Match List I with List II. Choose the correct answer: 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
(A)-(II), (B)-(IV), (C)-(I), (D)-(III)
Matching Business Valuation Terms: Normal Rate, Capital Employed, Super Profit
Understanding key terms used in business valuation, particularly when calculating goodwill, is crucial. This question asks us to match terms from List I with their correct definitions or related concepts from List II.
Let's analyze each item in List I and find its corresponding match in List II:
- Normal Rate of Return: This refers to the typical rate of return that businesses in the same industry or with similar risks earn on their capital employed. It represents the expected or usual return. Looking at List II, (II) "Usual return on capital employed" directly matches this definition.
- Number of years purchase: This is a multiplier used in some methods of goodwill valuation (like Average Profit or Super Profit methods). It signifies the estimated number of years for which the future super profits or average profits are expected to continue and accrue to the buyer of the business. From List II, (IV) "Expected period for which returns are anticipated to accrue" aligns perfectly with this concept.
- Capital Employed: This represents the total funds or investment used to run the business. It can be calculated in various ways, but a common method is subtracting external liabilities from total assets. List II includes (I) "Total Assets – Outside Liabilities", which is a standard way to calculate capital employed.
- Super Profit: Super profit is the profit earned by a business over and above the normal profit that businesses in the same industry would earn with the same amount of capital employed. It's the excess profit due to factors like good reputation, efficient management, etc. List II item (III) "Return over and above usual return in similar business" precisely defines super profit.
Based on this analysis, the correct matches are:
- (A) Normal Rate of Return matches with (II)
- (B) Number of years purchase matches with (IV)
- (C) Capital Employed matches with (I)
- (D) Super Profit matches with (III)
Let's present this matching in a table for clarity:
| List I (Term) | List II (Definition/Concept) | Match |
|---|---|---|
| (A) Normal Rate of Return | (II) Usual return on capital employed | (A)-(II) |
| (B) Number of years purchase | (IV) Expected period for which returns are anticipated to accrue | (B)-(IV) |
| (C) Capital Employed | (I) Total Assets – Outside Liabilities | (C)-(I) |
| (D) Super Profit | (III) Return over and above usual return in similar business | (D)-(III) |
Comparing these matches with the given options, we find that option (A)-(II), (B)-(IV), (C)-(I), (D)-(III) is the correct combination.
Understanding Normal Rate of Return in Business Valuation
The Normal Rate of Return (NRR) is a benchmark. It helps determine what is considered an average profit for a business given its investment (capital employed) and the industry it operates in. It is usually expressed as a percentage.
Normal Profit is calculated as:
\(\text{Normal Profit} = \text{Capital Employed} \times \frac{\text{Normal Rate of Return}}{100}\)
Understanding Number of Years Purchase for Goodwill
This is not a period of actual years but a factor representing the estimated number of years the business is expected to earn future enhanced profits (like super profits) at the current level. It's a factor used in goodwill calculation formulas.
For example, if Super Profit is calculated at ₹50,000 and the number of years purchase is 3, the goodwill by the Super Profit method would be ₹50,000 \(\times\) 3 = ₹1,50,000.
Understanding Capital Employed Calculation
Capital Employed represents the long-term funds invested in the business. The formula provided, "Total Assets – Outside Liabilities," is one common way to calculate it from the assets side. Another way is from the liabilities side: Shareholder's Funds + Long-term Loans.
Understanding Super Profit in Business Valuation
Super profit arises when a business performs better than average businesses in the same industry. It's the extra profit earned due to factors like good management, location, brand reputation, customer loyalty, etc., which contribute to goodwill.
Super Profit is calculated as:
\(\text{Super Profit} = \text{Actual or Average Profit} - \text{Normal Profit}\)
Revision Table: Key Business Valuation Terms
| Term | Concept/Calculation | Relevance to Goodwill |
|---|---|---|
| Normal Rate of Return | Usual percentage return on capital in similar businesses. | Used to calculate Normal Profit, which is then used to find Super Profit. |
| Number of Years Purchase | Multiplier representing anticipated period of future returns. | Directly used as a factor in goodwill calculation methods (e.g., Super Profit Method, Average Profit Method). |
| Capital Employed | Total long-term funds invested in the business (Assets - Outside Liabilities). | Base for calculating Normal Profit using NRR. |
| Super Profit | Profit above the Normal Profit. | Often the basis for calculating goodwill under the Super Profit method. |
Additional Information: Goodwill and Valuation Methods
Goodwill is an intangible asset representing the reputation and connections of a business that enable it to earn super profits. It is valuable because it helps the business attract customers and generate higher earnings than its tangible assets alone would suggest.
There are different methods to value goodwill:
- Average Profit Method: Goodwill is calculated as Average Future Maintainable Profits multiplied by the Number of Years Purchase.
- Super Profit Method: Goodwill is calculated as Super Profit multiplied by the Number of Years Purchase. Alternatively, it can be calculated by capitalizing the Super Profit.
- Capitalization Method: This method can capitalize either the Average Profit or the Super Profit to arrive at the value of the business or goodwill, respectively.
The terms discussed in the question (Normal Rate of Return, Number of Years Purchase, Capital Employed, Super Profit) are fundamental concepts used in these various methods to arrive at a fair valuation of goodwill, especially during events like partnership changes, sale of a business, or company amalgamation.
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:
Under the capitalisation method of calculating goodwill, the term capital refers to:
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:
