explain the method of valuation of goodwill?
Answers
Answer:
1. Average Profits Method:
Under this method, the goodwill is valued at agreed number of . ‘years’ purchase of the average profits of the past few years. It is based on the assumption that a new business will not be able to earn any profits during the first few years of its operations.
2. Supper Profits Method :
The basic assumption in the average profits (simple or weighted) method of calculating goodwill is that if a new business is set up, it will not be able to earn any profits during the first few years of its operations. Hence, the person who purchases an existing business has to pay in the form of goodwill a sum equal to the total profits he is likely to receive for the first‘few years’.
3. Capitalisation Methods: Under this method the goodwill can be calculated in two ways:
(a) by capitalizing the average profits, or
(b) by capitalizing the super profits.
(a) Capitalisation of Average Profits:
Under this method, the value of goodwill is ascertained by deducting the actual capital employed (net assets) in the business from the capitalized value of the average profits on the basis of normal rate of return. This involves the following steps:
1. Ascertain the average profits based on the past few years’ performance.
2. Capitalize the average profits on the basis of the normal rate of return to ascertain the capitalised value of average profits as follows: Average Profits × 100/Normal Rate of Return
3. Ascertain the actual capital employed (net assets) by deducting outside liabilities from the total assets (excluding goodwill). Capital Employed = Total Assets (excluding goodwill) – Outside Liabilities .
4. Compute the value of goodwill by deducting net assets from the capitalised value of average profits.
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