Capitalisation Method

The Capitalisation Method determines goodwill by relating a firm’s earnings to the capital that would be needed to generate those earnings at a normal rate of return. It works on a simple idea: if a business earns more than what a normal business of its size should earn, the extra earning power has a capital value — that value is goodwill.

This method has two distinct approaches, both of which arrive at the same final figure for goodwill.

(a) Capitalisation of Average Profits

Here, you first find out what the total capital of the business ought to be given its average profits and the normal rate of return. Then you compare that “capitalised value” with the firm’s actual net assets. The difference is goodwill.

Step-by-step procedure:

1. Calculate average profits based on the past few years’ performance.
2. Capitalise the average profits to find the capitalised value of the business:

   Capitalised Value of Average Profits = Average Profits × 100/(Normal Rate of Return)

3. Ascertain the firm’s actual capital (net assets):

   Firm’s Capital (Net Assets) = Total Assets (excluding goodwill and fictitious assets) - Outside Liabilities

   Outside liabilities include both long-term and short-term liabilities.

4. Compute goodwill:

   Goodwill = Capitalised Value of Average Profits - Net Assets

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(b) Capitalisation of Super Profits

This method skips the intermediate step of capitalising average profits. Instead, it directly capitalises the super profits — the excess of average profit over normal profit.

Step-by-step procedure:

1. Calculate the firm’s capital (net assets) — same as in method (a): Total assets (excluding goodwill and fictitious assets) minus outside liabilities.
2. Calculate normal profit on capital employed:

   Normal Profit = Firm’s Capital × (Normal Rate of Return)/100

3. Calculate average profit for the past years (as specified).
4. Calculate super profit:

   Super Profit = Average Profit - Normal Profit

5. Capitalise the super profit to get goodwill:

   Goodwill = Super Profit × 100/(Normal Rate of Return)

You can confirm this equivalence for any firm: capitalising the super profit at the normal rate of return yields exactly the same goodwill figure as subtracting the firm's net assets from the capitalised value of its average profits. …