Goodwill
Nature & Methods of Valuation (Part B)
Meaning and nature of goodwill, factors affecting its value, all four valuation methods — average profit, weighted average, super profit and capitalisation — plus the treatment of goodwill when partners change their profit-sharing ratio. Numericals of every method included.
Goodwill = Naam Ki Kamai, Rupees Mein
Do dukaanein same products bechti hain, but ek zyada kamati hai — kyun? Reputation, location, loyal customers. Yehi extra earning power ka monetary value is goodwill. This chapter teaches how to put a number on that reputation, and how partners settle it when their profit-sharing ratio changes.
1. Goodwill — Meaning and Nature
Goodwill is the value of the reputation of a firm which enables it to earn profits higher than the normal profits earned by other firms in the same business. It is an intangible asset — it cannot be seen or touched — but it is NOT a fictitious asset, because it has a real, realisable value: a buyer actually pays for it when purchasing a business.
Purchased vs Self-Generated Goodwill (AS-26)
| Basis | Purchased Goodwill | Self-Generated Goodwill |
|---|---|---|
| Arises | When a business is purchased and consideration paid exceeds net assets acquired | Built over time through own efforts and reputation |
| Recorded in books? | Yes — shown as an intangible asset | No — Accounting Standard 26 prohibits recording it |
| Payment | Consideration is paid for it | No payment is made |
2. Factors Affecting the Value of Goodwill
Favourable Location
Prime location = more customers = higher profits = higher goodwill.
Efficient Management
Capable management increases productivity and profits, raising goodwill.
Quality of Products / Services
Better quality builds customer trust and repeat business.
Longer Life of Business
Older, established firms enjoy more reputation and customer loyalty.
Market Situation
Monopoly or limited competition allows higher profits and goodwill.
Special Advantages
Patents, trademarks, import licences, long-term contracts, brand image.
When is valuation of goodwill needed?
Whenever the mutual rights of partners change: change in profit-sharing ratio, admission of a partner, retirement or death of a partner, and sale or amalgamation of the firm.
3. Method 1 — Average Profit Method
Past profits are averaged (after adjusting abnormal items) and multiplied by the agreed number of years’ purchase — the number of years for which the firm is expected to earn similar profits because of its past reputation.
| Year | Given Profit (₹) | Adjustment | Normal Profit (₹) |
|---|---|---|---|
| 2023–24 | 90,000 | − 10,000 (abnormal gain removed) | 80,000 |
| 2024–25 | 1,00,000 | + 20,000 (abnormal loss added back) | 1,20,000 |
| 2025–26 | 1,00,000 | — | 1,00,000 |
| Total | 3,00,000 |
Solution: Average Profit = 3,00,000 ÷ 3 = ₹1,00,000. Goodwill = 1,00,000 × 2.5 = ₹2,50,000.
4. Method 2 — Weighted Average Profit Method
Used when profits show a clear rising or falling trend. Higher weights are given to recent years because they better indicate future earning capacity.
| Year | Profit (₹) | Weight | Product (₹) |
|---|---|---|---|
| 2023–24 | 90,000 | 1 | 90,000 |
| 2024–25 | 1,20,000 | 2 | 2,40,000 |
| 2025–26 | 1,50,000 | 3 | 4,50,000 |
| Total | 6 | 7,80,000 |
Solution: Weighted Average Profit = 7,80,000 ÷ 6 = ₹1,30,000. Goodwill = 1,30,000 × 2 = ₹2,60,000.
5. Method 3 — Super Profit Method
Super profit is the excess of the actual average profit over the normal profit that similar firms earn on the same capital. Only this extra earning power deserves goodwill.
Solution: Normal Profit = 5,00,000 × 10/100 = ₹50,000. Super Profit = 80,000 − 50,000 = ₹30,000. Goodwill = 30,000 × 3 = ₹90,000.
6. Method 4 — Capitalisation Method
(a) Capitalisation of Average Profit
(b) Capitalisation of Super Profit
Solution (a): Capitalised Value = 80,000 × 100/10 = ₹8,00,000. Goodwill = 8,00,000 − 6,50,000 = ₹1,50,000.
Solution (b): Normal Profit = 6,50,000 × 10/100 = ₹65,000. Super Profit = 80,000 − 65,000 = ₹15,000. Goodwill = 15,000 × 100/10 = ₹1,50,000. ✔ Same answer — verified.
7. Treatment of Goodwill on Change in Profit-Sharing Ratio
When the ratio changes, the gaining partner buys a share of future profits from the sacrificing partner — so the gainer must compensate the sacrificer with a proportionate share of the goodwill of the firm. As per AS-26, self-generated goodwill cannot be raised in the books, so the adjustment is made directly through capital accounts:
Step 0 — existing goodwill: If any goodwill already appears in the books, it must first be written off in the OLD ratio: Partners’ Capital A/cs Dr. (old ratio) → To Goodwill A/c. Only after this is the compensation entry passed.
Working: A: 3/5 − 1/2 = 1/10 sacrifice. B: 1/2 − 2/5 = 1/10 gain. Compensation = 1,50,000 × 1/10 = ₹15,000. Existing goodwill ₹40,000 written off in old ratio 3 : 2 → A 24,000, B 16,000.
| Date | Particulars | L.F. | Dr. (₹) | Cr. (₹) |
|---|---|---|---|---|
| 2026 Apr 1 | A’s Capital A/c Dr. | 24,000 | ||
| B’s Capital A/c Dr. | 16,000 | |||
| To Goodwill A/c | 40,000 | |||
| (Being existing goodwill written off in the old ratio 3 : 2 as per AS-26) | ||||
| Apr 1 | B’s Capital A/c Dr. | 15,000 | ||
| To A’s Capital A/c | 15,000 | |||
| (Being adjustment of goodwill of ₹1,50,000 on change in ratio — B gained 1/10 and A sacrificed 1/10) | ||||
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20 MCQs — Goodwill: Nature & Valuation (Part B)
Mixed difficulty — theory, all four valuation methods, and CUET-level numericals in Q17–Q20.
Chapter 2 (Part B) — Live Quiz
20 questions · Goodwill: Nature & Valuation · One at a time · Instant feedback
