MCom I Semester Corporate Accounting Valuation of Goodwill Study Material Notes

MCom I Semester Corporate Accounting Valuation of Goodwill Study Material Notes: Meaning of Goodwill Features of Goodwill Reasons for |Arising Goodwill Partnership firm average capital employed Methods of Valuation goodwill Average Profit Method Super Profit Method Capitalisation Profit Method Discussion Question s Long Answer Questions Short Answer Questions Numericals Objective Type Questions :

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Valuation of Goodwill

Meaning of Goodwill

Goodwill is an intangible but real asset. It is not a fictitious asset. Sometimes, it is more valuable than a tangible asset. It is the value of good name and reputation of a business house which brings in the customers, as a result of which the business is expected to earn in future higher return on its capital employed as compared to normal level of return in the same class of business. In technical language it may be defined as the present value of firm’s anticipated excess earnings. The words “excess earnings” imply the rate of return on tangible assets and intangible assets other than goodwill over and above the normal rate of return earned by respective firms in the same industry. In his “A Dictionary for Accountants”. Kohler defines goodwill as “the current value of expected future income in excess of a normal return on the investment in net tangible assets.”

Features of Goodwill

Following are the special features of goodwill:

(i) It is an intangible asset.

(ii) It is a real and not a fictitious asset.

(iii) It can not be sold in isolation. Except on admission and retirement of a partner, goodwill is valuable only when the entire business is sold.

(iv) It is valuable only if it is capable of being transferred from one person to another.

(v) It is difficult to place an exact cost on goodwill.

(vi) Valuation of goodwill is based on the subjective judgment of the valuer.

Reasons for arising Goodwill

As stated earlier, the main reason for arising goodwill is firm’s expectation of higher earnings in future and this expectation is influenced by a number of causes which are as follows:

1 Personality of owner, his integrity, ability and behaviour.

2. Managerial superiority, i.e., active, intelligent, dynamic and forward looking management.

3. Managerial attitude towards fulfilment of commitments (e.g., timely delivery of goods, timely payment to creditors, delivery of goods at committed prices etc.).

4. Efficiency, integrity and faithfulness of employees.

5. Long-term arrangement of availability of technical knowhow of high degree.

6. Reputation of goods sold or services rendered and their reasonable price.

7. Good labor relations.

8. Favorable location of business premises and effective advertisement.

9. Possession of special advantages, such as patents, trade marks, copyrights, agencies and monopoly.

10. Special business gains, e.g. regular supply of raw materials and components, low rate and assured supply of electricity, favourable long-term sale contracts, import licence etc.

11. Adequate financial resources and good credit worthiness

12. After sales services.

Need for Valuation of Goodwill

Need for valuation of goodwill may be in the following circumstances :

(A) In the case of a company :

(i) When two or more companies are amalgamated.

(ii) When a company absorbs the other.

(iii) When a company is desirous of acquiring controlling interest in another company.

(IV) When the business of the company is sold or taken over by the Government.

(v) When stock exchange quotations are not available and shares have to be valued for estate duty or tax purposes

(vi) When shares of one class are being converted into shares of other class.

(Vii) when the company has previously written off goodwill and now it wants to write it back in order to wipe off or reduce the debit balance in the profit and loss account.

(B) In the case of a partnership firm:

(i) On admission of a partner.

(ii) On retirement of a partner.

(iii) On death of a partner.

(iv) On change in the profit-sharing ratio among the partners.

(v) On sale of business by a firm.

(vi) On amalgamation of two or more firms.

(vii) On conversion of partnership into a company.

(C) In the case of a sole trader :

(i) On death of the owner for wealth tax purpose.

(ii) On sale of business.

(iii) On admitting somebody as a partner in the business.

(iv) On amalgamation of two sole trade businesses for making a partnership firm.

Main factors affecting the value of Goodwill

The main determinants of the value of goodwill of a business are as follows:

(1) Profitability of business.

(2) Income expectations of investors.

(3) Capital employed in the business.

(4) Other factors.

