Q.(OR) Explain in brief the 'average profit method' of goodwill valuation.
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Goodwill: The Invisible Asset of a Business
Start with an Everyday Intuition
Think of two identical chai stalls next to each other. Same menu, same prices, same location size. Yet one stall has a long queue of loyal customers every morning, while the other struggles. Why? Because the first stall has built something over years — trust, a reputation for the best cutting chai, regular customers who know the owner by name. That "something" is goodwill.
In business, goodwill is the extra value a firm has earned beyond its physical assets (cash, furniture, machinery) and recorded liabilities. It's the reason a buyer is willing to pay more for a business than the sum of its individual parts.
The Precise Meaning (NCERT Definition)
Goodwill is the value of the reputation of a firm in respect of the profits expected in the future over and above the normal profits earned by other firms in the same industry.
In simpler terms: Goodwill = the present value of a firm's future super profits — the extra profit it earns compared to a normal business of similar size.
Why Does Goodwill Matter?
Goodwill is not recorded in the books unless it is actually paid for. It arises in specific situations:
- When a new partner is admitted — the existing partners have built the reputation; the new partner must compensate them for it.
- When a partner retires or dies — the continuing partners must pay the outgoing partner for their share of the firm's reputation.
- When the firm is sold — the buyer pays for goodwill as part of the purchase price.
Without valuing goodwill, the incoming partner would get a free ride on the hard work of the existing partners. That's unfair — and accounting fixes this.
Factors Affecting the Value of Goodwill
The NCERT textbook lists these key factors that determine how much goodwill a firm has:
| Factor | What It Means |
|---|---|
| Location | A shop in a busy market has higher goodwill than one in a remote area. |
| Quality of products/services | Consistent quality builds customer loyalty. |
| Efficiency of management | Good managers keep costs low and profits high. |
| Nature of business | A business with stable demand (e.g., essential goods) has more reliable goodwill. |
| Favourable contracts | Long-term supply or sales agreements add value. |
| Customer loyalty | Repeat customers reduce marketing costs. |
| Market conditions | Monopoly or limited competition increases goodwill. |
Goodwill is not a fixed number. It changes with time, competition, and the firm's performance. It is valued only when a change in partnership occurs.
Accounting Treatment: The Journal Entry
When a new partner brings in their share of goodwill (in cash), the entry is:
Journal Entry:
| Date | Particulars | L.F. | Dr. (₹) | Cr. (₹) |
|---|---|---|---|---|
| Premium for Goodwill A/c Dr. | xxx | |||
| To Existing Partners' Capital A/cs (in sacrificing ratio) | xxx |
Explanation:
- Debit the asset account "Premium for Goodwill" (or simply "Goodwill A/c") — because the firm has received cash for an intangible asset.
- Credit the existing partners' capital accounts in their sacrificing ratio — because they have given up a portion of their future profits to the new partner.
The sacrificing ratio = Old ratio − New ratio. This is the ratio in which the old partners have given up their share of profits. Goodwill is always distributed in this ratio, not the old profit-sharing ratio.
Proforma: Partners' Capital Account (When Goodwill is Brought in Cash)
Here is the format as per NCERT for the Partners' Capital Account when a new partner brings goodwill in cash:
Partners' Capital Account
| Particulars | A (₹) | B (₹) | C (₹) | | Particulars | A (₹) | B (₹) | C (₹) |
|-------------|-------|-------|-------|---|-------------|-------|-------|-------| …
Under the average profit method goodwill = average profit of past years × number of years' purchase. …
Goodwill = Average Profit × Years' Purchase.
Under the average profit method goodwill is valued as follows:
- Find the profits of the agreed number of past years (after adjusting for any abnormal gains/losses).
- Compute the average profit = Total Profits ÷ Number of Years (a weighted average may be used if recent years are more relevant). …
Showing the 12 most recent of 68 on this concept.
