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Goodwill Chapter Class XII

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    Akhil M

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Notes on Goodwill For Students of Class XII.

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    CHAPTER 2 GOODWILL: NATURE AND VALUATION (A) (B) (C) Meaning of Goodwill: Goodwill is an intangible asset which places an organization in such a position that it earns higher profits without putting in extra efforts. Reason for valuation of Goodwill: Whenever the mutual rights of the partner's changes then party which makes a sacrifice must be compensated. This basis of compensation is goodwill so we need to calculate goodwill. 1. When the profit sharing ratio amongst the partners is changed; 2. When a new partner is admitted; 3. When a partner retires or dies; and 4. When the business is dissolved or sold 5. When amalgamation of 2 firms take place. Method for valuation of Goodwill: Average Profit Method Valuation of Goodwill Super Profit Method Capitalisation Method Here we are talking about the profit in order to value the goodwill of the firm. So one question arise which profit we should take. I.e. Net profit as per P&L account or any adjustments need to be done? The answer is that we valuate goodwill on the basis of profitability of business which it earned by its operations/manufacturing/trading activity. Hence, adjusted profit must be calculated in manner given below; which will be used for calculating goodwill Particulars Profit/Loss of Past year(s) Add: Abnormal Losses (Theft, fire etc.) Loss on sale of assets Overvaluation of Opening Stock Non Recurring Expenditure Capital Exp. Charged as Revenue Less: Amount xxx xxx xxx xxx xxx xxx Abnormal Gain (Profit - Asset Sale)XXX Overvaluation of Closing Stock Non recurring Income Partner's remuneration ADJUSTED PROFITS xxx xxx xxx xxx Remarks Given in Question It is deducted in P&L a/c. Hence added here. It is not a normal activity business. Hence Added High Opening stock resulted in low profits. So Such expenses are not likely to happen in future. Added since profits are lowered due to wrong entry. It is added in P&L A/c. Hence deducted from here. High closing stock resulted in High profits. So (-) Such incomes not likely to occur in future. If not deducted & to be paid in future. To be considered while calculating Goodwill 31
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    Average Profit Method Under this method, goodwill is valued on the basis of a certain number of years' purchase of the Normal average profits of the past few years. Normal Average profit means profit which is calculated by adding abnormal losses and by subtracting abnormal profits. Normal profits are multiplied by the number of years of purchase to calculate value of the goodwill Average Profit = Total Profit/ No. of Years Goodwill = Average profit x No. of year of profits No of year of purchase means: Number of years for which firm will earn the same amount of profits because of its past efforts. Example: A, B and C are partners in a firm sharing profits and losses in the ratio of 3:2:1. They decide to take D into partnership from 01-Jan-2017 for 1/6th share in the future profits. For this purpose, goodwill is to be valued at 3 times the average annual profits of the previous four years. The average profits for the past four years were: Year 2013 2014 2015 2016 Amount 96,000 60,000 62,500 84,500 Calculate the value of goodwill Answer: Step 1: Calculation of average profit: Year Amount 2013 96,000 2014 60,000 2015 62,500 2016 Average profits = 3,03,000/4 = INR 75,750(Average Profit = Total Profit/No. of Years) Goodwill = 3 * 75,750 = INR 2,27,250 (Goodwill = Average profit x No. of year of profits) Super Profit Method If a firm earns higher profit in comparison to normal profit (generally earned by other firms of same industry) then the difference is called Super Profit. Goodwill is calculated on the basis of Super profit due to future expectations of learning capacity of the firm. The formula to derive super profit: Step 1: Calculation of super Profit Super profit = Average profit - Normal profit Step 2: Calculation of Normal Profit Normal Profit = Investment (Capital Employed) x Normal Rate of Return/ 100 41
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    Step 3: Calculation of Average Profit Average Profit will be calculated on the basis of Information provided in question. Example: A firm earned net profits during the last three years as: Year Profit (INR) 2008-09 30,000 2009-10 40,000 2010-11 50,000 The capital investment of the firm is 1, 20,000.Afair return on the capital having regard to the risk involved is 10%. Calculate the value of goodwill on the basis of three years purchase of the average profit for the last three years. Solution: Step 1: Calculation of super Profit Super profit = = INR 28,000 Step 2: Calculation of Normal Profit Normal Profit = INR x 10/100 = INR 12,000 Step 3: Calculation of Average Profit Average Profit • = = 40,000 Capitalization Method: ANS In this method capitalized value of the firm is calculated on the basis of normal rate of return. Difference between the capitalized value and actual capital employed is called goodwill. Example Akhil Ltd. earns INR as its annual profits, the rates of normal profit being 10% The assets of the firm amounted to INR and liabilities to INR Find out the value of goodwill by capitalization method. Goodwill = Capitalized value - capital Employed = INR Calculation of capitalized value Calculation of capitalized value ANS = Average Profit/Normal Rate of Return — Total Assets - Total Liabilities 51
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    Calculation of Capital employed: 2 way of calculating capital employed* LIABILITIES Capital account Reserves & surplus Creditors utstanding Expanses Liability approach: AMOUNT xxx xxx xxx xxx ASSETS Fixed Assets Current Asset Investment (Non-trade) Advertisement Ex Goodwill AMOUNT xxx xxx xxx xxx xxx Capital+ Reserves & surplus — Investment (Non-Trade)-Fictitious Assets Assets approach: Total asset (Except goodwill, fictitious assets & non trade investment) — Outside Liabilities 61


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