Page 248 - DCOM205_ACCOUNTING_FOR_COMPANIES_II

Unit 11: Valuation of Goodwill

Profits - 2010 1,50,000 notes
Less: 10% depreciation on capital expenditure
−
30,000 1,000 × 10 = 2,900
100
Annual charge for management cost 24,000 26,900

Adjusted profits for the year 2010 1,23,100
Computation of Weighted Average Profits
Years Adjusted Profits (`) Weights products
2007 77,000 1 77,000

2008 88,000 2 1,76,000
2009 1,17,000 3 3,51,000
2010 1,23,100 4 4,92,400
10 10,96,400

Average Profits = Totalof Products
Totalof Weights

= 10,96,400 = ` 1,09,640
10
Goodwill = Average Profit × No. of Years’ Purchase
= ` 109,640 × 3 = ` 3,28,920

11.5.2 Super Profit Method

Under this method, goodwill is determined by multiplying the super profits by a certain number
of years’ purchase. Super profit means excess of the average profits which is earned by a business
over normal profit, based on the normal rate of return for representative firm in the industry.
Thus:
Super profit = Average Profit – Normal Profit

To calculate the value of goodwill under this method, the following three items are required:
1. Average Profits or Future Maintainable Profits: Average profits will show the future
earnings of the business. These are based on the past profits. Generally 3 to 5 years’ profits
are considered to calculate the average profit. Before taking the past profits, all necessary
adjustments should be done, taking into consideration future possibilities. Necessary
adjustment means abnormal or extraordinary profits of past years of non-recurring nature
should be deducted and abnormal or extraordinary losses should be added back to the past
to the relevant past year’s profit.
In the following two cases, weighted average is suggested in the place of simple average.
(i) For the businesses, which are in existence only for a short period and its definite
trend of profits is not visible.

(ii) Where there is a marked increase or decrease in the past profits of business.
The average profits and weighted average profits and their adjustments are discussed in
detail in the average profit method earlier.

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