Question

The adjustment required for overvaluation of closing stock, while calculating adjusted profit for calculating goodwill is:
(A) reduction from concerned years profit.
(B) reduction from next years profit.
(C) addition to next years profit.
(D) addition to previous years profit.
Choose the correct answer from the options given below :

• A. (A), (B), and (D) only
• B. (A) and (C) only
• C. (A) and (D) only
• D. (B), (C), and (D) only

Answer 1

The Correct Option is C

Adjusting Profit for Goodwill Valuation: Overvaluation/Undervaluation of Closing Stock 

When valuing goodwill, it's essential to ensure that the reported profits accurately reflect the earning capacity of the business. This often requires adjustments to correct for any overvaluation or undervaluation of closing stock, which can distort the true profit picture.

Impact of Overvaluation of Closing Stock

Overvaluation of closing stock in one year has the following effects:

• Inflated Profit in the Year of Overvaluation: Overstating the closing stock increases the reported gross profit, leading to an artificially higher net profit for that year.
• Understated Profit in the Following Year: The overvalued closing stock becomes the opening stock for the next year. This overstated opening stock increases the cost of goods sold, leading to an artificially lower net profit for the subsequent year.

Adjustments for Goodwill Valuation

To correct for the effects of overvaluation/undervaluation of closing stock when calculating adjusted profit for goodwill valuation, the following adjustments are necessary:

• (A) Reduce the profit of the year where the overvaluation occurred. This corrects the inflated profit caused by the overstatement of closing stock.
• (D) Add the overvalued amount to the previous year’s profit. This corrects the understated profit in the year following the overvaluation, as the overstated closing stock became the overstated opening stock.

Correct Actions

Therefore, the correct actions are (A) and (D) only.

Rationale

These adjustments ensure that the goodwill valuation is based on a more accurate and representative measure of the company's earning capacity, free from the distortions caused by stock valuation errors.