Valuation of Goodwill and Shares, Corporate Accounting Notes B.Com 2nd & 4th Sem CBCS Pattern

Valuation of Goodwill and Shares
Corporate Accounting Notes
B.Com 2nd and 4th Sem CBCS Pattern

Meaning of Goodwill

Goodwill is an intangible asset which indicates the value of the reputation of a firm. It comes into existence due to various favourable factors such as favourable location, efficient management, good quality of product and services etc. It is one factor which distinguishes an old established business from a new business. It can also be defined as the capacity of a business to earn extra income.

In the words of Eric L. Kohler “Goodwill is the present value of expected future profits in excess of a normal return on the investment in tangible assets.”

American Accounting standard defines goodwill as follows: “Goodwill is the difference between the value of a business as a whole and the aggregate of the fair values of its separable net assets.” Manufacturing concern can sell its land, building and plant separately without necessarily selling its business or liquidating it. Thus goodwill may be described as the extra saleable value attaching to the prosperous business beyond the intrinsic value of its separable net assets.

Features of goodwill: Goodwill has certain peculiar features which distinguish from other assets and it is worthwhile considering them here.

a)       It is an intangible and not a fictitious asset.

b)      It indicates the capacity of a firm to earn extra income.

c)       It comes into existence due to various favourable factors such as favourable location, efficient management, good quality of product and services etc.

d)      It is difficult to ascertain the exact value of goodwill. The value of goodwill fluctuates from time to time due to changing circumstances which are internal and external to business.

e)      It can be sold along with the sale of the business.

f)        Goodwill may be positive value or negative value. It is positive when the value of business is more than the value of its net separable assets and negative when the value of the business is less than the value of its net separable assets.

g)       Goodwill may be purchased or inherent in the business. When a business concern is purchased and the purchase consideration is in excess of the fair value of the separable net assets acquired, such excess is recorded as goodwill. However, goodwill is recorded only when an amalgamation is in the nature of purchase and is not a merger. In the case of merger, pooling of interests method is followed and goodwill is not recorded.

Types of Goodwill

Goodwill is mainly of two types:

1.       Purchased Goodwill

2.       Non-Purchased Goodwill

Purchased Goodwill: It is that goodwill which is acquired by making a payment. When one business is taken over by another business, the excess of purchase consideration over its net value (assets-liabilities) of the business which is taken over is termed to as purchased Goodwill. This type of goodwill is shown in the balance sheet.

Non Purchased Goodwill: Non Purchased Goodwill is an internally generated goodwill which arises because of favourable factors that a business possesses (e.g., favourable location, time factor and efficiency of management). This type of goodwill is not to be recognised as an asset hence not shown in balance sheet.

Factors affecting the value of Goodwill are: There are several factors which contribute to the goodwill of the business and the important ones are listed below:

a)       Skill in Management: If the management is capable and efficient, the firm will earn good profits and that will raise the value of goodwill.

b)      Location Factor: If the business is located at a favourable place, it can increase the volume of sales which correspondingly increases the value of goodwill.

c)       Quality: If the quality of goods and services are high, then there will be a ready market for the goods and the value of its goodwill will be high.

d)      Favourable Contracts: Sometimes, a firm enters into long term contracts for sale and purchase of goods at favourable prices. This will also affect profits and goodwill of the firm.

e)      Risk Involved: When the risk is less in the business it creates more goodwill but if the risk is more, it creates less goodwill.

f)        Market situation: If a firm deals in a product whose demand is higher than the supply, it will lead to a higher profit thereby increasing the value of goodwill of the firm.

g)       Skill development of workers and employees: Training and development programmes for workers, supervisors and executives at various levels,

h)      Government policies: Favourable attitude of government to the industry in general and the particular business in special,

When valuation of goodwill is necessary?

In case of partnership business: In case of a partnership firm, the need for valuation of goodwill may arise under the following circumstances:

a)       When a new partner is admitted,

b)      When a partner retires from the firm

c)       When a partner dies

d)      When there is a change in profit sharing ratio among partners,

e)      When the firm is sold as a going concern,

f)        When two or more firms amalgamated.

In the case of limited companies

a)       When two or more companies amalgamate,

b)      When one company takes over another,

c)       When a company wants to acquire controlling interest in another company, and

d)      When government takes over the business.

Methods of Valuation of Goodwill:

1)      Average Profits Method: In this method, Actual maintainable profits of business over a number of years are taken into account. Actual maintainable profits earned over a number of years are totalled and average is determined by dividing total with number of years. The average profits so determined are multiplied by the number of year’s purchases to arrive at the value of goodwill.

For calculation of goodwill following steps are to be followed

1.       Calculate Actual maintainable profits with the help of following formula. Actual maintainable profits = Net Profit + Abnormal loss – Abnormal Gain – regular business expenses not considered in accounts.

2.       Calculate Average maintainable Profit = Total Actual maintainable profits /no of years.

3.       Calculate goodwill = Average maintainable Profit x no. of year’s purchase

2)      Weighted average method: This method is a modified version of average profit method. In this method each year profit is assigned a weight i.e. 1, 2, 3, 4 etc. Thereafter each year profit is multiplied by the weights so assigned and the sums of the products are calculated. The total of products is divided by the total of weights. As a result we find the weighted average profit. After this the value of goodwill is calculated by multiplying the weighted average profit with the agreed number of year’s purchase.

