Goodwill: three methods, and the step students skip

Goodwill questions look like a choice between methods. The marks are usually lost one step earlier.

The step students skip

Before averaging, correct each year’s profit. Take out abnormal gains (a profit on sale of a fixed asset, an insurance claim) and add back abnormal losses (a loss by fire). Adjust for anything the question says was wrongly charged. An average of uncorrected profits is the wrong number, and every method after it inherits the error.

The three methods

• Average profit: goodwill = average profit × number of years’ purchase. Use a weighted average when the question gives weights or a clear trend.
• Super profit: super profit = average profit − normal profit, where normal profit = capital employed × normal rate of return. Goodwill = super profit × number of years’ purchase.
• Capitalisation: either capitalise average profit (average profit × 100 ÷ normal rate) and subtract capital employed, or capitalise super profit directly (super profit × 100 ÷ normal rate).

A check that costs ten seconds

The two capitalisation routes must give the same goodwill. If yours differ, the capital employed or the normal profit is wrong.

Capital employed means assets less outside liabilities, leaving out existing goodwill, fictitious assets and non-trade investments. That exclusion is the second most common slip.