Identify the steps involved in calculating goodwill under the capitalized value of average profits method:

(A) Capitalize the average profits on the basis of the normal rate of return to ascertain the capitalized value of average profits

(B) Ascertain the average profits based on the past few years' performance

(C) Compute the value of goodwill by deducting net assets from the capitalized value of average profits

(D) Ascertain the actual firm's capital (net assets) by deducting outside liabilities from the total assets (excluding goodwill and fictitious assets)

Choose the correct answer from the options given below:

Under the Capitalization of Average Profits Method, goodwill is calculated using the formula:

Goodwill = Capitalized Value of Average Profits - Net Assets

The logical sequence of steps must be:

Step 1: (B) Calculate the average profits from past years' data. Without knowing the average profits, we cannot proceed further.

Step 2: (A) Capitalize these average profits using the normal rate of return.

$\text{Capitalized Value} = \frac{\text{Average Profits} \times 100}{\text{Normal Rate of Return}}$

Step 3: (D) Determine the actual capital employed (net assets) by calculating:

Net Assets = Total Assets (excluding goodwill and fictitious assets) - Outside Liabilities

Step 4: (C) Calculate goodwill by subtracting net assets from the capitalized value obtained in step 2.

$\text{Goodwill} = \text{Capitalized Value} - \text{Net Assets}$

The sequence (B) → (A) → (D) → (C) is the only logical flow as each step depends on the previous one. We must first know the profits, then capitalize them, then find what capital is actually employed, and finally compute the difference which represents goodwill (the excess earning capacity).

Correct Answer: Option 3