Page 244 - DCOM205_ACCOUNTING_FOR_COMPANIES_II

Unit 11: Valuation of Goodwill

(f) If the auditor has passed a comment regarding the inadequacy of provision for taxation, notes
bad debts, gratuity or depreciation and improper valuation of stock, necessary adjustment
should be made in the profits for these.
(g) All necessary adjustments should be made for the provision for liabilities.
(h) From the past profits, the necessary income tax according to the relevant Financial Act
must be deducted (profit after tax must be taken to calculate the average profit).
(i) Results due to discontinuation of part of the business, expansion of business and any major
change in policies of the business must also be adjusted in the profits.
(j) If some developmental work has taken place whose results are expected to materialise in
future, those should be adjusted in the profits.

(k) Profits of past four or five normal years should be taken to calculate the average profits,
because average profits are more reliable than a single year’s profit.
If there are cyclical fluctuations in a business, the number of years selected for average must
be long enough so that recovery, peak and recession phases of the business cycle may be
covered. In such a case the longer period will get closer to the average future maintainable
earnings.
If there is steady and gradual growth in a business, the average of a short period will be
more useful.

(l) According the court’s decision in the case of Califford and Martin, any allowances for loss
of a director with exceptional quality and for future increase in taxation should not be
considered at the time of calculating the average profits.

(m) If the profits of a business unit are markedly falling or rising over the past four or five
years, a simple average fails to project the future maintainable profits and then weighted
average should be used to calculate the average profits. In such a case more importance
(weights) is given to the recent year (latest years) and least importance (weight) is given
to the first year. A simple method to calculate the weighted average is to multiply the
profits by their respective number of years after arranging them chronologically in such a
manner, that most importance (weight) is given to the last year (most recent year) and least
importance (weight) to the first year (the remotest year). For instance, if we consider the
period 1995-2000, a period of 6 years, profit of the year 1995 will have the least weight i.e.,
and the profit of the year 2000 will get the highest weight i.e. 6.

Example: The profits of a firm for the last three years were as follows: ` 60,000, ` 70,000,
and ` 50,000. Calculate the goodwill of the firm taking 5 year’s purchase of the average profits.
Solution:
Average Profit = ` (60,000 + 70,000 + 50,000) ÷ 3 = ` 60,000
Therefore, Value of Goodwill at 5 years’ purchase of average profit

= Average profit x 5
= ` 60,000 x 5
= ` 3, 00, 000
Thus, the formula for Goodwill is as follows:
Goodwill = Average Profits × No. of years’ Purchase

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