The profits of a firm for 5 years are as follows: Calculate goodwill on the basis of 3 years purchase of weighted average profits of last five years based on weights 1, 2, 3, 4, and 5 respectively.Year Profits (₹) 2012-13 20,000 2013-14 24,000 2014-15 30,000 2015-16 25,000 2016-17 18,000
₹69,600
Understanding Goodwill Calculation Using Weighted Average Method
Goodwill is an intangible asset representing the future benefits arising from a business, such as its reputation, customer loyalty, or strong market position. Valuing goodwill is often necessary during business sales or mergers. One common method for calculating goodwill is the weighted average profit method.
The weighted average profit method assigns different weights to the profits of recent years, usually giving higher weights to more recent years. This is because recent profits are often considered a better indicator of future profitability than older profits.
Steps to Calculate Goodwill by Weighted Average Profits
To calculate goodwill using the weighted average profit method and a given number of years' purchase, follow these steps:
- Assign weights to the profits of each year.
- Multiply the profit of each year by its assigned weight to get the weighted profit.
- Calculate the total weighted profits by summing up the weighted profits for all years.
- Calculate the total weights by summing up the weights assigned to all years.
- Calculate the weighted average profit by dividing the total weighted profits by the total weights.
- Calculate goodwill by multiplying the weighted average profit by the number of years' purchase.
Applying the Weighted Average Method to the Given Data
We are given the profits for 5 years and the corresponding weights (1, 2, 3, 4, 5). We need to calculate goodwill based on 3 years' purchase of the weighted average profits.
| Year | Profits (₹) | Weight | Weighted Profits (₹) |
|---|---|---|---|
| 2012-13 | 20,000 | 1 | \(20,000 \times 1 = 20,000\) |
| 2013-14 | 24,000 | 2 | \(24,000 \times 2 = 48,000\) |
| 2014-15 | 30,000 | 3 | \(30,000 \times 3 = 90,000\) |
| 2015-16 | 25,000 | 4 | \(25,000 \times 4 = 100,000\) |
| 2016-17 | 18,000 | 5 | \(18,000 \times 5 = 90,000\) |
Calculating Total Weighted Profits and Total Weights
- Total Weighted Profits \( = 20,000 + 48,000 + 90,000 + 100,000 + 90,000 = ₹348,000\)
- Total Weights \( = 1 + 2 + 3 + 4 + 5 = 15\)
Calculating Weighted Average Profit
The formula for weighted average profit is:
\(\text{Weighted Average Profit} = \frac{\text{Total Weighted Profits}}{\text{Total Weights}}\)
\(\text{Weighted Average Profit} = \frac{348,000}{15} = ₹23,200\)
Calculating Goodwill
The formula for goodwill is:
\(\text{Goodwill} = \text{Weighted Average Profit} \times \text{Number of Years' Purchase}\)
We are given that the goodwill is to be calculated on the basis of 3 years' purchase.
\(\text{Goodwill} = 23,200 \times 3 = ₹69,600\)
Thus, the goodwill of the firm based on 3 years' purchase of weighted average profits is ₹69,600.
Revision Table: Weighted Average Goodwill Calculation
| Step | Description | Calculation | Result |
|---|---|---|---|
| 1 | Calculate Weighted Profits | Profit \(\times\) Weight for each year | See table above |
| 2 | Calculate Total Weighted Profits | Sum of Weighted Profits | \(₹348,000\) |
| 3 | Calculate Total Weights | Sum of Weights | \(15\) |
| 4 | Calculate Weighted Average Profit | Total Weighted Profits / Total Weights | \(348,000 / 15 = ₹23,200\) |
| 5 | Calculate Goodwill | Weighted Average Profit \(\times\) Years' Purchase | \(23,200 \times 3 = ₹69,600\) |
Additional Information: Methods of Goodwill Valuation
Apart from the weighted average profit method, other common methods for valuing goodwill include:
- Average Profit Method: Calculated as the simple average of past years' profits, multiplied by the number of years' purchase.
- Super Profit Method: Calculated based on the "super profit," which is the excess of average profit over the normal profit expected from the capital employed. Goodwill is then calculated as super profit multiplied by a certain number of years' purchase, or by using the annuity method or capitalization method.
- Capitalization Method: Goodwill can be valued by capitalizing the average profit or by capitalizing the super profit. Capitalizing average profit involves comparing the capitalized value of average profit with the net tangible assets. Capitalizing super profit involves capitalizing the super profit at a normal rate of return.
Each method has its own assumptions and is used based on the specific circumstances and industry practices.
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:
