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
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
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
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