Arrange the steps of method, Capitalization of Average for the calculation of goodwill, in the correct sequence:
(A) Capitalize the average profits on the basis of the normal rate of return to ascertain the capitalized value of average profits as follows:
Average Profits × 100/Normal Rate of Return
(B) Ascertain the average profits based on the past few years' performance.
(C) Ascertain the actual firm's capital (net assets) by deducting outside liabilities from the total assets (excluding goodwill and fictitious assets).
Firms' Capital = Total Assets (excluding goodwill) – Outside Liabilities
Where outside Liabilities include both long term and short term Liabilities
(D) Compute the value of goodwill by deducting net assets from the capitalized value of average profits.
Choose the correct answer from the options given below:
Arrange the steps of method, Capitalization of Average for the calculation of goodwill, in the correct sequence:
(A) Capitalize the average profits on the basis of the normal rate of return to ascertain the capitalized value of average profits as follows:
Average Profits × 100/Normal Rate of Return
(B) Ascertain the average profits based on the past few years' performance.
(C) Ascertain the actual firm's capital (net assets) by deducting outside liabilities from the total assets (excluding goodwill and fictitious assets).
Firms' Capital = Total Assets (excluding goodwill) – Outside Liabilities
Where outside Liabilities include both long term and short term Liabilities
(D) Compute the value of goodwill by deducting net assets from the capitalized value of average profits.
Choose the correct answer from the options given below:
Solution
Under the Capitalization of Average Profits Method, goodwill is calculated by finding the difference between the capitalized value of profits and the actual net assets of the firm.
The logical sequence of steps is:
Step B: Calculate average profits from past years' data. This is the starting point as we need the profit figure first.
Step A: Capitalize these average profits using the formula:
This converts the average profits into the capital value the firm should have to earn such profits at the normal rate.
Step C: Determine the actual net assets (firm's capital) of the business by:
Step D: Calculate goodwill as:
If the capitalized value exceeds actual net assets, the difference represents the firm's earning capacity beyond what its assets would normally generate, which is goodwill.
The correct sequence is (B), (A), (C), (D), which is Option 3.