For calculation of goodwill following steps are to be followed:

1.       Total of Product of Profits: Sum of product of each year’s profit with weights.

2.       Weighted average profit = (Total of Product of Profits / Total of Weights)

3.       Value of goodwill  = Weighted average profit × number of year of purchase

3)      Super Profit Method: Super Profits means excess of actual average maintainable profits over normal Profit of a firm. Normal profits mean the profit which the firms could normally earns in a particular business. It is calculated by multiplying capital employed in the firm with normal rate of return. Goodwill under this method is calculated by multiplying super profit with the agreed number of year’s purchase.

Under this method, the following steps are to be followed for calculation of goodwill:

1.       Calculate average maintainable profit with the help of following formula: Total Actual maintainable profits /no of years.

2.       Calculate normal profit by multiplying capital employed with normal rate of return.

3.       Calculate super profit. Super profit is the excess of average maintainable profit over normal profit.

4.       Calculate the value of goodwill = super profit x no. of year’s purchase

4)      Capitalization Method: Under this method, the value of goodwill is obtained by capitalizing the average profit or super profit of the basis of normal rate.

Value of goodwill under capitalization of average profit is

Goodwill = (Average normal profit of the business/ rate of return) – capital employed

Value of goodwill under capitalization of super profit is

Goodwill = Super profit/ rate of return

5)      Annuity Method: Under this method, goodwill is calculated on the basis of super profit of a definite period of time. Super profit so calculated is discounted at a given rate of interest to find the present value of super profit. The present value so calculated is the required amount of goodwill of the firm under annuity method.

In this method, goodwill is calculated with the help of following formula:

Goodwill = Annuity Factor x Super Profit 

Valuation of shares

Circumstances Warranting Valuation: The following circumstances warrant the valuation of shares:

1.       Sale of shares by one person to another,

2.       Mergers, acquisitions and Capital restructuring,

3.       Purchase and sale of shares in private companies and other unquoted shares

4.       Transfer of shares in an Indian company by a non-resident

5.       Valuation for tax purposes, eg., gift-tax, wealth-tax, etc.,

6.       When shares are pledged as a collateral for a loan,

7.       Determine the amount payable to dissentient shareholders under Section 494 of the Companies Act,

8.       Compensating shareholders when the undertaking is nationalized,

9.       Conversion of shares one class into another, and

10.   Valuation of shares held by an investment company.

Need for valuation

A part from the inadequacy of a stock exchange quotation serving the purpose of share valuation, the following occasions warrant share valuation by a qualified accountant. They are

1.       The shares are not listed and therefore a quotation is not available.

2.       There may be no price even for a listed share, in the absence of transactions.

3.       The market-quotation may not represent the true value of the share.

4.       The valuation is required statutorily.

5.       Shares relate to private limited companies.

6.       A large block of shares is under transfer.

Methods of valuation of shares

There are primarily three methods for valuation of shares, namely, Net assets methods which takes into account the net assets employed and earning capacity or yield basis or market method which takes into account the earning capacity of the organisations. Third method of valuation of shares considers both net asset method and earning yield method while calculating value of a share. All these methods are stated below:

1) Net assets method: Under this method value per share is obtained by dividing net value of the company’s assets subtracting therefrom the amount of the outsider’s liabilities and preference shareholders claims, with the number of equity shares. Net asset value may be expressed by the following formula:

Net assets value of a shares = (Net value of assets – Outsider’s Liabilities – preference shareholders’ claim)/Number of equity shares.

If goodwill is already given in the question, it is also added with assets while calculating value of a shares.

2) Yield or Earning capacity valuation or income method: In this method the valuation of share is done by comparing expected rate of return of a concern with normal rate of return. If the particular concern is able to give a higher return than the normal yield, its value should be higher. On the other hand, if it gives less return than normal yield, its value will be lower. The following steps are to be followed to find the value of shares:

a)       Ascertaining the future maintainable profits.

b)      Ascertaining the normal rate of return.

c)       Determining the capitalisation factor or the multiplier which is 100 divided by the normal rate of return. If normal rate of return is 10%, multiplier would be 100/10=10.

d)      Ascertaining the capitalised value of maintainable profits. This is ascertained by multiplying the future maintainable profits with the multiplier ascertained under step c.

e)      The yield value of share is ascertained by dividing capitalised value of maintainable profits under step d) with the number of equity shares.

This method is suitable for growing companies and small investors but this method fails to consider net asset of the company.

3) Fair value or dual method: This method is the combination of both the above methods. Fair value of share= intrinsic value+ yield value/2

Since this method takes the average of the values obtained in the net assets basis and earning basis, it makes an attempt to minimise the demerits of both net assets basis and earnings basis methods.

CORPORATE ACCOUNTING CHAPTER WISE NOTES

Unit-I: Shares & Debentures

1. ISSUE OF SHARES AND SHARE CAPITAL

2. RIGHTS SHARES AND BONUS SHARES

3. BUY-BACK OF SHARES

4. REDEMPTION OF PREFERENCE SHARES

5. ISSUE AND REDEMPTION OF DEBENTURES

Unit II: Preparation of financial statements of companies

1. FINAL ACCOUNTS OF COMPANIES

2. ACCOUNTS OF BANKING COMPANIES

Unit-III: Valuations of Goodwill and Shares & Cash Flow Statement

1. VALUATIONS OF GOODWILL AND SHARES

2. CASH FLOW STATEMENT

Unit-IV: Amalgamation, External Reconstruction and Internal Reconstruction

1. AMALGAMATION AND EXTERNAL RECONSTRUCTION

2. INTERNAL RECONSTRUCTION AND CAPITAL REDUCTIONS

Unit-V: Accounts of Holding Companies

ACCOUNTS OF HOLDING COMPANY COMPLETE NOTES

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