In the super profit method, what is the first step involved in calculating goodwill?

Calculate average profit of past years

The correct answer is option 1- Calculate average profit of past years.

The basic assumption in the average profits (simple or weighted) method of calculating goodwill is that if a new business is set up, it will not be able to earn any profits during the first few years of its operations. Hence, the person who purchases an existing business has to pay in the form of goodwill a sum equal to the total profits he is likely to receive for the first ‘few years’. But it is contended that the buyer’s real benefit does not lie in total profits; it is limited to such amounts of profits which are in excess of the normal return on capital employed in similar business. Therefore, it is desirable to value, goodwill on the basis of the excess profits and not the actual profits. The excess of actual profits over the normal profits is termed as super profits. To determine goodwill using this method, the following steps are involved:

1. Calculate the average profit.
2. Determine the normal profit on the firm's capital by applying the normal rate of return.
3. Calculate the super profits by subtracting the normal profit from the average profits.
4. Calculate goodwill by multiplying the super profits by the specified number of years' purchase.