Fixed Capital Method Fluctuating Capital Method
(i) Two accounts of each partner are maintained, i.e. capital account and current account
(i) Only one account of each partner i.e. capital account is maintained.
(ii) Balance in capital account remains the same except when capital is introduced or capital is withdrawn.
(ii) The balance in capital account changes every year because of profits/losses, drawings, interest on capital, interest on drawings, etc.
(iii) All adjustments in respect of profit, loss, drawings, interest on capital, interest on drawings, salary, commission, etc. are made in the current account.
(iii) All adjustments in respect of profit, loss, drawings, interest on capital, interest on drawings, salary, commission, etc. are made in the capital account.
(iv) The capital account will always have plus or credit balance while the current account may have debit (negative) balance.
(iv) Fluctuating capital account may sometimes show a debit (negative) balance.
GOODWILL
Goodwill is the value of reputation of a business house in respect of the profits expected in future over and above the normal level of profits earned by undertakings belonging to the same class of business. In other words, goodwill is the present value of a firm’s anticipated super normal earnings. The term super normal earnings means the earnings over and above the normal rate of return earned by representative firms in the same industry. Goodwill refers to the reputation of a business enterprise acquired by it over the period of time through its successful operations and customer’s satisfaction. It is an attribute of business which enables it to earn more than other firms in the industry. Goodwill is an intangible asset but not a fictitious one. The following are some of the factors that generally contribute to the value of goodwill of a firm:
–Quality of goods sold by the firm –Location of the business unit –Reputation of the owners of the firm –Monopolistic nature of the business –Risk involved in the business –Efficiency of management
–Possibility of competition –Government attitude
–Possession of special contracts for availability of materials –Trends of profits, etc.
Need for valuation of goodwill
Whenever there is any change in the existing relationship of the partners, some partners may have to sacrifice their future profits and some other partners may gain. Those who are sacrificing future profit should be compensated by others who are gaining. As a result, the need for the valuation of goodwill in a firm may arise in the following circumstances:
–Where the profit sharing ratio amongst the partners is changed. –When a new partner is admitted.
–When a partner retires or dies. –When the business is sold, and
–When a firm is amalgamated with another firm.
METHODS OF VALUATION OF GOODWILL
One of the main factors contributing to the value of goodwill is the earning capacity of the business. Following are the usual methods of calculating the value of goodwill:
(i) Average Profit Method:
Under this method, goodwill is valued on the basis of a certain number of years’ purchase of the average profits of the past few years.
Example: Suppose on 1st April, 2011 on the admission of a new partner, it is agreed that goodwill of the firm is valued at three years purchase of average profits for the last five years. Further, suppose the profits for last five years have been as follows:
`
For the year ended 31st March 2011 10,740
For the year ended 31st March 2010 7,900
For the year ended 31st March 2009 5,430
For the year ended 31st March 2008 400 (loss)
For the year ended 31st March 2007 8,500
Value of goodwill will be calculated as follows:
Total profits for the last 5 years =`(10,740 + 7,900 + 5,430 – 400 + 8,500) =`32,170
Average profits =` 32170
5 ,
=`6,434
Three years’ purchase of the above mentioned average profit=`6,434 x 3 =`19,302 Hence, value of goodwill =`19,302
(ii) Super Profit Method
In this case the future maintainable profits of the firm are compared with the normal profits for the firm. Normal earnings of a business can be judged only in the light of normal rate of earning and the capital employed in the business. Hence, this method of valuing goodwill would require the following information:
(i) A normal rate of return for representative firms in the industry.
(ii) The fair value of capital employed. (iii) Estimated future maintainable profits.
There are three methods of calculating goodwill based on super profit:
(a) Purchase of super profit
As per this method, value of goodwill is obtained by multiplying super profit by a certain number of years.
(b) Annuity method
Goodwill according to the annuity method is the present value of a terminal annuity of super profit for a reasonable period during which the super profit is likely to occur. It is calculated as:
Super profitxAnnuity rate.
(c) Capitalization of super profit
In this method, the value of goodwill is arrived at by capitalizing the super profit at the normal rate of return. It is calculated as:
Super profit x 100 Normal rate of return
(iii) Capitalization Method
The capitalization of profit method values goodwill at the excess of capital that should have been employed for earning the average profit over the capital which has been actually employed. In this method, the value of whole business is found by using the formula:
Average annual profit x 100 Normal rate of return
From this figure, the net assets (excluding goodwill) of the firm are deducted and the resultant value will be the goodwill.
Note: Normal rate of earning is that rate of earning which investors in general expect on their investments in the particular type of industry. Normal rate of earning depends upon the risk attached to the investment, bank rate, market need and the period of investment.
Capital employed is the aggregate of capital and reserves less the amount of non-trading assets such as investments. The capital employed may also be ascertained by adding up the present values of trading assets and deducting all liabilities therefore. Super profit is the simple difference between future maintainable operating profit and normal profit.
Example: A firm of X,Y and Z has a total capital investment of ` 2,25,000. The firm earned net profit during the last four years as`35,000,`40,000,`60,000 and`50,000. The fair return on the net capital employed is 15%. Find out the value of goodwill if it is based on 3 years’ purchase of the average super profits of past four years.
Solution:
`
Total Profits earned during four years 1,85,000
Average annual profit`1,85,000 / 4 46,250
Fair return on capital employed: 15% of`2,25,000 33,750
Super Profit:`46,250 –`33,750 12,500
Value of goodwill being 3 years’ purchases of the average