Goodwill On Entry Of New Partner Or Retirement or Death Of Old Partner

March 11th, 2009 Comments off
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In Part 2, we understand the various methods of valuing goodwill.

This article deals with one of the normal way of computing or valuing goodwill particularly in a partnership whether at the time of a new partner, or the retiring or death of an old partner.

Goodwill Valuation:
  1. Average annual net profit x an agreed figure
In this case, the goodwill valuation is based on the following steps:
  • the profits for an agreed number of years preceding the valuation are averaged to arrive at an average annual profit earned and
  • then goodwill is estimated to be worth so many years’ purchase of such average profit

 

 

Illustration No 1:

Say Partnership A registered the following annual profits:

Year 1 : Profits $10,000 Year 2:Profits $20,000 Year 3:Profits $30,000

If goodwill is agreed to be valued as:(a)two years’ purchase of average profit for the last three years

 

Solution:

Goodwill computation:

(a)Average profit = $10,000+$20,000+$30,000 / 3= $20,000

(b)Goodwill = $20,000 x 2 agreed years = $40,000

Illustration No 2

 

In the Partnership, the three partners A B C has the profit/loss sharing ratio of 2/5 ,2/5 and 1/5 respectively.In the partnership agreement, it states that in the event of death or retirement of a partner, goodwill should be valued on the basis of two years’ purchase of the average net profits for the preceding three years. EventuallyMr A retires on 31 /12 /xx.

Compute the goodwill due to Mr A.

Solution:

 

Following net profits registered:

 

Year 1 : $10,000 Year 2 : $20,000 Year 3 : $30,000

 

Total profits for preceding 3 years = $10,000+$20,000+$30,000=$60,000

Average profit = $60,000/3 = $20,000

 

Total goodwill = $20,000 x 2 = $40,000

 

Mr A’s share of goodwill = $40,000 x 2/5 = $16,000
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