- CBSE 2026Set 67/4/11 markMCQQ.Assertion (A) : Goodwill is an intangible asset. Reason (R) : Goodwill is the value of the reputation of a firm in respect of profits expected in future over and above the normal profits. Choose the correct option from the following : (A) Both Assertion (A) and Reason (R) are correct and Reason (R) is the correct explanation of Assertion (A). (B) Both Assertion (A) and Reason (R) are correct, but Reason (R) is not the correct explanation of Assertion (A). (C) Assertion (A) is incorrect, but Reason (R) is correct. (D) Assertion (A) is correct, but Reason (R) is incorrect.
›Reveal solutionSolution
Goodwill is indeed an intangible asset, and the reason given correctly explains why — it is the value of a firm’s reputation that generates above-normal future profits.
Let’s begin with the assertion. In accounting, assets are classified as tangible or intangible. Tangible assets have physical substance — land, machinery, cash. Intangible assets do not; they are non-physical rights or advantages that bring economic benefit. Goodwill fits this definition perfectly: you cannot touch or see it, yet it has real value because it represents the firm’s ability to earn more than the average business in its industry. The NCERT textbook for Class 12 Accountancy (Part II) explicitly lists goodwill under “Intangible Assets” in the balance sheet format. So Assertion (A) is correct.
Now the reason. Goodwill arises from a firm’s reputation — its brand name, customer loyalty, location, quality of products, and management efficiency. These factors allow the firm to earn super profits, i.e., profits above the normal rate of return expected in that line of business. The textbook defines goodwill as “the value of the reputation of a firm in respect of the profits expected in future over and above the normal profits.” That is exactly what Reason (R) states. So Reason (R) is also correct. …
- CBSE 2026Set MARCH1 markMCQQ.'Goodwill' is which type of asset?(a) Tangible asset(b) Intangible asset(c) Current asset(d) Fictitious asset
›Reveal solutionSolution
Goodwill is an intangible asset, so the answer is (b).
Assets are broadly tangible (having physical existence, like machinery) or intangible (having value but no physical form, like goodwill, patents, trademarks). Goodwill represents the extra earning power and reputation of a firm; it has a real, realisable money value and can be sold along with the b …
- CBSE 2026Set MARCH1 markMCQQ.Which method is appropriate for the computation of goodwill when profit of every year is increasing?(a) Simple average(b) Weighted average(c) Annual growth rate(d) Compound growth rate
›Reveal solutionSolution
For a steadily rising profit trend, the weighted average profit method is appropriate, so the answer is (b).
Under the simple average method every year's profit gets equal importance, which understates goodwill when profits are on an upward trend. The weighted average method assigns increasing weights (1, 2, 3, ...) to successive years so that the most recent, higher profits influence …
- CBSE 2026Set MARCH1 markQ.What is weighted average profit?
›Reveal solutionSolution
Weighted average profit gives greater importance to recent profits while averaging past profits for goodwill valuation.
Weighted average profit is used to value goodwill when profits show a rising or falling trend. Each year's profit is multiplied by a weight (normally 1 for the earliest year, increasing to the highest weight for the most recent year). The sum of these products is then divided by the sum of the weights.
Weighted average profit = Total of (Profit x Weight) / Total of weights
…
- CBSE 2026Set ANNUAL1 markQ.Fill in the blank: The cash or non-cash item bought by a new partner to acquire a share in the firm's profit are called __________. (Capital/Goodwill (Premium))
›Reveal solutionSolution
The amount a new partner brings to acquire a share in profits is goodwill (premium).
On admission, an incoming partner acquires a share of future profits that the existing partners sacrifice. To compensate them, the new partner brings in an extra amount (in cash or in kind) called goodwill or premium for goodwill. This is …
- CBSE 2026Set ANNUAL1 markMCQQ.Weighted average method of calculating goodwill is used when(a) Profit is equal(b) Profit has increasing trend(c) Profit has decreasing trend(d) Both (A) and (B)
›Reveal solutionSolution
The weighted average method is used when profits show an increasing (or definite) trend - option (b).
Under the simple average method all years' profits carry equal weight. But when profits are rising (or show a clear trend), recent years are a better guide to future earnings, so the weighted average method is used - higher weights are assigned to the later yea …
- CBSE 2026Set ANNUAL1 markMCQQ.Which of the following is not correct for goodwill?(a) It is an intangible asset(b) It is a fictitious asset(c) It may have a realizable value(d) It is amortized
›Reveal solutionSolution
Goodwill is a genuine intangible asset with real (realizable) value — calling it a "fictitious asset" is incorrect, which is exactly why that is the right choice for "not correct."
