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 Admission of a Partner - Average Profit Method in Valuation of Non-

Purchased Goodwill:

In this method, primarily average profit is computed on the basis of the

previous few years’ profits. At the time of computing average profit

preventative measure must be taken with regards to any abnormal items of

profit or loss which may affect profit in the mere prospect. It must be denoted

that average profit may be based on either weighted average or simple

average.

After computing average profit, it is multiplied by a number as agreed upon.

The product will be the worth of the goodwill. The significant drawback of this

method of computing goodwill is that any tendency in the height of

profitability is not reproduced in the valuation of goodwill. If the simple

average is used, that is, every year profits are provided the similar weightage,

no differentiation is made amongst a business that has increasing profits and

one that has dropping profits. To triumph over this, it is essential to providemore weightage to the profits of recent years. However, if the weighted

average profits are considered say, for latest four years the last year must be

given a weightage of 4, the previous year, a weightage of 3, preceding to that, a

weight of 2, and the prime year a weight of 1.

To acquire the weighted average profit, the profit of the year is required to bemultiplied by its weightage, and the aggregate total must be divided by the

collective number of the weights.

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Since goodwill values depend on a sequence of estimates and presumptions,

diverse weightings would create diverse outcomes. After computing average

profit, it is multiplied by a number as agreed upon. The outcome will be the

worth of the goodwill.

Let us discuss an illustration to understand the valuation of goodwill under

average profit method.

X, Y and Z are partners who share profits and losses in the ratio of 4:2:1. They

admit M for 1/4th share. For the purpose of admission of M, the goodwill of the

concern must be valued on the basis of 2 years’ purchase of last 3 years’ average

profit. The profits were 2012-13= $62,000, 2011-12 = $60,000, 2010-2011 =

$40,000 and 2009-2010 = $65,000. Compute the value of goodwill.

The average profit of latest three years = $(62,000+60,000+40,000)/3 = $54,000

The value of goodwill = $54,000 x 2 = $108,000

ILLUSTRATION 

SOLUTION 

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