Page 243 - DCOM205_ACCOUNTING_FOR_COMPANIES_II

Accounting for Companies – II

notes 15. From the following facts of a business, indicate the correct no. of years’ purchase:
Goodwill ` 36,000, Average profit ` 42,000 and Normal Profit ` 30,000.

(a) 3 years
(b) 4 years
(c) 2 years
(d) 5 years

11.5 methods for valuation of goodwill

The following four methods are used for valuing the goodwill, namely:

1. Average Profit Method
2. Super Profit Method
3. Capitalisation Method
4. Annuity Method.

11.5.1 Average Profit Method

Under this method, goodwill is calculated by multiplying the average profit or average future
maintainable profit of last few years with a certain number of years (commonly known as number
of years’ purchase). In these methods, there is an assumption that a new business will not be able
to earn any amount of profit during the first few years of its operations. Therefore, a person
who wants to acquire a running business has to pay in the form of goodwill, a sum equal to the
average profits multiplied by a certain number of years during which he is likely to receive the
profits for the first few years. In this method the following two steps are involved:
(i) Calculation of Average Profits;

(ii) Multiplication of Average Profits with the number of years’ purchase.
Calculation of average profit or average future maintainable profit: The purpose of calculating
the average profits is to project the future profits which are likely to be earned in the coming
years. And goodwill will be based on these profits. Therefore, the years chosen for average profits
should be normal years. For this purpose, necessary adjustments are made in the light of future
possibilities. These are as under:
(a) If there is any abnormal loss due to strikes, floods, fires, theft, damage, abnormal repair
charges, lump sum compensation etc., in a particular year and that is not likely to occur in
future, the same should be added back to past profits.
(b) All operational expenses, including the interest on debentures, should be provided for and
depreciation on fixed assets should be charged on the value arrived at as a result of the
revaluation.
(c) If non-trading investments are excluded from the capital employed, profit or loss derived
from these investments should be excluded from the total earnings of the business
enterprise.
(d) If any capital receipt has already been adjusted in profits that must be subtracted from the
earnings of the business enterprise.
(e) If directors’ or managers’ remuneration or commission is not adjusted in the profits, the
same must be subtracted from profits. In case of under or over-charge of this commission
or remuneration, necessary adjustment should be made.

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