Concept of Goodwill - Valuation of Goodwill & Shares, Advanced Corporate Accounting B Com Notes | EduRev

Advanced Corporate Accounting

B Com : Concept of Goodwill - Valuation of Goodwill & Shares, Advanced Corporate Accounting B Com Notes | EduRev

The document Concept of Goodwill - Valuation of Goodwill & Shares, Advanced Corporate Accounting B Com Notes | EduRev is a part of the B Com Course Advanced Corporate Accounting.
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Concept of Goodwill

When one company buys another company, the purchasing company may pay more for the acquired company than the fair market value of its net identifiable assets (tangible assets plus identifiable intangibles, net of any liabilities assumed by the purchaser). The amount by which the purchase price exceeds the fair value of the net identifiable assets is recorded as an asset of the acquiring company. Although sometimes reported on the balance sheet with a descriptive title such as “excess of acquisition cost over net assets acquired”, the amount is customarily called goodwill.

Goodwill arises only part of a purchase transaction. In most cases, this is a transaction in which one company acquires all the assets of another company for some consideration other than an exchange of common stock. The buying company is willing to pay more than the fair value of the identifiable assets because the acquired company has a strong management team, a favourable reputation in the marketplace, superior production methods, or other unidentifiable intangibles.

The acquisition cost of the identifiable assets acquired is their fair market value at the time of acquisition. Usually, these values are determined by appraisal, but in some cases, the net book value of these assets is accepted as being their fair value. If there is evidence that the fair market value differs from net book value, either higher or lower, the market value governs.

Illustration 1

Company X acquires all the assets of company Y, giving Company Y Rs 15 lakh cash. Company Y has cash Rs 50,000 accounts receivable that are believed to have a realisable value of Rs 60,000, and other identifiable assets that are estimated to have a current market value of Rs 11 lakhs.

Particulars Rs Rs
Total purchase price   15,00,000
Less:    

Cash acquired

50,000  

Accounts receivable

60,000  

Other identifiable assets (estimated)

 11,00,000  
Goodwill   12,10,000
    2,90,000

 

This extra amount of Rs 2,90,000 paid over an above, Net worth Rs 12,10,000 is goodwill, which is a capital loss far purchasing company and to be shown on assets side of Balance Sheet. This entire amount will be written off against revenue profit, i.e., Profit and Loss Account over period of time.

Types of Valuing Goodwill

There are basically two types of valuing goodwill: (a) Simple profit method and (b) Super profit method.

(a) Simple Profit Method: Goodwill is generally valued on the basis of a certain number of years’ purchase of the average business profits of the past few years. While calculating average profits for the purposes of valuation of goodwill, certain adjustments are made. Some of the adjustments are as follows:

Trading Profit/Business Profit/Recurring Profit/Normal Profit (of Past Year)​

Particulars

1st Year

2nd Year

3rd Year

Net Profit before Adjustment and Tax

xx

xx

xx

Less: Non Trading Income
(i.e., Income from investment Asset)

 xx

 xx

 xx

Less: Non-recurring Income
(i.e., profit on sale of investment/Asset)

xx

xx

xx

Add: Non-recurring Loss
​(i.e., Loss on sale of investment/Asset)

(xx)

(xx)

(xx)

Trading Profit after Adjustment and before Tax

xx

xx

xx


Calculation of Average profit:

(a) Simple Average Profit  Concept of Goodwill - Valuation of Goodwill & Shares, Advanced Corporate Accounting B Com Notes | EduRev

(b) Weighted Average profit:

Years

Trading Profit (a)

Weight (b)

Product (a x b)

2007

xx

1

xx

2008

xx

2

xx

2009

xx

3

xx

 

 

6

xxx


Weighted Average Profit =  Concept of Goodwill - Valuation of Goodwill & Shares, Advanced Corporate Accounting B Com Notes | EduRev

Notes: If past profits are in increasing trend, then calculate Average Profit by weighted average method or otherwise simple average method.

Calculation of F.M.P. (Future Maintainable Profit):

(i) All actual expenses and losses not likely to occur in the future are added back to profits.
(ii) All actual expenses and losses not likely to occur in the future are added back to profits.
(iii) All profits likely to come in the future are added.

Particulars Rs
Simple/Weighted Average Profit before Tax xx
Add: Expenses incurred in past not to be incurred in future
(i.e., Rent paid in past not payable in future)
xx
Less: Expenses not incurred in past to be incurred in future
(i.e., Rent not paid in past payable in future)
(xx)
Less: Notional Management Remuneration xxx
Future Maintainable Profit before Tax xx
Less: Tax (if Rate is not given me 50%) (xx)
Future Maintainable Profit after Tax xxx


After adjusting profit in the light of future possibilities, average profit are estimated and then the value of goodwill is estimated. If goodwill is to be valued at 3 years’ purchase of the average profits which come to Rs 50,000, the goodwill will be Rs 1,50,000, i.e., 3 × Rs. 50,000.

This method is a simple one and has nothing to recommend since goodwill is attached to profits over and above what one can earn by starting a new business and not to total profits.

It ignores the amount of capital employed for earning the profit. However, it is usual to adopt this method for valuing the goodwill of the practice of a professional person such as a chartered accountant or a doctor.

Calculation of Capital Employed and Average Capital Employed

Tangible Trading Assets (At Agreed/Adjustment Value) (Except: Intangible, Non-trading/Fictitious Assets)

 

 

Plant and Machinery

xx

 

Land and Building

xx

 

Furniture and Fixtures

xx

 

Stock

xx

 

Cash/Bank

xx

xx

Less: External Liability (At Agreed/Adjust Value)
(Except: Capital and Reserve and surplus)

 

 

Loans

xx

 

Debentures

xx

 

Creditors

xx

xxx

Outstanding Expenses, etc.

xx

 

Capital Employed

 

xxx

 

∴ Average Capital Employed =  Concept of Goodwill - Valuation of Goodwill & Shares, Advanced Corporate Accounting B Com Notes | EduRev

= Closing Capital Employed – ½ of Current Years’ Profit + Current Years’ Dividend

(b) Super Profit Method: The future maintainable profits of the firm are compared with the normal profits for the firm. Normal earnings of a business can be judged only in the light of normal rate of earning and the capital employed in the business. Hence, this method of valuing goodwill would require the following information:

(i) A normal rate of return for representative firms in the industry.
(ii) The fair value of capital employed.

The normal rate of earning is that rate of return which investors in general expect on their investments in the particular type of industry. Normal rate of return depends upon the risk attached to the investment, bank rate, market, need, inflation and the period of investment.

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