Page 245 - DCOM205_ACCOUNTING_FOR_COMPANIES_II

Accounting for Companies – II

notes Merits of Average Profit Method
1. This method is simple and easy to understand and apply.

2. As the average profits are considered to find out the value of goodwill, there is the possibility
that result will be satisfactory. Average profits are more reliable than one year’s profit to
know the future earning capacity.

3. Generally, this method is adopted when a partner retires or expires.
Demerits of Average Profit Method
1. Only profits are considered to ascertain the value of goodwill. No account is taken for
capital employed while that is an important factor affecting the goodwill.
2. There is uncertainty regarding the number of years for finding out the average profits and
number of years’ purchase. Therefore, results arrived are far from satisfactory.
Illustration 1 (Calculation of Average Profits)

The following information is available in respect of a business of Mr. Ramesh:
(a) Profit – 2006 ` 6,00,000, 2007 ` 4,80,000, 2008 ` 3,80,000, 2009 ` 5,30,000.
(b) Profit for 2006 has been reduced by ` 70,000 being the loss of stock by fire.
(c) Profit for 2007 includes ` 40,000 non-recurring income.

(d) The goods were not insured but it is decided to go for insurance in future and insurance
premium is expected to be ` 3000 p.a.
(e) Profit for 2008 includes ` 10,000 being the income from non-trading investments.
(f) Profit for 2009 includes ` 70,000 for a claim lodged in 2002 for which no entry was made
then.
(g) The reasonable amount of remuneration of the proprietor of the business is ` 50,000 p.a.
This has not been considered in ascertaining the profits for the past years.

Calculate the future maintainable average profits:
Solution
` `
Profits of 2006 6,00,000
Add: Loss due to fire 70,000 6,70,000
Profit of 2007 4,80,000
Less: Non-recurring income 40,000 4,40,000
Profits of 2008 3,80,000

Less: Income from Non-trading Investments 10,000 3,70,000
Profit of 2009. 5,30,000
Less: Income relating to 1998 (claim lodged) 70,000 4,60,000
Total Profit of four years 19,40,000

19,40,000
Average Profits = = ` 4,85,000
4
Less: Expected Expenses:
Insurance premium 3000

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