital accounts with respect to undistributed profits and reserves, revaluation of assets and reassessment of liabilities.

Some Important Terms
1. Old Ratio: The ratio in which partners were sharing profits and losses before reconstitution of the firm is known as old ratio.
2. Sacrificing Partners: The partners whose share have decreased due to change in profit sharing ratio are known as Sacrificing Partners.
3. Gaining Partners: The partners whose share have increased due to change in profit sharing ratio are known as Gaining Partners.
4. Sacrificing Ratio: The ratio in which the partners have agreed to sacrifice their shares of profit in Favour of the other partner or partners, is known as Sacrificing Ratio. In other words, the ratio in which the partner(s) surrender their shares of profit in Favour of other partner(s), is known as sacrificing ratio. This ratio is calculated by taking out the difference between Old Profit Shares and New Profit Shares.                S.R. = O.R. – N.R.
            Sacrificing Ratio = Old Share – New Share

5. Gaining Ratio: The ratio in which the partners have agreed to gain their shares in profit from the other partner or partners, is known as Gaining Ratio. In other words, the ratio in which the partner(s) acquire the share from other partner(s), is known as gaining ratio. This ratio is calculated by taking out the difference between New Profit Shares and Old Profit Shares. 
            Gaining Ratio = New Share - Old Share (G.R. = N.R. – O.R.)

6. New Profit-Sharing Ratio: It is the ratio in which all the partners share the future profits and losses.

Revaluation of Assets and Reassessment of Liabilities
When there is a change in the profit-sharing ratio (PSR) of existing partners, then the assets and liabilities of the firm are revalued. They are revalued because if there is any change (increase or decrease) in the value of assets and liabilities, then such change belongs to the period prior to change in PSR. Hence, any profit or loss arising on such revaluation must be shared by the old partners in their old profit-sharing ratio.

The journal entries recorded for revaluation of assets and reassessment of liabilities are as follows:

(i) For increase in the value of an asset Asset A/c                                Dr.             To Revaluation A/c (Gain) (ii) For reduction in the value of an asset Revaluation A/c                      Dr.             To Asset A/c (Loss) (iii) For appreciation in the amt. of a liability Revaluation A/c                      Dr.             To Liability A/c (Loss) (iv) For reduction in the amt. of a liability Liability A/c                           Dr.             To Revaluation A/c (Gain) (v) For an unrecorded asset Asset A/c                                Dr.             To Revaluation A/c (Gain) (vi) For an unrecorded liability Revaluation A/c                      Dr.             To Liability A/c (Loss) (vii) For increase in Prov. on asset Revaluation A/c                      Dr.             To Prov. on asset A/c (Loss)

(viii) For decrease in Prov. on asset Prov. on asset A/c                   Dr.             To Revaluation A/c (Gain) (ix) For Overvalued Asset Revaluation A/c                      Dr.             To Overvalued Asset A/c (Loss) (x) For Undervalued Asset Undervalued Asset A/c           Dr.             To Revaluation A/c (Gain) (xi) For transfer of gain on Revaluation if credit balance Revaluation A/c                      Dr.             To Old Partners Cap. A/cs (Individually in old ratio) (xii) For transferring loss on revaluation Old partner’s Capital A/cs      Dr.              To Revaluation A/c (Individually in old ratio)

           

                                                            Format of Revaluation Account
Dr.                                                                   Revaluation Account                                                     Cr.

Particulars	Amt. (Rs.)	Particulars	Amt. (Rs.)
Decr. in the value of an asset Incr. in the value of liability Increase in prov. on asset Unrecorded Liability Overvalued Asset Outstanding Expenses Unearned Income Advance Income Profit transferred to:             A’s Capital                  B’s Capital		Incr. in the value of an asset Decr. in the value of liability Decrease in prov. on asset Unrecorded Asset Undervalued Asset Prepaid Expenses Accrued/Earned Income Cash (B/D recovered) Or, Loss transferred to:             A’s Capital                  B’s Capital

x