Calculating Goodwill Using the Super Profit Method: Correct Sequence

Understanding how to calculate Goodwill is important in accounting. The Super Profit Method is one way to do this. This method focuses on the extra profit a business earns compared to a normal business in the same industry. The calculation involves several steps that must be followed in a specific order.

The question asks for the correct sequence of these steps when calculating Goodwill under the Super Profit Method based on the provided list of steps:

• (A) Calculation of Super profit
• (B) Calculation of Capital Employed
• (C) Calculation of Normal profit
• (D) Calculation of Average profit
• (E) Calculation of Goodwill

Let's break down the typical steps involved in the Super Profit method to determine the logical sequence, and then compare it to the options provided.

Steps in Super Profit Method Calculation

Generally, the Super Profit Method involves these core calculations:

1. Determine the actual profit earned by the business. This is often the average profit over a few years.
2. Calculate the capital employed in the business. This is the total investment used to generate profit.
3. Calculate the normal profit that should be earned on the capital employed based on a normal rate of return.
4. Calculate the super profit, which is the excess of actual/average profit over normal profit.
5. Calculate goodwill by multiplying the super profit by an agreed number of years' purchase.

Mapping these general steps to the options provided:

• Step 1 (Actual/Average Profit): Corresponds to (D) Calculation of Average profit.
• Step 2 (Capital Employed): Corresponds to (B) Calculation of Capital Employed.
• Step 3 (Normal Profit): Corresponds to (C) Calculation of Normal profit.
• Step 4 (Super Profit): Corresponds to (A) Calculation of Super profit.
• Step 5 (Goodwill): Corresponds to (E) Calculation of Goodwill.

Based on the typical method, the logical sequence would be: First, calculate Capital Employed (B) to know the investment base. Then, calculate Normal Profit (C) using the Capital Employed. You also need the Actual/Average Profit (D) to compare with Normal Profit. Once both Normal Profit and Actual/Average Profit are known, you calculate Super Profit (A). Finally, you calculate Goodwill (E) using the Super Profit.

A common sequence is (D), (B), (C), (A), (E) or (B), (C), (D), (A), (E) - the exact order of (D) and (B)/(C) can vary slightly depending on whether Average Profit is determined first or Capital Employed/Normal Profit. However, Capital Employed (B) and Normal Profit (C) are prerequisites for calculating Super Profit (A), and Super Profit (A) is a prerequisite for calculating Goodwill (E). Also, Average Profit (D) is usually needed before Super Profit (A).

Let's examine the provided answer options:

• Option 1: (B), (C), (A), (E) - Capital Employed, Normal Profit, Super Profit, Goodwill.
• Option 2: (C), (D), (B), (A), (E) - Normal Profit, Average Profit, Capital Employed, Super Profit, Goodwill. (Incorrect order as Capital Employed needed for Normal Profit)
• Option 3: (D), (C), (B), (A), (E) - Average Profit, Normal Profit, Capital Employed, Super Profit, Goodwill. (Incorrect order as Capital Employed needed for Normal Profit)
• Option 4: (C), (A), (B), (E) - Normal Profit, Super Profit, Capital Employed, Goodwill. (Incorrect order as Capital Employed needed for Normal Profit)

Option 1, (B), (C), (A), (E), presents the sequence: Calculate Capital Employed, then Normal Profit, then Super Profit, and finally Goodwill. While the calculation of Average Profit (D) is typically needed before Super Profit (A), Option 1 is the only one that correctly places Capital Employed (B) before Normal Profit (C), and places both Normal Profit (C) and Super Profit (A) before Goodwill (E). Given the provided options, this sequence is the most logical flow among the choices presented, assuming Average Profit calculation is implicit or done earlier.

Explanation of the Correct Sequence (B), (C), (A), (E):

1. (B) Calculation of Capital Employed: This is the starting point. You need to determine the funds invested in the business to earn profits.
2. (C) Calculation of Normal profit: Once Capital Employed is known, you calculate the normal profit expected on this investment using the normal rate of return. This establishes a benchmark. \( \text{Normal Profit} = \text{Capital Employed} \times \text{Normal Rate of Return} \)
3. (A) Calculation of Super profit: Super Profit is the profit earned over and above the normal profit. You compare the actual profit (or average profit) with the normal profit calculated in step (C). \( \text{Super Profit} = \text{Actual Profit (or Average Profit)} - \text{Normal Profit} \)
4. (E) Calculation of Goodwill: Finally, Goodwill is calculated by multiplying the Super Profit (calculated in step A) by an agreed number of years' purchase. \( \text{Goodwill} = \text{Super Profit} \times \text{Number of Years' Purchase} \)

This sequence (B), (C), (A), (E) correctly follows the dependency where Capital Employed leads to Normal Profit, which helps determine Super Profit, ultimately leading to Goodwill calculation.

Therefore, the correct sequence from the given options is (B), (C), (A), (E).

Revision Table: Super Profit Method Key Terms

Additional Information: Goodwill Calculation Methods

Goodwill is an intangible asset representing the future economic benefits arising from assets acquired in a business combination that are not individually identified and separately recognized. It often arises from factors like good reputation, customer loyalty, efficient management, and location.

Besides the Super Profit Method, other methods for calculating Goodwill include:

• Average Profit Method: Goodwill is calculated based on the average profit of past years, multiplied by a certain number of years' purchase. It can be Simple Average Profit Method or Weighted Average Profit Method.
• Capitalisation Method: This involves capitalising either the average profit or the super profit at the normal rate of return to find the value of the business or the goodwill directly.
• Annuity Method: Similar to the super profit method, but instead of multiplying super profit by years' purchase, the present value of an annuity of super profit for a certain number of years is calculated.

Each method provides a different perspective on valuing the intangible asset of goodwill, and the most appropriate method depends on the specific circumstances of the business valuation.