GOODWILL AND METHOD OF ITS VALUATION
Goodwill is the value of an established business over and above the value represented by its tangible assets. It is the reputation that the firm has built up in the course of its business. It is also the value attached to the super profit earning capacity of a business arising from its wide connections and long standing in the business. Goodwill is the value of the good name of a firm, which attracts more customers and helps it earn more profits. It is an intangible fixed asset built up slowly by the owners of the business over a period of time and is very often recorded in the books of account. Unlike a fictitious asset, which has no realisable value, Goodwill has a realisable value and can be bought and sold in the market.
Necessity: The necessity for valuation of goodwill in a firm arises in the following cases:
1. Change in profit sharing ratio.
2. Admission of a new partner.
3. Retirement, expulsion or death of a partner
4. Sale of business
There are mainly three methods of valuation of goodwill, viz. (i) Average Profit Method
(ii) Super Profit Method
(iii) Capitalisation of Profit Method
(i) Average Profit Method
In this method, goodwill is valued on the basis of the average profits of past few years (normally abnormal increase or decrease in profit is left out). Average profit (simple or weighted), so arrived at, is multiplied by an agreed multiplier factor (called number of years’ purchase) and the amount so arrived is taken as the amount of goodwill.
(ii) Super Profit Method
Under this method, goodwill is calculated on the basis of the number of years’ purchase of Super Profits. Super Profit is the difference between the Actual Profit and the normal expected profit in the trade.
Super profit is multiplied by a certain multiplier, as in the simple average method.
(iii) Capitalisation of Profit Method
Under this method, value of goodwill is arrived at after capitalising the normal profit at a given reasonable or normal rate of return. Profit, when divided by the normal rate of return, gives the amount, which should have been invested in the business of the firm in the form of capital. This value is compared with the net assets of the firm. The value of goodwill is the excess of capitalised value over the net assets of the firm.
ADMISSION OF A PARTNER
A new partner may be admitted into an existing partnership for the purpose of securing additional capital or additional skill or for any other purpose. When a new partner is admitted in an existing firm, the new partner will get certain benefits such as:
• Share in the assets and liabilities of the firm.
• Share in the profit/loss of the firm.
• Share in the goodwill enjoyed by the firm.
All these advantages are derived by the new partner at the initial sacrifice of the old partners. Thus, at the time of admission of a new partner, the following steps are required to be taken by the firm:
1. Revaluation of assets and liabilities
2. Treatment of goodwill
3. Decision regarding amount of capital to be brought in by the new partner
4. Adjustment regarding accumulated losses and reserves
5. Capital accounts of the partner.
1. Revaluation of Assets and Liabilities
A new partner, admitted into a partnership, gets a share in the profits as well as the assets of the business. On the date of admission of the new partner, the real value of assets of the firm may be more or less than the value appearing in the books of account. This increase or decrease in value belongs entirely to the old partners and hence, has to be adjusted before the admission of the new partner. Similarly, the liabilities existing on the date of admission of the new partner may also need revision.
When the asset value increases, there is a profit and when it goes down, there is a loss. When liabilities increase, there is a loss and when liabilities decrease, there is a profit. This increase or decrease in assets and liabilities is adjusted to the accounts of the old partners through an account called the
‘Revaluation Account’ or ‘Profit and loss Adjustment Account’. The entries recorded in this account are on the principle that when there is a loss, debit profit and loss adjustment account and when there is a gain, credit profit and loss adjustment account. The difference in the two sides of this account will show either profit or loss, which is transferred to the accounts of the old partners in old profit sharing ratio.
2. Treatment of Goodwill
A. Admission of a Partner
When a new partner is admitted to partnership, adjustments of goodwill is necessary because goodwill has been built up by the old partners over a period of years for which they have worked hard and they would not like to just pass on a part of it to the new partner. The new partner also gets a share in profits of the firm from the date of his admission, which is sacrificed by the existing partners. The existing partners would not like to just pass on this benefit to the new partner without a consideration.
B. Retirement or Death of a Partner
On retirement or death of any partner, the portion of goodwill of the firm belonging to the retiring partner or the partner who died, has to be paid by the continuing/surviving partners, to the retiring partner or the heirs of the deceased partner, as the case may be. As the continuing/surviving partners gain in terms of increase in share of profits due to death/retirement of a partner, they bear this amount of goodwill paid, in the gain ratio.