(4) Profitability of Business : Future profitability of the business is the chief factor in the valuation of goodwill. Future profitability implies assessment of the quantity of future maintainable profits of the concern. Greater the amount of such profits, higher will be the goodwill of the business. Future maintainable profits of a business concern are assessed on the basis of its past profits, their markedly rising or falling tendency and expected developments.

(A) Profits of past years : Profits of past years of the business concern is the most important basis for estimating the profits expected to be earned by the concern. While calculating the past profits, the following points should be duly considered :

(i) All usual working expenses including interest to debenture holders and depreciation of assets should be provided for

(ii) All necessary provisions including provision for taxation should be made. But no appropriation of profit should be made, such as transfer to general reserve, dividend equalization fund or sinking fund for redemption of liabilities etc.

Goodwill Study Material

(iii) If non-trading assets have been excluded from capital employed then the income derived from such assets should also be excluded.

(iv) Average of the profits of four or five years is more reliable than a single year’s profit. If results of any year in the past have been affected by certain exceptional events such as earthquake, flood etc. then results of such exceptional year should be excluded in the calculation of average profit.

(v) In determining the profit of each year, extra-ordinary and non-recurring incomes or expenses should be excluded.

(vi) In case assets have been revalued or shown at their replacement cost then depreciation should be calculated on their revised values.

(B) Markedly rising or falling profits : If the profits over the past years have been continuously falling or rising in a marked manner then average profit should be calculated by weighted average basis instead of simple average, attaching more importance to the profits of the last year and least importance to the profits of the first year. For example, if profits of 1998, 1999, 2000 and 2001 are given and they are showing continuous rise then they can respectively be attached weights of 1, 2, 3 and 4 for calculating average profits. If, however, there is continuous and marked decline in profits then profits for the future should be estimated on the basis of the trend – they will be lower than the profits for the latest year.

(C) Expected developments : If development expenditures in the undertaking are significant then the average profit of past years should be adjusted for the likely fruits in future of such expenditure in order to arrive at the future maintainable profit.

(2) Yield Expected by Investors : In the valuation of goodwill, the second main factor is the income expectation of investors on their investments. In fact, expectations of investors determine the normal level of profits or normal rate of return. This rate is determined on the basis of prevalent price-earnings ratio of shares of other companies of similar nature in the same industry. On increase in income-expectation rate of investors, goodwill decreases and goodwill increases on decrease in this rate. This expectation is affected by the following factors

(i) The degree of business and financial risk in the investment – Higher the risk, higher will be the income expectation rate of investors.

(ii) The period of investment – Longer the period, higher the income expectation rate.

(iii) The bank rate – An increase in the bank rate will lead to an increase in income-expectation rate and on decrease, the rate decreases.

(iv) Business cycle – During boom period, investors’ income expectation rate increases and during depression, this rate decreases.

(v) The general economic and political situation – Stable economic and political situation in the country leads to decrease in investors’ income-expectation rate. In case investors’ confidence is shaken in the economic and political stability, there will be a sharp rise in this rate.

(3) Capital Employed : This is the third important factor in the valuation of goodwill, since the size of profits is significant only in relation to the capital used to earn it. Capital employed generally implies net fixed assets plus net current assets and non-trading assets (e.g. investment of spare funds in government securities) are excluded. This may also be expressed as aggregate of share capital, reserves and surplus and long-term loans

The aforesaid idea of capital employed is not suitable for the valuation of goodwill of a company since the advantage of goodwill accrues to shareholders only. Hence, the amount of debentures and other loans should not be included in capital employed. Here, it is important to note that profit considered for valuation of goodwill should also be after interest on debentures and loans. Again, as profits are expressed at current values, it is proper that fixed assets are shown at their current prices.

