Question

Identify the components required to calculate goodwill using the Capitalisation of Average Profits Method.

Hint:

Capitalisation method needs 3 key inputs:

Average Profit
NRR
Capital Employed

Answer 1

Concept: Under the Capitalisation of Average Profits Method, goodwill is calculated by comparing the capitalised value of the firm with its actual capital employed. Formula: \[ \text{Goodwill} = \text{Capitalised Value of Firm} - \text{Net Assets (Capital Employed)} \] Components required:

Average Maintainable Profits: Average of past profits after adjusting abnormal items.
Normal Rate of Return (NRR): Expected return in the industry used for capitalisation.
Capitalised Value of Business: \[ \text{Capitalised Value} = \frac{\text{Average Profit}}{\text{NRR}} \times 100 \]
Net Tangible Assets / Capital Employed: Value of total assets minus outside liabilities.
Conclusion: The main components required are:

Average profits
Normal rate of return
Capital employed (net assets)