Goodwill is the value of a firm's reputation, built up over years through good customer relationships, locational advantage, quality of products/services, or efficient management — it allows the firm to earn profits above what a similarly placed new business could normally earn.
Checking each statement:
- "It is an intangible asset" — TRUE. Goodwill cannot be seen or touched, but it is nonetheless a genuine asset reflected on the Balance Sheet.
- "It is a fictitious asset" — FALSE. A fictitious asset (e.g., discount on issue of shares/debentures, or preliminary expenses not yet written off) has no real/realizable value — it is merely a deferred revenue expenditure carried forward on the asset side. Goodwill is the opposite: it has genuine economic value and can be sold.
- "It may have a realizable value" — TRUE. When a business (or a partner's share in it) is sold, goodwill is often sold along with it for real money — e.g., an incoming partner pays a real premium for goodwill. …
- CBSE 2026Set ANNUAL1 markQ.A firm earned profits/losses over the past four years as follows: 2021–22 ₹9,000; 2022–23 ₹5,000; 2023–24 ₹4,000 (Loss); 2024–25 ₹6,000. Calculate the value of Goodwill on the basis of two years' purchase of average profit of past four years.
›Reveal solutionSolution
Averaging the four years' results (including the one loss year) gives ₹4,000; at 2 years' purchase, Goodwill = ₹8,000.
Under the Average Profit Method, Goodwill = Average Profit × Number of Years' Purchase. The average must be taken over all the years given, treating any loss as a negative figure (it genuinely reduces the average, since it reflects the firm's real earning record over that period).
Profits/(Losses) over the four years:
- 2021–22: ₹9,000
- 2022–23: ₹5,000
- 2023–24: (₹4,000) — a loss
- 2024–25: ₹6,000 …
- CBSE 2025Set MARCH1 markMCQQ.Goodwill depends on which aspect.(a) On employee of business enterprise(b) On management of business enterprise(c) On assets of business enterprise(d) On future maintainable profit
›Reveal solutionSolution
Goodwill depends mainly on the firm's future maintainable profit, because a buyer pays for the earning capacity that will continue. Correct option: (d).
In GSEB Class-12 Commerce Accountancy, goodwill is the monetary value of the reputation/earning capacity of a business.
…
- CBSE 2025Set MARCH1 markMCQQ.Internally generated goodwill cannot be shown in the books as per which accounting standard?(a) 25(b) 26(c) 27(d) 28
›Reveal solutionSolution
Internally generated goodwill cannot be recorded as per AS-26 (Intangible Assets). Correct option: (b) 26.
In GSEB Class-12 Commerce Accountancy:
- AS-26 governs intangible assets and states that only purchased goodwill (paid for) can be recorded. …
- CBSE 2025Set MARCH1 markQ.Goodwill is an ________ asset.
›Reveal solutionSolution
Goodwill is an INTANGIBLE asset.
Goodwill represents the reputation, customer loyalty and earning capacity a firm has built over time. Because it has no physical existence (it cannot be seen or touched) but still carries a monetary value that can be bought or sold when a firm is reconstituted, …
- CBSE 2025Set ANNUAL1 markMCQQ.Which of the following is a nature of goodwill ? (A) Rat goodwill (B) Cat goodwill (C) Dog goodwill (D) All of these
›Reveal solutionSolution
Goodwill is classified by how loyally customers stay with the business into cat, dog and rat (and rabbit) goodwill. Since all three listed are genuine classifications, the answer is (D) All of these.
For Bihar Class-12 (BSEB Inter) commerce students, the traditional "animal" classification of goodwill describes how firmly customers are attached to a business rather than to a person or place:
- Cat goodwill: customers are loyal to the place/firm; the most stable and valuable goodwill.
- Dog goodwill: customers are loyal to the person (owner/manager); it may leave when that person leaves. …
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