Goodwill Study Material

In brief, capital employed may be calculated by either of the following two approaches :

1 Assets side approach :

Rs. Assets (other than goodwill, fictitious

assets, such as preliminary

expenses, discount etc. and trading losses) at market value

Less Liabilities to outside parties (such as creditors, bills payable,

debentures, taxation, outstanding bills, loans etc.) at revised values, if any

Capital Employed

Liabilities side approach :

Share Capital

Add Reserves, profits and gains on revaluation of assets and liabilities

Less Fictitious assets, goodwill, trading losses and losses on revaluation of assets and liabilities Capital Employed

Note : Some authors are of the view that capital employed should be calculated on the basis COSE or assets. If this view is followed then it will be essential to adjust depreciation on the basis replacement cost of the assets.

Average Capital Employed

A refinement to the above approach of capital emploved is that the figure of capital employed should be the average for the year concerned since this figure changes during the year at least because of the profit. The average capital employed is calculated as follows:

(1) Average capital employed may be calculated by taking the mean of the capital employed at the end of the year and that employed in the beginning of the year, i.e. opening capital employed plus closing capital employed divided by two.

(2) As, except for fresh capital, capital employed increases over a year mainly due to profits earned, hence average capital employed can be found out by deducting half the profit of the year from the capital employed at the end of the year or by adding half of the profits of the year to the capital employed in the beginning of the year. This approach is based on the assumption that profits have been earned evenly over the year (hence by the middle of the year half the profits were earned and so used in the business) and that the profits have not yet been distributed.

Goodwill Study Material

If proposed dividend appears in the balance sheet of the company, this amount should be treated as part of profits for this purpose. If the business concern pays advance income-tax then the amount of income-tax will also be deducted from the profit of the year and adjustment will be made for half of the profit after tax.

(4) Other Factors : Besides the above mentioned three main factors, the following factors also affect the value of goodwill :

(A) Personal Skill in Management : If higher profits in the business are due to personal skill and reputation of its management and owners, goodwill can not be valued at a high figure if the services of old management and owners are not to be available.

(B) Nature of Business : If there are effective barriers for the new firms to enter into that business, the goodwill of existing firms will be high by the mere fact of their existence. Similarly, if the firm deals in articles or services of continuous demand, its goodwill will be higher as compared to a firm which deals in articles of fashion or public fancy (e.g. jeans).

(C) Favourable Location : A favourable location plays a significant role in assessing the value of goodwill.

(D) Easy availability of raw materials and trained labour : If the firm enjoys favourable position regarding regular supply of materials and trained labour, its goodwill will be high.

(E) Useful life of patents and trade mark : A firm possessing valuable patent rights for long-term use will have valuable goodwill. Similarly, if the firm has built up good reputation for its products by means of a trademark or if the firm has copyrights of publishing the works of renounced authors, its goodwill is likely to go up.

(F) Political and Government Protection : The value of goodwill of those firms will be high which enjoy political and/or government protection.

(G) Capital Requirements : If the capital required is large considering the profits likely to be available, the value of goodwill will be small. Conversely, if the capital required is relatively small and the business is highly profitable, the value of goodwill will be higher.

(H) Specific Contracts : Exceptionally favourable contracts for supply of goods or services to the customers will raise the value of goodwill. But if it is unlikely that such contracts will be obtained in future, the value of goodwill will not be influenced by such existing contracts.

Methods of Valuation of Goodwill

Following are the methods of valuation of goodwill!

1 Average Profit Method.

2. Super Profit Method.

3. Capitalization of Profit Method.

Goodwill Study Material

Average Profit Method Under this method, goodwill is valued at an agreed number of years’ purchase (normally two or three years and this is purely arbitrary) of the average annual profits of three to five past years. Average annual profit is calculated by aggregating the amounts of profit or loss of specified years and then dividing this aggregate by the number of years.

In arriving at the annual profits, all income and expenditure of extra-ordinary and non-recurring nature should be excluded. Similarly, expenses and losses expected to be borne in future are deducted and all profits likely to come in future are added to such profits. Where the profits of the concern are progressively rising or falling, it is better to calculate the average annual profits by means of a weighted average instead of a simple average. Alternatively, simple average of past profits may be adjusted considering the trend of the business.

Illustration 1. The goodwill of a partnership firm is valued at four years’ purchase of average profits of past three years which are as under:

1996 – Rs. 10,000; 1997- Rs. 11,000; and 1998 – Rs. 12,000.