3. Capital to be brought in by a New Partner
The new partner brings in capital, in addition to goodwill, to get a share in the firm’s assets, liabilities and profits. It can be in the form of cash or assets.
4. Adjustment Regarding Accumulated Losses and Reserves
Normally, the profits of the partnership are divided between the partners at the end of each year. In case, a part of the profits is kept in reserve, to take advantage of it in bad times, then the old partners would not like the newly admitted partner to share the benefit of this reserve or undistributed profits. Therefore, the said amount is divided by the old partners amongst themselves in the old profit sharing ratio.
Sometimes, losses of the earlier years are carried by the partnership under the head profit and loss account. They also belong entirely to the old partners and the new partner would definitely not bear this loss.
5. Adjustment of Capital Accounts of Partners
Sometimes, it may be decided that after the admission of a new partner, the old partners’ capitals should also be adjusted according to the new profit sharing ratio. This is because old partners’ capital balances may have changed considerably due to revaluation of assets and liabilities, transfer of reserves, adjustment of goodwill, etc. For this purpose, generally, the new partner’s capital and his share of profit are taken as the basis for calculation and the old partners’ capitals are ascertained according to the future profit sharing ratio. The amounts so arrived at are compared with the capitals standing to the credit of their capital accounts. Excess may be paid off by the firm to the old partners and deficiency, if any, may be required to be made up by them by bringing in additional cash.
RETIREMENT AND DEATH OF A PARTNER
A. Retirement of a Partner
Retirement of a partner means that the partner breaks off his/her relations with all other partners and withdraws himself/herself from the firm.
Reasons of Retirement
(a) Due to old age
(b) Retiring partner may not have faith in the future prospects of the firm or in other partners
(c) Difference of opinion with other partners
(d) Retiring partner may migrate or shift from the place of business
(e) Voluntarily decides to retire
(f) As per terms of partnership deed.
According to Section 32 of the Indian Partnership Act, 1932, a partner may retire: (a) with the consent of all the partners,
(b) in accordance with the terms of the partnership agreement, or
(c) by giving a notice to all the partners of his intention to retire, when the partnership is ‘At Will’.
In case of retirement, a retiring partner is interested in collecting his share in the various activities of the business of which he was a part owner till the date of his retirement.
B. Death of a Partner
In retirement, a partner breaks off his/her relation with the firm voluntarily, i.e. on his own. Death of a partner automatically terminates such relationship. Unlike retirement, which is on a specific convenient date mutually agreed upon with other partners, death of a partner can occur at any time during the accounting year.
C. New Profit Sharing Ratio of Continuing Partners
After retirement or death of a particular partner, the continuing partners may agree to share the profits in the same old ratio or in a new agreed ratio. The ratio in which the continuing partners gain or benefit from the share of the retiring or dead partner is called the ‘Gaining ratio’. Gaining ratio is equal to the new ratio minus the old ratio.
D. Joint Life Policy
In order to provide for the cash in contingency like the death of a partner, etc., a firm may decide to take a joint life policy on the lives of partners so that the proceeds received from the insurance company may be utilised to make payments of the dues of a deceased partner and the firm is saved from financial hardship.
SLEEPING PARTNER AND QUASI PARTNER
Sleeping Partner
In a partnership, very often, some partners agree to work while others are interested in merely investing the capital and getting a share of profits. Such partners are normally not interested in the day-to-day working of the partnership and are called sleeping partners. The other partners who work for the business of the firm are called working partners or active partners. However, it must be noted that law makes no difference between a sleeping partner and a working partner and the sleeping partner will be equally responsible to the third parties for all acts or omissions of a working partner.
Quasi or Nominal Partner
Sometimes, some prominent persons lend their names to a firm in order to allow the firm to enjoy their goodwill in furtherance of its business. Likewise, in some cases, a person’s name may be used by the partnership firm showing him/her to be a partner, whereas the person is, in fact, not a partner in the firm. In such cases, although no relationship of partnership exists, the law stops a person from disclaiming his/her status as partner vis-à-vis third parties, if he/she keeps quiet, in spite of being fully aware of the fact that his/her name is utilised as partner. Such a quasi-partnership protects the third parties who may make a non-partner liable in these circumstances.
