Accountancy · Ch 4 — Goodwill in Partnership Accounts
Valuing Goodwill — Average Profit and Weighted Average Profit Methods
Valuing Goodwill — Average Profit and Weighted Average Profit Methods
Average Profit Method
The simplest and most widely used method values goodwill as a multiple of the firm's average profit over a chosen number of past years:
Goodwill = Average Profit of past years × Number of Years' Purchase
The "number of years' purchase" is simply how many years of average profit the incoming/continuing partners agree the firm's reputation is worth paying for — it is fixed by mutual agreement, based on how strong and stable the firm's earning capacity is expected to be.
Getting the average profit right is the real skill in this method. The profits of past years must first be adjusted so that only profits genuinely reflecting the firm's normal, recurring trading operations are averaged. The common adjustments are:
| Item found in a past year's profit | Treatment before averaging |
|---|---|
| Abnormal loss (fire, theft, strike, flood, an insured loss, etc.) | Add back to that year's profit — it will not recur under normal conditions. |
| Abnormal gain (profit on sale of a fixed asset, a windfall gain, insurance claim received in excess of loss, etc.) | Deduct from that year's profit — it is non-recurring and unrelated to normal trading. |
| Closing stock overvalued/undervalued in a year | Correct that year's profit for the over/under-valuation (an overvalued closing stock overstates that year's profit, so the excess is deducted; an undervalued closing stock understates profit, so the shortfall is added). |
| An expense that will not recur in the future (e.g., a one-time legal expense, or a loss covered by insurance that will not happen again) | Add back, since future profits will not carry this expense. |
| Interest on non-trade investments (e.g., interest earned on investments held outside the business) | Deduct, since this income does not arise from the firm's core trading activity and should not inflate the trading profit used for goodwill valuation. |
Once every year's profit has been corrected this way, they are simply totalled and divided by the number of years to get the Average Profit, which then feeds into the goodwill formula above.
Weighted Average Profit Method
The simple average treats every year equally — but if a firm's profits show a clear rising or falling trend, treating an old, less relevant year exactly like the most recent year understates (or overstates) the firm's true current earning power. The Weighted Average Profit Method corrects for this by giving more weight to the more recent years. …
The average of a firm's past years' profits, after adjusting each year for abnormal items, stock over/under-valuation, and non-trade income, so that only normal, recurri …
An average of past years' (adjusted) profits in which more recent years are given a larger weight than older years, used when the firm's profits show a cl …
The number of years of profit that the partners agree to pay for the firm's goodwill; it reflects how many years the firm's superior earning capaci …