AccountsISC Class 12 · Goodwill

Average Profit Method of Valuing Goodwill: ISC Class 12 Accounts

Updated 15 October 2026 · Fact-checked

Under the average profit method, goodwill equals the firm's average profit multiplied by the agreed number of years' purchase. Past profits are first adjusted for abnormal gains and losses, errors and expected future changes. A simple average is used when profits are steady; a weighted average, with more weight on recent years, when they show a trend.

Clean the past profits first (add back abnormal losses, deduct abnormal gains), then average them and multiply by the years' purchase.

Illustration drawn for QuestionBuddy.

Understand Average Profit Method of Valuing Goodwill

What goodwill is. Goodwill is the value of a firm's reputation: its customers, location, management and special advantages that let it earn profits. It is an intangible asset (no physical form, but it can be sold with the business), not a fictitious one. CISCE asks for its meaning, nature, features, the factors affecting it and three modes of valuation; this page covers the first mode.

Factors that raise goodwill: a good location, efficient management, quality products, a monopoly or patent, long-standing customers and a favourable market. Heavy competition lowers it.

Step 1: adjust past profits. The past is used to predict the future, so remove anything that will not recur.

Add back abnormal losses (fire, flood, theft), and any private expense of a partner charged to the business.
Deduct abnormal gains (profit on sale of a fixed asset, an insurance claim for an old loss) and income from non-trade investments (the syllabus treats investments as non-trade unless stated otherwise).
Errors in stock: if the closing stock of a year was undervalued by ₹X, that year's profit rises by X and the next year's profit falls by X (it was the next year's opening stock). Total profit over the two years does not change.
Future changes: deduct a fair remuneration for a partner not charged in the past, or a new expense that will now arise.

Step 2: average.

Simple average = total adjusted profit ÷ number of years. A loss year is subtracted, not ignored.
Weighted average = Σ(profit × weight) ÷ Σweights. Use it when weights are given or profits rise or fall steadily; the latest year normally carries the highest weight.

Step 3: multiply. Goodwill = Average profit × number of years' purchase. The years' purchase is the number of years for which the firm is expected to keep earning that profit thanks to its reputation.

Self-generated and purchased goodwill. Under AS-26, only purchased goodwill appears as an asset. Goodwill valued on admission, retirement or death is self-generated and is adjusted through partners' capital accounts, not recorded as an asset. The 2024 ISC paper used a sole trader admitting a partner, and examiners reported candidates confusing self-generated with purchased goodwill.

Average Profit Method of Valuing Goodwill: key facts

Goodwill by average profit: Goodwill = Average profit × Number of years' purchase; Write this formula first; examiners asked for it in 2024.
Simple average profit: Total adjusted profits (losses subtracted) ÷ Number of years
Weighted average profit: Σ(Adjusted profit × weight) ÷ Σ weights; Weights 1, 2, 3 ... from oldest to latest year unless given.
Items added back to profit: Abnormal losses
Private expenses of partners charged to the firm
Undervaluation of closing stock (that year)
Items deducted from profit: Abnormal gains
Income from non-trade investments
Overvaluation of closing stock (that year)
Fair remuneration of partners not charged; A stock error reverses in the next year.
Factors affecting goodwill: Nature of business
Location
Efficiency of management
Market situation
Special advantages
Quality of products

How to answer Average Profit Method of Valuing Goodwill questions

ISC usually sets goodwill as a 1-mark MCQ or a 3-mark numerical, and it often sits inside a 6- or 10-mark admission or retirement problem.

1Read the last line: which average (simple or weighted) and how many years' purchase?
2Make a table of years with recorded profit, each adjustment, and adjusted profit.
3Handle stock errors in both affected years.
4Average the adjusted profits; subtract any future remuneration or new expense from the average.
5Multiply by the years' purchase and label the answer.
6If the goodwill feeds an admission, find the incoming partner's share of it as a separate step.

Average Profit Method of Valuing Goodwill in real life

The idea, met in an everyday situation. Answer the question in your own words, then compare with the model answer. The one-line hook is what to remember.

Paying for a shop's reputation

Suppose a family selling a well-known stationery shop near a school shows profits of ₹1,80,000, ₹2,10,000 and ₹2,40,000 for the last three years. The buyer agrees to pay two years' average profit for the shop's name and regular customers, on top of the value of its stock and fittings.

How much will the buyer pay for goodwill?

Try it first, then show the solutionSolution

Average profit = (1,80,000 + 2,10,000 + 2,40,000) ÷ 3 = ₹2,10,000.
Goodwill = 2,10,000 × 2 = ₹4,20,000.

Answer: ₹4,20,000, paid for the customers and name that will keep earning profits after the sale.

