Arrange the following steps in the correct order to calculate the value of Goodwill by the super profit method. A. Calculate Capital Employed B. Calculate Average profit C. Calculate Super profit D. Calculate Normal profit E. Calculate the value of Goodwill Choose the correct answer from the options given below:
A, B, D, C, E
Calculating Goodwill using the Super Profit Method Steps
The super profit method is a popular way to value the goodwill of a business. Goodwill represents the intangible value of a business over and above its net tangible assets. Super profit is the profit earned by a business over and above the normal profit that a similar business would earn on the capital employed.
To calculate Goodwill using the super profit method, a specific sequence of steps is followed. Let's break down the required steps provided in the question and arrange them in the correct logical flow for calculating Goodwill.
The steps are:
- A. Calculate Capital Employed
- B. Calculate Average profit
- C. Calculate Super profit
- D. Calculate Normal profit
- E. Calculate the value of Goodwill
Let's arrange these steps in the order needed to arrive at the value of Goodwill.
The calculation process typically involves the following flow:
- First, you need to determine the capital base of the business. This is the Capital Employed (Step A). This is the amount of funds invested in the business.
- Next, you need to figure out what a typical business with this capital would earn. This involves calculating the Normal profit (Step D), which is based on the Capital Employed and a normal rate of return for that industry. So, Step A is usually needed before Step D.
- You also need to know the actual profit the business has been making over a period. This is the Average profit (Step B). This calculation is independent of Capital Employed and Normal Profit, but is needed for the next step.
- Once you have the Average profit (Step B) and the Normal profit (Step D), you can find the excess profit earned by the business. This excess is the Super profit (Step C). Super Profit = Average Profit - Normal Profit. Thus, Steps B and D are needed before Step C.
- Finally, the value of Goodwill (Step E) is calculated by multiplying the Super profit (Step C) by the number of years' purchase. Thus, Step C is needed before Step E.
Putting these dependencies together, a logical sequence is: Calculate Capital Employed (A), Calculate Average Profit (B), Calculate Normal Profit (D), Calculate Super Profit (C), and finally Calculate Goodwill (E).
Let's verify this sequence with the steps given:
- A. Calculate Capital Employed: This establishes the investment base.
- B. Calculate Average profit: This determines the actual earnings over recent years.
- D. Calculate Normal profit: This calculates the expected earnings based on capital employed (from A).
- C. Calculate Super profit: This compares actual earnings (B) with expected earnings (D). \text{Super Profit} = \text{Average Profit} - \text{Normal Profit}
- E. Calculate the value of Goodwill: This uses the super profit (C) and the number of years' purchase. \text{Goodwill} = \text{Super Profit} \times \text{Number of Years' Purchase}
This order (A, B, D, C, E) makes logical sense for calculating Goodwill using the super profit method.
| Step | Description | Prerequisites |
|---|---|---|
| A | Calculate Capital Employed | Initial step, requires balance sheet data |
| B | Calculate Average profit | Requires historical profit data |
| D | Calculate Normal profit | Requires Capital Employed (A) and Normal Rate of Return |
| C | Calculate Super profit | Requires Average profit (B) and Normal profit (D) |
| E | Calculate the value of Goodwill | Requires Super profit (C) and Number of Years' Purchase |
Therefore, the correct sequence of steps to calculate the value of Goodwill by the super profit method is A, B, D, C, E.
Goodwill Calculation Revision Table
| Key Term | Definition/Calculation |
|---|---|
| Capital Employed | Total Assets - External Liabilities OR Shareholder's Funds + Non-Current Liabilities |
| Normal Profit | Capital Employed \(\times\) (Normal Rate of Return / 100) |
| Average Profit | Total Profits of past years / Number of past years |
| Super Profit | Average Profit - Normal Profit |
| Goodwill (Super Profit Method) | Super Profit \(\times\) Number of Years' Purchase |
Additional Information on Goodwill & Super Profit Method
Understanding the components of the super profit method is key to mastering Goodwill valuation. Here's a bit more detail:
What is Capital Employed?
Capital Employed represents the long-term funds used in the business. There are two common ways to calculate it:
- Asset Side Approach: Fixed Assets + Current Assets - External Liabilities (excluding Goodwill already appearing in books).
- Liability Side Approach: Share Capital + Reserves & Surplus + Long-term Loans - Fictitious Assets (like preliminary expenses, accumulated losses).
Often, Average Capital Employed (Capital Employed at the beginning of the year + Capital Employed at the end of the year) / 2 is used, especially if profits are averaged over several years.
What is Normal Rate of Return (NRR)?
NRR is the expected rate of return that investors in a particular industry would expect on their capital. This rate is influenced by factors like the risk associated with the industry, market conditions, and interest rates.
Calculating Average Profit
Average profit is usually calculated by taking the simple average of the profits earned over the past few years. Sometimes, weighted average profit is used, especially if there is a trend (increasing or decreasing) in profits, giving more weight to recent years' profits.
Number of Years' Purchase
This factor represents the estimated number of years for which the business is likely to earn the super profit in the future. It is an arbitrary figure based on market conditions, industry practices, and expert judgment.
The super profit method is favored because it focuses on the business's ability to earn more than just a normal return, which is a strong indicator of its intangible value or goodwill.
Important Questions from Accounting for Partnership : Goodwill
Consider the following facts about valuation of Goodwill of a partnership firm:
A. Goodwill valuation is done on change in profit sharing ratio among the existing partners.
B. Goodwill is valued on admission of a partner, to know the amount to be paid by him to compensate sacrificing partner(s).
C. Goodwill valuation is done on the retirement of a partner to know the amount to be paid to him as compensation for his sacrifice.
D. Goodwill valuation is done at the time of dissolution of a firm which involves sale of business as a going concern.
E. Goodwill valuation is done during the distribution of profits of the partnership firm.
Choose the correct answer from the options given below:
In the context of a partnership firm, the need for valuation of goodwill arises in the following circumstances.
According to AS-26 on Intangible Assets:
(A) Internally generated goodwill should not be recognised as an asset
(B) Self-generated goodwill is accounted for in the books and shown as an asset
(C) Intangible assets should be written off as early as possible but not exceeding its estimated life
(D) Purchased goodwill is not recognised as an asset
(E) Can be written off even beyond 10 years depending upon the nature of the asset
Choose the correct answer:
Match List I with List II.
List - I List - II (A) Normal Rate of Return (I) Total Assets – Outside Liabilities (B) Number of years purchase (II) Usual return on capital employed (C) Capital Employed (III) Return over and above usual return in similar business (D) Super Profit (IV) Expected period for which returns are anticipated to accrue Choose the correct answer:
Under the capitalisation method of calculating goodwill, the term capital refers to:
