Goodwill for a Buy-Sell Agreement: Four Years of Profit That Are Not Comparable
M/s Keerti & Sourav is a nine-year-old wholesale stationery firm in Patna. The partners, Keerti and Sourav, share profits 3:2 and have asked you to value the firm's goodwill as on 31 March 2024 for a buy-sell agreement they are signing with an insurer. Reported profits for the four years ended 31 March were: 2020-21 ₹1,80,000; 2021-22 ₹2,10,000; 2022-23 ₹2,40,000; 2023-24 ₹2,05,000. Your scrutiny of the ledger shows four items that the reported figures do not separate: the 2020-21 profit includes a ₹30,000 gain on sale of a plot the firm will never repeat; 2021-22 profit was struck after charging ₹40,000 for stock destroyed by flood, which no insurer covered; 2022-23 profit includes ₹15,000 interest on a fixed deposit that matured and was withdrawn in June 2023; and 2023-24 profit includes ₹25,000 commission from a one-off agency that ended in March 2024. Capital accounts total ₹8,00,000 and accumulated reserves ₹4,00,000; the firm carries no intangible assets. A term-lending bank quotes 10% as the normal rate for firms of this size and risk.
1. Compute the adjusted average profit for the four years and the value of goodwill at three years' purchase of super profit. For each of the four adjustments, state whether it is added back or deducted, and why.
Read the worked answer
Step 1 - Normalise each year (a profit must reflect what the firm will keep earning).
| Year | Reported | Adjustment | Adjusted |
|---|---|---|---|
| 2020-21 | 1,80,000 | −30,000 non-recurring gain on plot | 1,50,000 |
| 2021-22 | 2,10,000 | +40,000 abnormal loss charged, uninsured | 2,50,000 |
| 2022-23 | 2,40,000 | −15,000 interest on a deposit no longer held | 2,25,000 |
| 2023-24 | 2,05,000 | −25,000 one-off agency commission | 1,80,000 |
Logic: an abnormal gain already credited is removed (it will not recur); an abnormal loss already charged is added back (it will not recur); income from an asset that no longer exists is removed because the earning capacity has gone.
Step 2 - Average. Total adjusted profit = ₹8,05,000; average = 8,05,000 ÷ 4 = ₹2,01,250.
Step 3 - Capital employed. Capital ₹8,00,000 + reserves ₹4,00,000 = ₹12,00,000 (no intangibles or fictitious assets to deduct).
Step 4 - Normal profit and super profit. Normal profit = 10% × 12,00,000 = ₹1,20,000. Super profit = 2,01,250 − 1,20,000 = ₹81,250.
Step 5 - Goodwill. 3 × 81,250 = ₹2,43,750.
Note the exam trap: using the reported average (2,08,750) would give super profit of 88,750 and goodwill of ₹2,66,250 - an overstatement of ₹22,500 caused purely by not adjusting.
2. Sourav has read that goodwill can also be valued by the capitalisation method. Compute goodwill by (a) capitalisation of super profit and (b) capitalisation of average profit, and advise which of the three figures should go into the agreement.
Read the worked answer
(a) Capitalisation of super profit = Super profit ÷ Normal rate = 81,250 ÷ 0.10 = ₹8,12,500.
(b) Capitalisation of average profit = (Average profit ÷ Normal rate) − Capital employed = (2,01,250 ÷ 0.10) − 12,00,000 = 20,12,500 − 12,00,000 = ₹8,12,500.
The two answers are identical, and that is not a coincidence: algebraically, (Average ÷ r) − Capital employed = (Average − r × Capital employed) ÷ r = Super profit ÷ r. Whenever the same normal rate is used in both steps, the two capitalisation methods must agree. A candidate who gets different answers has used two different rates or has mis-stated capital employed.
Which figure should go into the agreement? The three results are ₹2,43,750 (3 years' purchase), ₹8,12,500 (capitalisation). The gap is enormous, and the reason is that capitalisation assumes the super profit lasts forever and divides by a small rate. Test the sensitivity: at a normal rate of 12%, normal profit becomes ₹1,44,000, super profit ₹57,250, and capitalised goodwill only ₹4,77,083 - a change of ₹3,35,417 from a two-percentage-point change in one assumption.
Advice: use the three-years'-purchase figure (₹2,43,750) as the negotiating number. It is a multiple of a proven, adjusted profit stream, it is the convention Indian partnership deeds use, and it does not depend on an indefinitely sustainable super profit. Reserve capitalisation for cases where a buyer is buying a genuinely protected earnings stream (licence, brand, long contract).
3. The junior accountant wants to debit Goodwill A/c with ₹2,43,750 and credit the partners' capital accounts, so that the balance sheet 'shows the firm's true worth'. State whether this is permissible and set out the consequences if it is done.
Read the worked answer
Not permissible. The goodwill being valued here is internally generated - it arose from the firm's own trading over nine years and has never been paid for. AS 26 permits recognition of goodwill only when it is acquired for consideration (a purchase). Self-generated goodwill must not be recognised as an asset, however reliable the valuation.
If the entry is nevertheless passed (Goodwill A/c Dr ₹2,43,750; To Keerti's Capital ₹1,46,250; To Sourav's Capital ₹97,500 in the 3:2 ratio), the following follow:
- The balance sheet is inflated by a non-existent asset. Total assets and partners' capitals both rise by ₹2,43,750 with no rupee entering the business - the firm is no richer than before.
- Profit is eventually hit. A recognised intangible with a finite life must be amortised; AS 26 presumes a life of not more than ten years where no better estimate exists. The ₹2,43,750 would come back as a charge against future profit.
- The insurer and the bank are misled. The buy-sell cover and any lending limit are being set on a balance sheet that contains an unverified number.
- Capital accounts become distorted. Each partner's capital now includes ₹1,46,250 / ₹97,500 of unreal money, which will distort any later admission, retirement or dissolution settlement if the goodwill is not reversed first.
Correct treatment: value the goodwill, record it in the agreement as a memorandum figure only, and bring it into the books solely when a partner actually pays for it (on admission, retirement or death) - and even then the firm may choose to raise and immediately write it off so that no goodwill account survives.