ACCOUNTING FOR PARTNERSHIP FIRMS
LESSON - 12
METHODS OF GOODWILL VALUATION
1) AVERAGE PROFIT METHOD
a) Simple average profit method
Under this method the profits earned by the partnership business for a specific number of years are considered for the calculation of goodwill.
FORMULA
Goodwill = Average profit * Number of years purchase
Here average profit is the total profit of the number of years upon the specific number of years we have considered for the calculation of goodwill. The number of years purchase means the
years for which the firm is likely to earn the same amount of profit. This method of calculating goodwill is mainly used by the newly purchased business, when a buyer buys the business he calculates the future possibilities of profits by the firm.
PROCEDURE OF CALCULATION OF GOODWILL UNDER SIMPLE AVERAGE PROFIT METHOD
Step 1 : Calculate Normal Profit. Total profit of the firm may have many unexpected and extraordinary items, so first normal profit of the business should be calculated by adjusting those extraordinary items.
Profit/loss before adjustments XXX
ADD:
- Abnormal losses XXX
- Loss on sale of fixed asset XXX
- Overvaluation of opening stock XXX
- Undervaluation of closing stock XXX
- Expenses which are not expected to arise in future XXX
- Any capital expenditure wrongly charged as revenue expenses XXX
Note : All the above items are unexpected situations which had reduced the normal
profit of the firm.
LESS:
- Abnormal gains XXX
- Overvaluation of closing stock XXX
- Undervaluation of opening stock XXX
- Incomes that are not expected in the future XXX
- Partner's remuneration not deducted XXX
Note : All the above items are unexpected items which had increased the normal
profit of the firm so it has to be deducted.
ADJUSTED PROFIT TOTAL
Step 2 : Find Average profit of the business
FORMULA
Average profit = Total profit of number of years
Number of years
Step 3 : Determine the number of years purchase. The number of the years the partnership firm is expected to earn the same amount of profit.
Step 4 : Calculate the value of goodwill by applying formula
FORMULA
Goodwill = Average profit * Number of years purchase
b) Weighted average profit method
The method of calculation is similar to the simple average profit method. Under this method a value (weight) is allotted for every year, the profit of the particular year is multiplied to the weight assigned to that year to get the product, then the total of products are divided by the total of the weights (value) assigned for every year to get the average profit. Usually more values (weights) are assigned to the recent years.
PROCEDURE FOR CALCULATING GOODWILL UNDER WEIGHTED AVERAGE PROFIT METHOD
Step 1 : Calculate Normal Profit. Total profit of the firm may have many expected and extraordinary items, so normal profit of the business should be calculated first by adjusting those extraordinary items.
The process is same as the previous method
- consider each years profit
- Deduct abnormal gains
- Deduct recurring expenses
- Add abnormal losses
Step 2 : Weights (values) are to be assigned for every year
Step 3 : Find average profit
- Each years profit is multiplied by its weight assigned
- Calculate total products and the total weights
FORMULA
Weighted Average = Total profit or product
Profit Total of weights
Step 4 : Calculate goodwill by applying the formula
FORMULA
Goodwill = Weighted average profit * Number of years purchased
2) SUPER PROFIT METHOD
Why some business earn more profit and other similar businesses don't ? Imagine if similar business of same resources (investment, workings etc.) are operating why are they not earning the same amount of profit ?
Every business earns profit but some business earn more profit than normal amount of profit than that of the other similar business with same investments etc. This excess amount of profit 
earned than the normal profit of the other similar business is called "super profit".
While calculating super profit three things are to be considered
a) Average profit - the profit that is adjusted after all extraordinary and non-business activities
b) Normal rate of return - The rate of return (profit) normally earned by the other similar type of business
c) Capital employed - The money invested for running the business
Capital employed can be found using two ways
1) Liabilities side approach
Using the information form the liabilities side we can calculate the amount of money invested in the business.
FORMULA
Capital employed = Capital + Reserves - Fictitious asset - non-trade investments
2) Asset side approach
Using the information given in the asset side we can calculate the amount of money invested in the business. 
FORMULA
Capital employed = All assets ( except goodwill, fictitious asset and non-trade investments) - outside liabilities
Note: As capital employed fluctuates time to time average capital employed should be calculated
FORMULA
Average capital employed = Opening capital employed + Closing capital employed
2
PROCEDURE FOR CALCULATING GOODWILL UNDER SUPER PROFIT METHOD
Step 1: Calculate average capital employed
Step 2: Calculate adjusted profit
Step 3: Calculate normal profit
FORMULA
Normal profit = Average capital * Normal rate of return
employed 100
Step 4: Calculate super profit
FORMULA
Super profit = Average profit - Normal profit
Step 5: Calculate goodwill by applying the formula
FORMULA
Goodwill = Super profit * number of years purchase
3) CAPITALIZATION METHOD
a) Capitalization of average profit
In capitalization method goodwill is calculated by deducting capital employed from capitalized value of average profit on the basis of normal rate of return (profit).
FORMULA
Capitalized average = Average profit * 100
profit Normal rate of return
PROCEDURE FOR CALCULATING GOODWILL UNDER CAPITALIZATION OF AVERAGE PROFIT METHOD 
Step 1: Calculate average profit
Step 2: Find the capitalized value of average profit by applying the formula
Step 3: Calculate the value of net assets
Step 4: Calculate goodwill by applying the formula
FORMULA
Goodwill = Capitalized value of average profit - net asset
b) Capitalization of super profit
The process of capitalizing the super profit is similar to the process of capitalization of average profit. Goodwill is calculated by capitalizing super profit
PROCEDURE FOR CALCULATING GOODWILL UNDER CAPITALIZATION OF SUPER PROFIT METHOD
Step 2: Capitalize super profit to get the amount of goodwill by directly applying the formula
FORMULA
Goodwill = Super profit * 100
Rate of return