Memory hook: Goodwill = what reputation earns × how long it lasts.

Tricks to remember Average Profit Method of Valuing Goodwill

Short memory aids. Say each one aloud once, then use it on a question the same day.

Abnormal: loss in, gain out
Put abnormal losses back in; take abnormal gains out.
Use it when: Adjusting past profits.
Stock error see-saw
Closing stock undervalued: this year up, next year down by the same amount.
Use it when: Two-year stock adjustments.
Loss is minus, not zero
A loss year is subtracted from the total and still counts as a year.
Use it when: Averages with a loss.

Average Profit Method of Valuing Goodwill: solved examples

Ordered from board level to HOTS. Try each one before you open the solution.

Example 1: Simple average · 1 mark · MCQBoard level

A firm's profits for three years were ₹84,000, ₹96,000 and ₹1,08,000. Goodwill at 2.5 years' purchase of the average profit is:
(a) ₹2,88,000
(b) ₹2,40,000
(c) ₹2,70,000
(d) ₹96,000

Try it first, then show the solutionSolution

Average = 2,88,000 ÷ 3 = ₹96,000.
Goodwill = 96,000 × 2.5 = ₹2,40,000.

Answer: (b) ₹2,40,000

Example 2: Average with a loss year · 3 marks · Short answerBoard level

The profits and losses of a firm for four years were: ₹1,30,000 profit; ₹1,50,000 profit; ₹20,000 loss; ₹1,80,000 profit. Calculate goodwill at three years' purchase of the average profit. (3 marks)

Try it first, then show the solutionSolution

Goodwill = Average profit × Number of years' purchase.
Total = 1,30,000 + 1,50,000 − 20,000 + 1,80,000 = ₹4,40,000; average = 4,40,000 ÷ 4 = ₹1,10,000.
Goodwill = 1,10,000 × 3 = ₹3,30,000.

Answer: Goodwill = ₹3,30,000.

Example 3: Weighted average over four years · 3 marks · Short answerHarder board level

Profits of Sunbeam Traders were: 2022-23 ₹1,00,000; 2023-24 ₹1,25,000; 2024-25 ₹1,40,000; 2025-26 ₹1,60,000. Weights are 1, 2, 3 and 4 respectively. Calculate goodwill at two years' purchase of the weighted average profit. (3 marks)

Try it first, then show the solutionSolution

Products: 1,00,000 + 2,50,000 + 4,20,000 + 6,40,000 = ₹14,10,000.
Weighted average = 14,10,000 ÷ 10 = ₹1,41,000.
Goodwill = 1,41,000 × 2 = ₹2,82,000.

Answer: Goodwill = ₹2,82,000.

Example 4: Adjusted profits with a stock error · 6 marks · Long answerHarder board level

Profits of a firm were: 2023-24 ₹2,40,000 (including ₹15,000 profit on sale of machinery); 2024-25 ₹1,90,000 (after a loss of ₹40,000 by flood; closing stock of this year was undervalued by ₹12,000); 2025-26 ₹2,73,000 (including ₹8,000 dividend on non-trade investments). The partners have not charged a fair remuneration of ₹30,000 a year for their work. Calculate goodwill at three years' purchase of the average profit. (6 marks)

Try it first, then show the solutionSolution

2023-24: 2,40,000 − 15,000 = ₹2,25,000.
2024-25: 1,90,000 + 40,000 + 12,000 = ₹2,42,000.
2025-26: 2,73,000 − 12,000 (opening stock understated) − 8,000 = ₹2,53,000.
Average = 7,20,000 ÷ 3 = ₹2,40,000; less remuneration ₹30,000 = ₹2,10,000.
Goodwill = 2,10,000 × 3 = ₹6,30,000.

Answer: Goodwill = ₹6,30,000.

Example 5: Sole trader admits a partner · 6 marks · Long answerHOTS / competency

Kiran started a business on 1st April 2023 with capital of ₹4,00,000. Results: 2023-24 loss ₹30,000; 2024-25 profit ₹90,000; 2025-26 profit ₹1,20,000. Over the three years he withdrew ₹45,000 in all. On 1st April 2026 he admits Lila for a one-third share. Goodwill is valued at two years' purchase of the average profit; Lila brings her share of goodwill as premium and capital proportionate to her share, based on Kiran's capital before any goodwill adjustment. Calculate goodwill, Lila's premium and her capital. (6 marks)

Try it first, then show the solutionSolution

Average profit = (−30,000 + 90,000 + 1,20,000) ÷ 3 = ₹60,000; goodwill = 60,000 × 2 = ₹1,20,000.
Lila's premium = 1,20,000 × 1/3 = ₹40,000.
Kiran's capital = 4,00,000 + 1,80,000 (net profit) − 45,000 = ₹5,35,000.
Kiran keeps 2/3, so the total capital = 5,35,000 × 3/2 = ₹8,02,500; Lila's capital = 8,02,500 × 1/3 = ₹2,67,500.
The goodwill is self-generated, so it is not recorded as an asset; the premium is credited to Kiran.

