Page 246 - DCOM205_ACCOUNTING_FOR_COMPANIES_II

Unit 11: Valuation of Goodwill

Proprietor’s remuneration 50,000 53,000 notes
Future Maintainable Profits 4,32,000

Working Note:
Number of Years’ Purchase: Average maintainable profits are multiplied by a certain number of
years to determine the value of goodwill. The logic behind multiplication is that the purchaser has
to pay the seller the profits of the business which the purchaser would derive from the business
due to vendor’s efforts. In other words, the purchaser compensates the vendor of goodwill for
the few years’ profit which the purchaser receives due to vendor’s efforts. Generally, Average
Profits are multiplied by two or three years. Whatever number of years are taken for finding out
total profits for average profits, normally, their half is the number which should be used after
approximating would be for multiplying the average profits.

1
Example: For example, if 5 years’ profits are to totalled up, half of 2 years, it is
2
approximated to 3 years. Thus, average maintainable profits will be multiplied by 3 years to
determine the value of goodwill.

Notes In general, Average Profit Method can be applied. Actually the number of years
purchase is decided on the basis of mutual agreement between purchaser and vendor of
the business.

Illustration 2 (Average Profit Method)

X, Y and Z are partners, sharing profits and losses in the ratio of 1:2:2. It is provided in partnership
deed that, on the death or retirement of a partner goodwill should be calculated on the basis
of three years’ purchase of the average net profits for the preceeding five years. Y retires on
31 December, 2010. Calculate the value of firm’s goodwill and Y’s shares in goodwill. The
st
net profits for the five years ended 31st December, 2010 were ` 2,70,000, ` 2,40,000, ` 1,20,000,
` 2,50,000, and ` 1,70,000 (Loss).
Solution
Calculation of Average Profits `

I Year’s Profit 2,70,000
II Year’s Profit 2,40,000
III Year’s Profit 1,20,000
IV Year’s Profit 2,50,000
8,80,000

Less: V Year loss 1,70,000
Total Profits of 5 years 7,10,000

7,10,000
Average Profit = = ` 1,42,000
5
Value of goodwill = Average Profits × No. of Years’ Purchase
= ` 1,42,000×3
Firm’s goodwill = ` 4,26,000

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