Goodwill is the value of an established business over and above the value represented by its tangible assets. It is the reputation that the firm has built up in the course of its business. It is also the value attached to the super profit earning capacity of a business arising from its wide connections and long standing in the business. Goodwill is the value of the good name of a firm, which attracts more customers and helps it earn more profits. It is an intangible fixed asset built up slowly by the owners of the business over a period of time and is very often recorded in the books of account. Unlike a fictitious asset, which has no realisable value, Goodwill has a realisable value and can be bought and sold in the market.
Necessity: The necessity for valuation of goodwill in a firm arises in the following cases:
1. Change in profit sharing ratio.
2. Admission of a new partner.
3. Retirement, expulsion or death of a partner
4. Sale of business
There are mainly three methods of valuation of goodwill, viz. (i) Average Profit Method
(ii) Super Profit Method
(iii) Capitalisation of Profit Method
(i) Average Profit Method
In this method, goodwill is valued on the basis of the average profits of past few years (normally abnormal increase or decrease in profit is left out). Average profit (simple or weighted), so arrived at, is multiplied by an agreed multiplier factor (called number of years’ purchase) and the amount so arrived is taken as the amount of goodwill.
(ii) Super Profit Method
Under this method, goodwill is calculated on the basis of the number of years’ purchase of Super Profits. Super Profit is the difference between the Actual Profit and the normal expected profit in the trade.
Super profit is multiplied by a certain multiplier, as in the simple average method.
(iii) Capitalisation of Profit Method
Under this method, value of goodwill is arrived at after capitalising the normal profit at a given reasonable or normal rate of return. Profit, when divided by the normal rate of return, gives the amount, which should have been invested in the business of the firm in the form of capital. This value is compared with the net assets of the firm. The value of goodwill is the excess of capitalised value over the net assets of the firm.
ADMISSION OF A PARTNER
A new partner may be admitted into an existing partnership for the purpose of securing additional capital or additional skill or for any other purpose. When a new partner is admitted in an existing firm, the new partner will get certain benefits such as:
• Share in the assets and liabilities of the firm.
• Share in the profit/loss of the firm.
• Share in the goodwill enjoyed by the firm.
All these advantages are derived by the new partner at the initial sacrifice of the old partners. Thus, at the time of admission of a new partner, the following steps are required to be taken by the firm:
1. Revaluation of assets and liabilities
2. Treatment of goodwill
3. Decision regarding amount of capital to be brought in by the new partner
4. Adjustment regarding accumulated losses and reserves
5. Capital accounts of the partner.
1. Revaluation of Assets and Liabilities
A new partner, admitted into a partnership, gets a share in the profits as well as the assets of the business. On the date of admission of the new partner, the real value of assets of the firm may be more or less than the value appearing in the books of account. This increase or decrease in value belongs entirely to the old partners and hence, has to be adjusted before the admission of the new partner. Similarly, the liabilities existing on the date of admission of the new partner may also need revision.
When the asset value increases, there is a profit and when it goes down, there is a loss. When liabilities increase, there is a loss and when liabilities decrease, there is a profit. This increase or decrease in assets and liabilities is adjusted to the accounts of the old partners through an account called the
‘Revaluation Account’ or ‘Profit and loss Adjustment Account’. The entries recorded in this account are on the principle that when there is a loss, debit profit and loss adjustment account and when there is a gain, credit profit and loss adjustment account. The difference in the two sides of this account will show either profit or loss, which is transferred to the accounts of the old partners in old profit sharing ratio.
2. Treatment of Goodwill
A. Admission of a Partner
When a new partner is admitted to partnership, adjustments of goodwill is necessary because goodwill has been built up by the old partners over a period of years for which they have worked hard and they would not like to just pass on a part of it to the new partner. The new partner also gets a share in profits of the firm from the date of his admission, which is sacrificed by the existing partners. The existing partners would not like to just pass on this benefit to the new partner without a consideration.
B. Retirement or Death of a Partner
On retirement or death of any partner, the portion of goodwill of the firm belonging to the retiring partner or the partner who died, has to be paid by the continuing/surviving partners, to the retiring partner or the heirs of the deceased partner, as the case may be. As the continuing/surviving partners gain in terms of increase in share of profits due to death/retirement of a partner, they bear this amount of goodwill paid, in the gain ratio.