Answer: Goodwill ₹1,20,000; premium ₹40,000; Lila's capital ₹2,67,500.

Example 6: Working back to a missing profit · 3 marks · Short answerHOTS / competency

Goodwill valued at three years' purchase of the weighted average profit of three years (weights 1, 2, 3) is ₹4,50,000. Profits of the first two years were ₹1,20,000 and ₹1,50,000. Find the third year's profit. (3 marks)

Try it first, then show the solutionSolution

Weighted average = 4,50,000 ÷ 3 = ₹1,50,000; sum of products = 1,50,000 × 6 = ₹9,00,000.
Known products = 1,20,000 + 3,00,000 = ₹4,20,000.
3 × third year's profit = 4,80,000, so profit = ₹1,60,000.

Answer: Third year's profit = ₹1,60,000.

Where students lose marks in Average Profit Method of Valuing Goodwill

The slips examiners see most often, and what to write instead.

Mistake: Not multiplying by the years' purchase
Stopping at the average profit.
Wrong working
Goodwill = 60,000
Right working
Goodwill = 60,000 × 2 = 1,20,000
Do this: ISC examiners in 2024 reported this; write the formula before substituting.
Usually costs: 1-2 marks.
Mistake: Adjusting a stock error in one year only
Forgetting that closing stock becomes next year's opening stock.
Wrong working
2024-25 + 12,000; 2025-26 unchanged
Right working
2024-25 + 12,000; 2025-26 − 12,000
Do this: Every stock error affects two years in opposite directions.
Usually costs: 1 mark.
Mistake: Including non-trade investment income
Treating dividend received as business profit.
Wrong working
2025-26 profit 2,61,000
Right working
2025-26 profit 2,53,000
Do this: Investments are non-trade unless specified; their income is excluded.
Usually costs: 1 mark.
Mistake: Wrong 'added back' item
Mixing up abnormal gains and losses.
Wrong working
Adding back profit on sale of machinery
Right working
Deduct the gain; add back the flood loss
Do this: In 2025 examiners noted candidates overlooking the words 'added back'.
Usually costs: 1 mark.

Exam tips

Show a year-wise adjustment table; it earns method marks even if one figure slips.
Label the answer, e.g. 'Goodwill (2 years' purchase of average profit) = ₹1,20,000'.
Deduct a partner's fair remuneration from the average, not from each year, unless told otherwise.
In a sole-trader admission question, find the trader's closing capital: opening capital + profits − losses − drawings.

Practice questions on Average Profit Method of Valuing Goodwill

Write each answer on paper first. Open the hint only if you are stuck, and the answer only when you have finished.

