Question

explain the main limitations of simple average profit method for valuation of goodwill​

Answer 1

Answer:

The choice of the method of goodwill valuation depends entirely on the partners or the partnership deed when they have made it.

1. Average Profits Method

i] Simple Average: Under this method, the goodwill is valued at the agreed number of years’ of purchase of the average profits of the past years. Goodwill = Average Profit x No. of years’ of purchase

ii] Weighted Average: Under this method, the goodwill is valued at an agreed number of years’ of purchase of the weighted average profits of the past years. We use the weighted average when there exists an increasing or decreasing trend in the profits giving the highest weight to the current year’s profit.

Goodwill = Weighted Average Profit x No. of years’ of purchase

Weighted Average Profit = Sum of Profits multiplied by weights/ Sum of weights

2. Super Profits Method

(i) The Number of Years Purchase Method: Under this method, the goodwill is valued at the agreed number of years’ of purchase of the super profits of the firm.

Goodwill = Super Profit x No. of years’ of purchase

# Super Profit = Actual or Average profit – Normal Profit

# Normal Profit = Capital Employed x (Normal Rate of Return/100)

(ii) Annuity Method: This method considers the time value of money. Here, we consider the discounted value of the super profit.

Goodwill = Super Profit x Discounting Factor

3. Capitalization Method

(i) Capitalization of Average Profits: Under this method, the value of goodwill is calculated by deducting the actual capital employed from the capitalized value of the average profits on the basis of the normal rate of return.

Goodwill = Normal Capital – Actual Capital Employed

# Normal Capital or Capitalized Average profits = Average Profits x (100/Normal Rate of Return)

# Actual Capital Employed = Total Assets (excluding goodwill) – Outside Liabilities

(ii) Capitalization of Super Profits: Under this method, Goodwill is calculated by capitalizing the super profits directly.

Goodwill = Super Profits x (100/ Normal Rate of Return)