ACCOUNTANCY

Valuation of Goodwill

Part 2: The Super Profit Method - Concept, Components, and Advanced Application

1. Concept of Super Profit

In the competitive business landscape, many firms operate in the same industry with similar capital investments. However, some firms consistently earn higher profits than others due to their superior reputation, efficient management, and loyal customer base. These "excess profits" earned over and above the normal return on capital are known as Super Profits.

The Super Profit Method is based on the philosophy that if a firm has no "excess" earning capacity compared to its peers, it essentially has no goodwill. Therefore, goodwill is only the capitalized value of these super profits. This method is considered more scientific than the Average Profit method because it accounts for the capital invested and the risk associated with the business.

Definition: Super Profit is the difference between the Actual/Average Adjusted Profit earned by a firm and the Normal Profit expected from the capital employed in that line of business.

2. Components of the Super Profit Method

To value goodwill using this method, we must understand and calculate three critical components:

A. Capital Employed (Net Assets)

This refers to the actual capital used by the firm to generate operating profits. It is calculated by taking the total of all assets (at their current values) and deducting all outside liabilities.

Warning (Exam Point): While calculating Capital Employed, always exclude Goodwill (if already appearing in books), Non-Trade Investments, and Fictitious Assets (like Preliminary Expenses).

B. Normal Rate of Return (NRR)

This is the rate of return which is normally earned by other firms in the same industry under similar conditions. It represents the "opportunity cost" of the capital. It is usually provided in the examination as a percentage.

C. Normal Profit

This is the minimum profit that the firm should have earned on its capital investment based on the industry standard.

---

3. The Formulas

Normal Profit = Capital Employed × (Normal Rate of Return / 100) (Calculated on the basis of industry standard)

Super Profit = Average Adjusted Profit - Normal Profit (If Normal Profit is higher than Average Profit, Super Profit is Nil)

Value of Goodwill = Super Profit × Number of Years' Purchase

---

Numerical Demonstrations

Numerical 1: Basic Super Profit (Easy)

Question: A firm’s capital investment is ₹ 5,00,000. The normal rate of return in the industry is 10%. The firm’s average profit for the last 3 years is ₹ 80,000. Calculate goodwill on the basis of 3 years' purchase of super profits.

Solution:

1. Normal Profit: ₹ 5,00,000 × 10% = ₹ 50,000
2. Average Profit: ₹ 80,000 (Given)
3. Super Profit: ₹ 80,000 - ₹ 50,000 = ₹ 30,000
4. Goodwill: ₹ 30,000 × 3 = ₹ 90,000

Numerical 2: Advanced Technical Case (Difficulty: Very High)

Question: On 1st April 2024, an existing firm had assets of ₹ 10,00,000 including Cash of ₹ 20,000. Its creditors amounted to ₹ 1,50,000 on that date. The firm had a Reserve Fund of ₹ 1,00,000 while Partners' Capital Accounts showed a balance of ₹ 7,50,000. The Normal Rate of Return is 15%. The average adjusted profits of the firm are ₹ 2,00,000.

However, while calculating the average profit, the following was discovered:

• A non-trade income of ₹ 10,000 was included in the profit.
• Partners' remuneration of ₹ 30,000 p.a. was not deducted.
• The assets included Goodwill of ₹ 50,000 and Non-trade investments of ₹ 1,00,000 (Face value).

Calculate Goodwill at 4 years' purchase of Super Profits.

Solution:

Step 1: Calculation of Adjusted Capital Employed

Particulars	Amount (₹)
Total Assets (Given)	10,00,000
(-) Existing Goodwill (Cannot be part of capital employed)	(50,000)
(-) Non-trade Investments (Not used for business operations)	(1,00,000)
Value of Business Assets	8,50,000
(-) Outside Liabilities (Creditors)	(1,50,000)
Net Capital Employed	7,00,000

Step 2: Calculation of Average Maintainable Profit (AMP)

Average Profit (Given) = ₹ 2,00,000
(-) Non-trade Income = (₹ 10,000)
(-) Partners' Remuneration = (₹ 30,000)
Adjusted Average Profit = ₹ 1,60,000

Step 3: Final Calculation of Goodwill

1. Normal Profit: Capital Employed × NRR = 7,00,000 × 15% = ₹ 1,05,000
2. Super Profit: Adjusted Profit - Normal Profit = 1,60,000 - 1,05,000 = ₹ 55,000
3. Goodwill: Super Profit × 4 Years' Purchase = 55,000 × 4 = ₹ 2,20,000

Key Accounting Adjustments in this Problem:

• Goodwill/Non-trade Assets: These are always excluded from total assets to find "Capital Employed" because they don't contribute to the "Operating Profit" of the business.
• Internal vs External Liabilities: Reserve Funds and Partners' Capital are "Internal Liabilities" (Equity) and are not deducted from assets. Only Creditors (External) are deducted.
• Non-Trade Income: Since we excluded non-trade investments from capital, we must also exclude the income they generated from the profits.

PREVIOUS PAGE

CONTENT PAGE

NEXT PAGE