Question

Explain the method of calculation of goodwill on the basis of average profit.

Hint:

The average profit method for calculating goodwill is simple and commonly used, but it assumes that the future profitability of the business will be similar to its past performance.

Answer 1

The method of calculating Goodwill on the basis of average profit involves determining the average annual profit of a business over a specified number of years and then multiplying it by a factor (known as the multiplier) to estimate the value of the goodwill. The steps for calculating goodwill are as follows:

Calculate the Average Profit: The first step is to calculate the average profit over a specified number of years. This is done by adding the profits for each year and then dividing the total by the number of years. \[ \text{Average Profit} = \frac{\text{Sum of Profits for n Years}}{n} \] where \( n \) is the number of years used for calculation.
Determine the Multiplier: The multiplier is typically determined based on the industry standards, the risk factor, and the expected future earnings of the business. A higher multiplier is used when the business has a good reputation and growth potential, while a lower multiplier is used for businesses with more risk or less growth potential.
Calculate the Goodwill: Goodwill is calculated by multiplying the average profit by the multiplier. \[ \text{Goodwill} = \text{Average Profit} \times \text{Multiplier} \] For example, if the average profit is \$10,000 and the multiplier is 3, then the goodwill would be: \[ \text{Goodwill} = 10,000 \times 3 = 30,000 \]