Average Profit Method of Valuation of Goodwill

Under the Average Profit Method, goodwill is valued on the basis of the average maintainable profits of past years. The assumption is that a business will continue to earn similar profits in the future.

Goodwill = Average Profit × Number of Years’ Purchase

Steps in Valuation

1. Collection of Past Profits: Collect the profit figures of the past 3 to 5 years (as agreed).

2. Adjustment of Profits: Adjust for abnormal items:

   • Deduct abnormal gains (e.g., profit from sale of fixed assets).

   • Add back abnormal losses (e.g., loss due to fire, one-time expenses).

   • Adjust for changes in depreciation, salary, or interest not previously recorded.

3. Calculation of Average Profit: Compute average profits by summing the adjusted profits and dividing by the number of years.

4. Selection of Years’ Purchase: Decide the number of years’ purchase depending on industry practice, stability of business, and mutual agreement.

5. Valuation of Goodwill: Multiply average profit by years’ purchase to get goodwill.

Types of Average Profits

Simple Average Profit:

All years’ profits are given equal weight.

Simple Average = Total of adjusted profits / Number of years

​Weighted Average Profit:

Profits of recent years are given more importance because they are more relevant for future expectations.

Weighted Average Profit = Total of (Profit × Weight) / Total of Weights​