Compute the value of goodwill – (i) when simple average is used, (ii) when weighted average is used and (iii) when adjusted average is used and a 10% increase in the annual profits is considered reasonable.

Reasonable remuneration of the proprietor of business is Rs. 6.000 per year, but it has not been taken into account for the calculation of above mentioned profits.

Calculate the value of firm’s goodwill on the basis of 2 years’ purchase of the average profits for the last three years.

Solution : Year Normal Profits

Rs. 1995 (Rs. 40,000 – Rs. 5,000)

35,000 1996 (Rs. 50,000+ Rs. 10,000)

60,000 1997 (Rs. 45,000 – Rs. 5,000)

40,000 Total Profits for last 3 years

1,35,000 Average Profits = 1,35,000+ 3 =

45,000 Less Imputed reasonable remuneration 6,000

Average Annual Maintainable Profits 39,000 Goodwill at 2 years’ purchase = Rs. 39,000 x 2 = Rs. 78,000

Goodwill Study Material

Merits of Average Profit Method

1 This is a simple method and is free from mathematical complexities.

2. Since under this method average profit is calculated on the basis of results of past several years, it is possible to know the true earning capacity of the business.

Demerits of Average Profit Method

1 This method ignores the amount of capital employed for earning the profit. In fact the amount of profit of a business concern is relevant only in reference to capital used to earn it.

2. There can be no any concrete basis of ascertaining the number of past years on the basis of which average profit is to be calculated.

3. There is no scientific basis of ascertaining the number of years’ purchase of profits.

4. It is wrong to make total profits of business as the base for valuation of goodwill. If fact goodwill is attached to profits over and above the normal profits. Hence, every rupee of profit earned does not accrue goodwill. Due to this very defect this method is not popular in business world. However, this method is usually adopted for valuing the goodwill of the professional persons or firms such as chartered accountants or doctors.

Super Profit Method

Under this method, super profits (or excess earnings) of the business concern are taken as a basis of computing the value of goodwill. The super profits of a business are the excess of actual average profit of the business over its normal profit, i.e..

Super Profit – Actual Average Profit – Normal Profit

Actual average profit implies estimated future annual profit or future maintainable profit of the business concern. For this purpose, the amount of average normal profits of past few years is adjusted with reference to future expectations. Normal profit is calculated by multiplying the firm’s average capital employed (or net capital employed) with normal rate of return for representative firms in the industry. The normal rate of return is that rate of earning which investors in general expect on their investments having regard to the prevailing rates of interest and the business and financial risks associated with the investment. This rate is usually given in the problem but if it is not given, the students should solve the problem assuming a normal rate of return basing his judgment on the merit of each case,

For example, estimated future annual profit of a firm are Rs. 1.50,000 and capital employed in it is Rs. 8.00.000. If normal rate of return in that business is 10% then the super profit will be 1.50.000 – 10% of 800.000 = Rs. 70.000 and this figure will be taken as the basis of computation of goodwill.

Here, it is important to remember that if the amount of super profit is zero or a negative figure, the value of goodwill will be considered zero.

Goodwill Study Material

Discussion Questions

Descriptive Questions

1 What is Goodwill? Why does it arise ?

2. Define Goodwill. Describe the factors affecting the value of Goodwill.

3. Why valuation of goodwill is needed ? Describe in brief the various methods of its valuation.

4. What do you understand by Super Profit Method of valuing goodwill? What are the different methods of calculating goodwill based on super profit?

5. What is the importance of goodwill ? What factors should be kept in mind at the time of valuation of goodwill?

6. What do you mean by goodwill valuation ? Explain the factors which affect the valuation of goodwill.

Short Answer Questions

(i) State the three main determinants of the value of goodwill.

(ii) Explain the principal methods of valuation of goodwill.

(iii) Give formula for valuation of goodwill by capitalization of annual profit method.

(iv) How is super profit calculated ?

(V) What factors should be kept in mind at the time of valuation of goodwill ?

Goodwill Study Material