Method of Valuation of Goodwill By Simple Average Profits Method

Simple Average Profit method is the simplest method for the calculation of the Goodwill of a concern.

The formula:

Goodwill = Average Future Maintainable Profits X No. of years’ purchase

Steps:

1. Calculate Average Future Maintainable Profits of the given number of past years.

2. Multiply the Average Future Maintainable Profits with the number of years’ purchase.

Example:

Alpha Ltd. acquire the business of Beta Ltd. Goodwill for this purpose is to valued on 4 years’ purchase of average of previous 5 years’ adjusted profits. The profits for the last 5 years from 2006 to 2010 were as follow: $ 4 million; $ 3.7 million; $ 5.2 million; $ 4.64 million; $ 5.8 million subject to the follwing adjustments.

a) The closing stock for the year 2006 was overvalued by $ 15000.

b) In 2007, expenditure on a major repair work to plant and machinery for $ 250000 was charged to revenue

Solution:

Calculation of Adjusted Profits

Total profits for the last five years ( 4+3.7+5.2+4.64+5.8 ) 23,340,000

Add: overvaluing of opening stock for 2007 15,000

Add: Expenditure on plant wrongly debited to Profit and Loss Account in 2007 250,000

____________

23,605,000

Less: overvaluing of closing stock for 2006 15,000

____________

Total adjusted Profits for five years 23,590,000

Average Adjusted Profits =23,590,000 / 5 = 4,718,000

Goodwill = Number of years’ purchase X Adjusted Profits

= 4 X 4,718,000 = $ 1,887,2000

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