3. Capital to be brought in by a New Partner
The new partner brings in capital, in addition to goodwill, to get a share in the firm’s assets, liabilities and profits. It can be in the form of cash or assets.
4. Adjustment Regarding Accumulated Losses and Reserves
Normally, the profits of the partnership are divided between the partners at the end of each year. In case, a part of the profits is kept in reserve, to take advantage of it in bad times, then the old partners would not like the newly admitted partner to share the benefit of this reserve or undistributed profits. Therefore, the said amount is divided by the old partners amongst themselves in the old profit sharing ratio.
Sometimes, losses of the earlier years are carried by the partnership under the head profit and loss account. They also belong entirely to the old partners and the new partner would definitely not bear this loss.
5. Adjustment of Capital Accounts of Partners
Sometimes, it may be decided that after the admission of a new partner, the old partners’ capitals should also be adjusted according to the new profit sharing ratio. This is because old partners’ capital balances may have changed considerably due to revaluation of assets and liabilities, transfer of reserves, adjustment of goodwill, etc. For this purpose, generally, the new partner’s capital and his share of profit are taken as the basis for calculation and the old partners’ capitals are ascertained according to the future profit sharing ratio. The amounts so arrived at are compared with the capitals standing to the credit of their capital accounts. Excess may be paid off by the firm to the old partners and deficiency, if any, may be required to be made up by them by bringing in additional cash.
RETIREMENT AND DEATH OF A PARTNER
A. Retirement of a Partner
Retirement of a partner means that the partner breaks off his/her relations with all other partners and withdraws himself/herself from the firm.
Reasons of Retirement
(a) Due to old age
(b) Retiring partner may not have faith in the future prospects of the firm or in other partners
(c) Difference of opinion with other partners
(d) Retiring partner may migrate or shift from the place of business
(e) Voluntarily decides to retire
(f) As per terms of partnership deed.
According to Section 32 of the Indian Partnership Act, 1932, a partner may retire: (a) with the consent of all the partners,
(b) in accordance with the terms of the partnership agreement, or
(c) by giving a notice to all the partners of his intention to retire, when the partnership is ‘At Will’.
In case of retirement, a retiring partner is interested in collecting his share in the various activities of the business of which he was a part owner till the date of his retirement.
B. Death of a Partner
In retirement, a partner breaks off his/her relation with the firm voluntarily, i.e. on his own. Death of a partner automatically terminates such relationship. Unlike retirement, which is on a specific convenient date mutually agreed upon with other partners, death of a partner can occur at any time during the accounting year.
C. New Profit Sharing Ratio of Continuing Partners
After retirement or death of a particular partner, the continuing partners may agree to share the profits in the same old ratio or in a new agreed ratio. The ratio in which the continuing partners gain or benefit from the share of the retiring or dead partner is called the ‘Gaining ratio’. Gaining ratio is equal to the new ratio minus the old ratio.
D. Joint Life Policy
In order to provide for the cash in contingency like the death of a partner, etc., a firm may decide to take a joint life policy on the lives of partners so that the proceeds received from the insurance company may be utilised to make payments of the dues of a deceased partner and the firm is saved from financial hardship.
SLEEPING PARTNER AND QUASI PARTNER
Sleeping Partner
In a partnership, very often, some partners agree to work while others are interested in merely investing the capital and getting a share of profits. Such partners are normally not interested in the day-to-day working of the partnership and are called sleeping partners. The other partners who work for the business of the firm are called working partners or active partners. However, it must be noted that law makes no difference between a sleeping partner and a working partner and the sleeping partner will be equally responsible to the third parties for all acts or omissions of a working partner.
Quasi or Nominal Partner
Sometimes, some prominent persons lend their names to a firm in order to allow the firm to enjoy their goodwill in furtherance of its business. Likewise, in some cases, a person’s name may be used by the partnership firm showing him/her to be a partner, whereas the person is, in fact, not a partner in the firm. In such cases, although no relationship of partnership exists, the law stops a person from disclaiming his/her status as partner vis-à-vis third parties, if he/she keeps quiet, in spite of being fully aware of the fact that his/her name is utilised as partner. Such a quasi-partnership protects the third parties who may make a non-partner liable in these circumstances.
