Compute the value of goodwill on the basis of four years' purchase of the average profits based on the last five years. The profits for the last five years were as follows:
| Year | Profits (₹) |
|---|---|
| 2015 | 40,000 |
| 2016 | 50,000 |
| 2017 | 60,000 |
| 2018 | 50,000 |
| 2019 | 60,000 |
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Start your 14-day free trial to unlock the full solution →Goodwill is valued at ₹2,08,000, calculated as four years' purchase of the average profit of the last five years (₹52,000 × 4).
Concept and Treatment
Goodwill represents the intangible value of a business's reputation, customer loyalty, and earning capacity. When a firm is sold or a new partner is admitted, goodwill must be valued to compensate the existing partners for the super-profits they are giving up.
The average profit method is the simplest approach: we compute the average of past profits (after adjusting for any abnormal items) and multiply it by an agreed number of years' purchase. The logic is that a buyer would pay for the right to earn the average profit for a certain number of years into the future.
Key rule: Only normal, recurring profits are considered. Any abnormal gains (like a windfall profit from a lawsuit) or abnormal losses (like a major theft) must be adjusted out. Here, all five years show routine profits, so no adjustment is needed.
Solution
Step 1: Compute Total Profit for Five Years
| Year | Profit (Rs.) |
|---|---|
| 2015 | 40,000 |
| 2016 | 50,000 |
| 2017 | 60,000 |
| 2018 | 50,000 |
| 2019 | 60,000 |
| Total | 2,60,000 |
Step 2: Compute Average Profit
Average Profit = Total Profit / Number of Years
Average Profit = 2,60,000 / 5 = 52,000
Step 3: Compute Goodwill
Goodwill = Average Profit × Number of Years' Purchase …
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