Average Profit Method: A Brief Overview
There are three methods to commute the goodwill of the firm: the Average Profit Method, Super Profit Method, and Capitalisation Method. In the case of the valuation of goodwill under the method of average profit, the goodwill can be measured by the simple average profit method and the weighted average profit method. In this context, weighted average profit is briefly discussed along with its formula and computation method.
What is the Weighted Average Profit Method?
Being an intangible asset, the valuation of goodwill is a complicated task; hence, method selection plays a major role in determining its value. So the very basic method is the average profit method. To determine the goodwill valuation under this method, the average profit of all the given years is multiplied by the year of purchases specified in the question.
In the case of weighted average profit, the weights are assigned in the question, or the weights are given in ascending order, meaning less weight to the later years and more weight to the most recent years. It is considered a better-than-average method due to the allocation of weights to specific years.
The number of years of purchase means the specific number of years in which the business will earn the same amount of profits due to the efforts made by the company during its previous years. The weighted average method of calculating goodwill is used when different weights are given for different years.
Weighted Average Profit Formula and Computation
Steps to be followed while computation of goodwill in case of the weighted average profit method:
Step 1: Computation of weighted average profit is as follows:
Fill in the details in the above manner to arrive at the total of profit and weight.
Step 2: The formula of weighted average profit is as follows
Weighted Average Profit= Total of the product of profit and weights/Total of weights
Step 3: Valuation of goodwill is computed as follows:
Value of goodwill= Weighted average profit X Number of years of purchase
Hence after following the above procedure we can arrive at the value of goodwill as per the weighted average profit method.
Lord Lindley states, “The term goodwill is generally used to denote the benefit arising from the connection and reputations.” It is directly related to the profits earned by the organisation, and it has added advantage over the other organisations in the same industry. Goodwill can be classified into two categories: purchased goodwill, which is acquired by paying consideration in cash or kind, and self-generated goodwill, which is generated from the company's efforts to outshine the markets.
FAQs on Valuation of Goodwill: Weighted Average Profit
1. Why is the weighted average profit method preferred over the average profit method for the goodwill valuation?
Weighted average profit method is considered better than the simple average profit method because it assigns more weightage to the latest year's profits, which are more likely to be earned in future. This method is preferred when profits over the past years have been continuously rising or falling, and hence the weighted average profit facilitates the better presentation and evaluation of the goodwill; hence, the weighted average profit method is preferred over the average profit method for the valuation of goodwill.
2. Can the weighted average profit method of goodwill be used when the profits show a declining trend?
When profits show a rising or falling trend, the weighted average profit method is preferred as it gives more weightage to the latest profit, which is likely to be maintained in the future by the firm. Goodwill is the value of a firm's reputation in respect of the profits expected in the future over and above the normal profits earned by similar firms in the same industry. The higher the value of goodwill of the business the higher becomes the earning potential of the company becomes.
3. What are the factors considered while estimating future maintainable profits?
Factors to be considered while estimating future maintainable profits involve the inclusion of items like all normal working expenses, appreciation in the value of Current Assets, Provision for taxes, Income from non-trading assets, and non-recurring expenses. Items that must be excluded include appreciation in the fixed assets, income from non-trading assets, transfer to the General Reserve, and Dividend to Preference Shareholders.