Average profit of a firm during the last few years is Rs. 8,00,000. In similar business, the normal rate of return is 10% of the capital employed. Assets of the business were Rs. 60,00,000 and its external liabilities were Rs. 20,00,000. Calculate the value of goodwill by : (i) Capitalisation of super profits method (ii) Super profit method if the goodwill is valued at four years' purchase of super profits.
Average profit of a firm during the last few years is Rs. 8,00,000. In similar business, the normal rate of return is 10% of the capital employed. Assets of the business were Rs. 60,00,000 and its external liabilities were Rs. 20,00,000. Calculate the value of goodwill by : (i) Capitalisation of super profits method (ii) Super profit method if the goodwill is valued at four years' purchase of super profits.
Step 1 — Capital Employed:
Capital Employed = Assets − External Liabilities = = Rs. 40,00,000
Step 2 — Normal Profit:
Normal Profit = Capital Employed × Normal Rate of Return = = Rs. 4,00,000
Step 3 — Super Profit:
Super Profit = Average Profit − Normal Profit = = Rs. 4,00,000
| Method | Formula | Calculation | Goodwill |
|---|---|---|---|
| (i) Capitalisation of Super Profit | Super Profit × (100 / Normal Rate of Return) | Rs. 40,00,000 | |
| (ii) Super Profit Method (4 years' purchase) | Super Profit × No. of years' purchase | Rs. 16,00,000 |
Marking Scheme
- 11 mark: correct calculation of Capital Employed (Rs. 40,00,000) and Normal Profit (Rs. 4,00,000).
- 21 mark: correct calculation of Super Profit (Rs. 4,00,000).
- 31 mark: correct goodwill under both methods — Rs. 40,00,000 (capitalisation of super profit) and Rs. 16,00,000 (super profit method, 4 years' purchase).
Hint
First find Capital Employed (Assets − External Liabilities), then Normal Profit and Super Profit; capitalise the super profit for method (i), and multiply it by the years' purchase for method (ii).
Quick Oral Answer
Super profit is the excess of average profit over normal profit; under the capitalisation method it is multiplied by 100/normal rate of return, while under the super profit method it is simply multiplied by the agreed number of years' purchase.
Analysis & Explanation
This question tests two distinct goodwill valuation techniques built on the same underlying super profit.
Concept: Super profit is the excess profit a firm earns over the normal return expected in similar businesses; goodwill is essentially the capitalised or purchased value of this super-earning capacity.
Key distinction: The capitalisation method assumes the super profit continues forever and capitalises it at the normal rate of return (100/rate), while the super profit method only values it for a limited, agreed number of years' purchase — hence the capitalisation figure (Rs. 40,00,000) is always higher than the super profit figure (Rs. 16,00,000) here.
Exam trap: Students often confuse capital employed with total assets, forgetting to deduct external liabilities.
Real-world use: Goodwill valuation of this kind is used whenever a firm undergoes reconstitution — admission, retirement, death, or change in profit-sharing ratio.
Common Mistakes
- 1Computing capital employed by adding liabilities to assets instead of subtracting them (Capital Employed = Assets − External Liabilities).
- 2Applying the years'-purchase multiplier to average profit instead of super profit in the super profit method.
- 3Forgetting to convert the normal rate of return into a capitalisation factor (100/rate) while using the capitalisation of super profit method.
Interesting Facts
The Capitalisation of Super Profit method almost always gives a higher goodwill value than the plain Super Profit method for the same data, because it capitalises the entire super profit in perpetuity rather than for a limited number of years.
Under AS 26 / Ind AS 38, self-generated goodwill can never be recognised in the firm's own balance sheet — it is computed only for specific events such as admission, retirement, death or dissolution.
The normal rate of return used in these formulas is usually based on the rate of return earned by similar risk-profile firms in the same industry, making goodwill valuation partly an external benchmarking exercise.
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Frequently Asked Questions
What is the formula for capital employed in goodwill valuation?
Capital Employed = Total Assets (excluding fictitious assets) − External Liabilities. Here it is .
Why does the capitalisation method give a higher goodwill value than the super profit method?
The capitalisation method assumes the super profit will continue indefinitely and capitalises it at the normal rate of return, whereas the super profit method values goodwill only for a fixed, agreed number of years, so it is naturally a smaller figure.
Can super profit be negative?
Yes — if average profit is less than normal profit, super profit is negative and indicates the firm is earning below the industry-normal return; goodwill would then be treated as nil rather than negative.