Capitalization Method of Goodwill Valuation
Capitalization Method of Goodwill Valuation under Partnership Accounts! Let's explore this step-by-step with real examples and interactive calculations.
🎯 What is the Capitalization Method?
This method works on the premise that, how much capital other business will need, to earn profits, similar to your business, at the normal rate of return. If your business has less capital employed then your business will have goodwill.
Key Concept:
Instead of using "years of purchase" like other methods, the Capitalization Method calculates goodwill by comparing the capital employed between your business and capital employed of other similar business.
🌟 Two Types of Capitalization Methods
We capitalize the entire average profit of the business
We capitalize only the extra profits (super profits) earned by the business
- "Number of years of purchase" not needed
- Based on earning capacity
- Uses Normal Rate of Return (NRR)
- Compares Capital required vs. actual capital employed
📊 Method 1: Capitalization of Average Profits
🧮 Example: Capitalization of Average Profits
Problem:
ABC Partnership has the following details:
- Average Profits = ₹60,000
- Normal Rate of Return = 10%
- Total Assets = ₹6,00,000
- Outside Liabilities = ₹1,00,000
Find the value of Goodwill using Capitalization of Average Profits method.
📝 Step-by-Step Solution:
= (₹60,000 × 100) ÷ 10
= ₹60,00,000 ÷ 10
= ₹6,00,000
= Total Assets - Outside Liabilities
= ₹6,00,000 - ₹1,00,000
= ₹5,00,000
= Capitalized Value - Capital Employed
= ₹6,00,000 - ₹5,00,000
= ₹1,00,000
The goodwill is ₹1,00,000 because the capital needed to earn Rs 60,000 profits at 10% NRR is Rs 6,00,000. But the business actual capital employed is only Rs 5,00,000 which is Rs 1,00,000 less.
🚀 Method 2: Capitalization of Super Profits
This method focuses only on the extra profits (super profits) that the business earns above normal expectations. It's like asking: "How much extra value does this business create?"
🔍 How to Find Super Profits - Detailed Steps
💼 Finding Capital Employed - Two Approaches
📈 Assets Side Approach
Less: Goodwill (existing)
Less: Fictitious Assets
Less: Non-trade Investments
Less: Outside Liabilities
= Capital Employed
📊 Liabilities Side Approach
Add: Current Accounts (Cr)
Add: Reserves
Add: P&L A/c (Cr balance)
Less: Goodwill (existing)
Less: Fictitious Assets
Less: Non-trade Investments
= Capital Employed
- Goodwill: Only the existing goodwill in books (if any)
- Trade Investments: Made for furtherance of own business
- Non-trade Investments: Not made for furtherance of own business
- Fictitious Assets: Deferred revenue expenditure, Advertisement Expenditure, Debit balance in Profit and Loss A/c, etc.
🧮 Example: Capitalization of Super Profits
Problem:
XYZ Partnership has the following details:
- Average Profits = ₹80,000
- Normal Rate of Return = 12%
- Partners' Capital = ₹4,00,000
- Reserves = ₹1,00,000
- No other adjustments
Find the value of Goodwill using Capitalization of Super Profits method.
📝 Step-by-Step Solution:
= Partners' Capital + Reserves
= ₹4,00,000 + ₹1,00,000
= ₹5,00,000
= ₹5,00,000 × 12 ÷ 100
= ₹60,000
= Actual Average Profits - Normal Profits
= ₹80,000 - ₹60,000
= ₹20,000
= (Super Profits × 100) ÷ NRR
= (₹20,000 × 100) ÷ 12
= ₹1,66,667
The business is earning ₹20,000 more than expected. When capitalized at 12%, this extra earning capacity is worth ₹1,66,667 as goodwill!
📊 Average Capital Employed
Sometimes, instead of using a single point capital employed, we use the average capital employed to get a more accurate picture of the business's performance.
🔍 When to Use?
📐 Formula
(Opening Capital Employed + Closing Capital Employed) ÷ 2
Quick Example:
Given:
Opening Capital Employed = ₹4,00,000
Closing Capital Employed = ₹6,00,000
Solution:
Average Capital Employed = (₹4,00,000 + ₹6,00,000) ÷ 2 = ₹5,00,000
⚖️ Comparison: Both Methods at a Glance
| Aspect | Capitalization of Average Profits | Capitalization of Super Profits |
|---|---|---|
| What we capitalize | Entire average profits | Only super profits |
| Formula | Goodwill = Capitalized Value - Actual Capital Employed | Goodwill = (Super Profits × 100) ÷ NRR |
| Average Profits Needed | Yes, for finding Capitalized Value | Yes, for finding Super Profits |
| Capital Employed Needed | Yes, for final calculation | Yes, to find normal profits |
| Years of Purchase | Not used | Not used |
| When to Use | When question asks for this method | When question asks for this method |
🎯 Practice Problem - Try It Yourself!
Challenge Problem:
PQR Partnership provides the following information:
- Profits for last 3 years: ₹60,000, ₹80,000, ₹70,000
- Normal Rate of Return = 15%
- Fixed Assets = ₹3,00,000
- Current Assets = ₹2,00,000
- Current Liabilities = ₹50,000
- Bank Loan = ₹1,00,000
- Goodwill appearing in books = ₹25,000
Calculate Goodwill using both methods of Capitalization.
📚 Key Points to Remember
Capitalization of Average Profits :
Capitalized Value = (Average Profits × 100) ÷ NRR
Goodwill = Capitalized Value - Capital Employed
Capitalization of Super Profits :
Super Profits = Actual Profits - Normal Profits
Goodwill = Super Profits X 100 / NRR
Congratulations! You've Mastered the Capitalization Method!
You now understand how to value goodwill using capitalization method. The capitalization method shows the true economic value of a business based on its earning capacity.
✅ What You've Learned:
- Two types of capitalization methods
- Step-by-step calculation process
- How to find capital employed
- Practical problem-solving techniques
- Key formulas and concepts
🚀 Next Steps:
- Practice more problems
- Compare with other goodwill methods
- Apply in partnership admission/retirement
- Understand business valuation concepts
- Master advanced adjustments