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Admission of a Partner - Average Profit Method in Valuation of NonPurchased 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 provide more 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 be multiplied 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.

ILLUSTRATION

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.

SOLUTION
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

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