Q1 · 1 mark · MCQBoard level
Goodwill is:
(a) a fictitious asset
(b) a current asset
(c) an intangible asset
(d) a tangible fixed asset
Hint
No physical form, but saleable.
Answer
(c) an intangible asset
Q2 · 1 mark · MCQBoard level
Which of the following does NOT raise the goodwill of a firm?
(a) favourable location
(b) efficient management
(c) heavy competition
(d) monopoly rights
Hint
Which one reduces excess earnings?
Answer
(c) heavy competition
Q3 · 3 marks · Short answerBoard level
Profits for five years were ₹60,000, ₹75,000, ₹90,000, ₹45,000 and ₹1,05,000. Calculate goodwill at four years' purchase of the average profit. (3 marks)
Hint
Divide by 5.
Answer
Average = 3,75,000 ÷ 5 = 75,000; goodwill = 75,000 × 4 = ₹3,00,000.
Q4 · 3 marks · Short answerHarder board level
Profits were 2023-24 ₹80,000, 2024-25 ₹95,000 and 2025-26 ₹1,25,000. The closing stock of 2024-25 was undervalued by ₹10,000. Calculate goodwill at two years' purchase of the average profit. (3 marks)
Hint
Adjust 2024-25 up and 2025-26 down.
Answer
Adjusted: 80,000; 1,05,000; 1,15,000. Average = 1,00,000; goodwill = ₹2,00,000. (The total is unchanged, so the average is too.)
Q5 · 3 marks · Short answerHarder board level
Profits for three years were ₹1,50,000, ₹1,80,000 and ₹2,10,000 with weights 1, 2 and 3. Calculate goodwill at three years' purchase of the weighted average profit. (3 marks)
Hint
Σ weights = 6.
Answer
Products = 1,50,000 + 3,60,000 + 6,30,000 = 11,40,000; weighted average = 1,90,000; goodwill = ₹5,70,000.
Q6 · 6 marks · Long answerHarder board level
Profits were: 2023-24 ₹1,60,000 (including ₹20,000 gain on sale of land); 2024-25 ₹1,10,000 (after a theft loss of ₹50,000); 2025-26 ₹1,98,000. A partner's personal insurance premium of ₹6,000 was charged to the P&L each year. From now on the firm will pay rent of ₹12,000 a year for premises previously used free. Calculate goodwill at 2.5 years' purchase of the average profit. (6 marks)
Hint
Add back the personal premium every year; deduct future rent from the average.
Answer
Adjusted: 1,46,000; 1,66,000; 2,04,000; average = 1,72,000; less rent 12,000 = 1,60,000; goodwill = 1,60,000 × 2.5 = ₹4,00,000.
Q7 · 1 mark · Assertion-reasonHarder board level
Assertion (A): The weighted average profit method is preferred when profits show a rising trend.
Reason (R): Higher weights to recent years make the average reflect the trend.
(a) Both A and R are true, and R is the correct explanation of A.
(b) Both A and R are true, but R is not the correct explanation of A.
(c) A is true, but R is false.
(d) A is false, but R is true.
Hint
Why weight at all?
Answer
(a) Both A and R are true, and R is the correct explanation of A.
Q8 · 3 marks · Short answerHarder board level
A firm's average profit is ₹1,50,000. A partner who manages the business has not been paid a salary; a fair salary would be ₹3,000 per month. Calculate goodwill at two years' purchase. (3 marks)
Hint
Annual salary 36,000.
Answer
Future maintainable profit = 1,50,000 − 36,000 = 1,14,000; goodwill = ₹2,28,000.
Q9 · 6 marks · Long answerHOTS / competency
Profits: Year 1 ₹1,00,000; Year 2 ₹1,22,000 (including an abnormal gain of ₹10,000); Year 3 ₹1,57,000 (after an abnormal loss of ₹15,000). Weights 1, 2, 3. Calculate goodwill at two years' purchase of the weighted average profit. (6 marks)
Hint
Adjust first, then weight.
Answer
Adjusted: 1,00,000; 1,12,000; 1,72,000. Products = 1,00,000 + 2,24,000 + 5,16,000 = 8,40,000; weighted average = 1,40,000; goodwill = ₹2,80,000.
Q10 · 3 marks · Short answerHOTS / competency
Ritu, a sole trader, admits Om for a one-fourth share. Goodwill is valued at three years' purchase of the average profit of the last four years: ₹50,000, a loss of ₹10,000, ₹70,000 and ₹90,000. How much premium must Om bring, and why is no Goodwill Account opened? (3 marks)
Hint
AS-26.
Answer
Average = 2,00,000 ÷ 4 = 50,000; goodwill = 1,50,000; Om's premium = 1,50,000 × 1/4 = ₹37,500. No Goodwill Account is opened because this is self-generated goodwill, which AS-26 does not allow to be recorded as an asset.

Test your recall

Answer in your head or on paper first, then open the card. Pulling an answer out of memory makes it stick far better than re-reading.

1.Formula for goodwill by the average profit method?Show answer
Average profit × number of years' purchase.
2.Profits ₹40,000, ₹50,000, ₹60,000 with weights 1, 2, 3: weighted average?Show answer
(40,000 + 1,00,000 + 1,80,000) ÷ 6 = ₹53,333.33.
3.Is an insurance claim for an old loss added or deducted?Show answer
Deducted (abnormal gain).
4.Closing stock of Year 1 overvalued by ₹5,000: effect on Year 1 and Year 2 profits?Show answer
Year 1 −₹5,000; Year 2 +₹5,000.
5.Can self-generated goodwill be shown as an asset?Show answer
No, under AS-26 only purchased goodwill is recorded.

Average Profit Method of Valuing Goodwill: frequently asked questions

When should I use the weighted average instead of the simple average?

When the question gives weights or says profits show a rising or falling trend. Otherwise use the simple average.

Do I ignore a year in which the firm made a loss?

No. Subtract the loss from the total and still divide by the full number of years.

What is 'years' purchase'?

The number of years for which the firm's reputation is expected to keep earning the average profit. It is the multiplier in the formula.

Is income from investments part of the profit for goodwill?

Not if the investments are non-trade, which the ISC syllabus assumes unless the question says they are trade investments.