Understanding Goodwill: Definition, Features, Valuation, and Importance

2. Introduction • Goodwill is that element arising from the reputation, connection with customers, employees and outside parties and other advantages possessed by a businesswhich enables it to earn greater profits than returns normally to be expected onthe capital represented by net tangible assets employed in the business. It is thus the present value of a firm’s anticipated super normal earnings. • It is said to be an attractive force that brings in customers. • Goodwill is the estimated value of the reputation of an enterprise.

3. Definition • According to Institute of Chartered Accountants of India “ Goodwill is an intangible asset arising from business connections or trade name or reputation of an enterprise.”

4. Features of Goodwill • Goodwill can be sold with the entire business except on admission or retirement of a partner where new partner compensate the old partners or retiring partner gives up his rights in favour of remaining partners • Goodwill is valuable only if it is capable of being transferred from one person to another. • Goodwill represents a non physical value over and above the physical assets.

5. Contd… • Goodwill cannot have an exact cost as its value fluctuates from time to time due to internal or external factors which ultimately affect the fortune of the company. • The value of goodwill is based on the subjective judgement of the valuer.

6. Factors to be considered in valuation of Goodwill • Profitability: Profitability refers to the profit which the firm is expected to earn in future . The buyer of goodwill when paying for goodwill looks to the future profits which he expects to earn and not the profits earned in past. However, if past good profitability was due to nature of business, favourable location, ownership of patents and trademarks, access to supplies, stable political conditions, exceptionally favourable contracts or good management (which is likely to continue) the buyer will be prepared to pay a good amount for goodwill. • Capital Employed: The value of goodwill depends on the capital employed in the business to earn the average maintainable profits. it represents the equity shareholder’s funds in the company.

7. Contd.. • While calculating equity shareholder’s funds any profit or loss on revaluation of assets should also be taken into account. Non trading assets, fictitious assets and goodwill appearing in balance sheet should be excluded. • Goodwill can be said to have value only when it can be transferred for valuable considerations. • A prospective buyer of business will be very much concerned with the possible future taxation liability. Buyer of goodwill expects to recoup what he has paid for goodwill out of future profits. The future profits are likely to be reduced by taxation and the buyer will not be ready to pay any large amount for goodwill.

9. Classes of Goodwill According to Rowland, “there are four major categories of goodwill • Local arising from the situation of the trader’s premises ,e.g., a retail shopkeeper in a busy market centre. • The personality and reputation of the owner or management, arising through his skills and influence, as in the case of a professional man. For example, a chartered accountant or a doctor. • The reputation of the articles sold arising from the high standard or quality of the goods themselves. • Possession of advantageous contracts or complete or partial monopoly.

10. Need for valuation of Goodwill • When the business is sold as a going concern. • When the business is amalgamated with another firm. • When business is converted into private or public company. • When there is a change in the profit-sharing ratio amongst the existing partners. • When a new partner is admitted. • When a partner retires or dies or reconstruction.

11. Capitalisation of Average Profit Method Capitalisation of Super Profit Method

12. 1. AVERAGE PROFIT METHOD • Under this method, at first, average profit is calculated on the basis of the past few years profits. Then itis multiplied by one or more number of years purchase in order to ascertain the value of goodwill of the firm. Past profit are adjusted in respect of any abnormal items of profit or loss which may affect future profit. • For calculating Adjusted future profit or Maintainable profits: • All expenses and losses not likely to incur in future as extraordinary salary of a person , abnormal losses are added to profits. • All profits likely to come in the future as profit due to new line of business are added to profits. • All expenses and losses expected to occur in future as salary of directors, depreciation in future, cost of management are deducted from profits. • Profit not likely to recur are deducted from profits. Value of Goodwill = Future Maintainable Profits x No. of years’ purchase.

13. Example: X Ltd. agreed to purchase business of a sole trader. For that purpose, goodwill is to be valued at 3 years’ purchase of average profits of last 5 years.

14. Example: Y Ltd. proposed to purchase business carried on by Mr. A. Goodwill for this purpose is agreed to be valued at 3 year’s purchase of the weighted average profits of the past four years. The profit for these years and respective weights to be assigned are as follows: • On a scrutiny of the accounts, the following matters are revealed: • (a) On 1st September, 2012 a major repair was made in respect of plant incurring Rs. 6,000 which was charged to revenue, the said sum is agreed to be capitalized for goodwill calculation subject to adjustment of depreciation of 10% p.a. on reducing balance method. • (b) The closing stock for the year 2011 was over valued by Rs. 2,400; and • (c) To cover management cost an annual charge of Rs. 4,800 should be made for the purpose of goodwill valuation.

15. Solution:

17. 2. SUPER PROFIT METHOD: Super profit is the excess of estimated future maintainable profits over normal profits. The goodwill under this method is ascertained by multiplying the super profits by certain number of year’s purchase. Steps Involved in Calculating Goodwill under Super Profit Method: Step 1: Calculate capital employed (it is the aggregate of Shareholders’ equity and long term debt or fixed assets and net current assets). Step 2: Calculate Normal Profits by multiplying capital employed with normal rate of return. Step 3: Calculate average maintainable profit. Step 4: Calculate Super Profit as follows: Super Profit = Average maintainable profits – Normal Profits. Step 5: Calculate goodwill by multiplying super profit by number of year’s purchase.

18. Example: From the following information calculate the value of goodwill on the basis of 3 years purchase of super profits of the business calculated on the average profit of the last four years: (i) Capital employed – Rs. 50,000 (ii) Trading profit (after tax): 2010 Rs. 12,200; 2011 Rs. 15,000; 2012 Rs. 2,000 (loss); and 2013 Rs. 21,000 (iii) Rate of interest expected from capital having regard to the risk involved is 10%. (iv) Remuneration from alternative employment of the proprietor (if not engaged in business) Rs. 3,600 p.a.

19. 2

20. 3. CAPITALISATION METHOD: Goodwill under this method can be calculated by capitalizing average normal profit or capitalizing super profits. (i) Capitalisation of Average Profit Method: Under this method goodwill is ascertained by deducting Actual Capital Employed (i.e., Net Assets as on the valuation date) from the capitalised value of the average profits on the basis of normal rate of Return (also known as value of the firm) Goodwill = Capitalised Value – Net Assets of Business Net Assets = All Assets (other than goodwill, fictitious assets and non-trade investments) at their current values – Outsider’s Liabilities

21. Example:

22. (ii) Capitalisation of Super Profit Method: The goodwill under this method is ascertained by capitalizing the super profits on the basis of normal rate of return. This method assesses the capital needed for earning the super profit. The value of goodwill is computed as follows:

26. VALUATION OF SHARES

27. A share represents an interest in a company. There are a number of ways in which the shares of a company can be valued. A stock exchange is the most common source of ascertaining the value of shares. It can be valued either as an entitlement to a share of future profits, or as an interest in the net assets that comprise the company. • There may be instances where a company’s shares are not quoted on any stock exchange like shares of private limited companies and therefore market price of these shares is not available. • The valuation of shares may be done by an accountant for two reasons: • Where there is no market price. In case shares are quoted on a recognised stock exchange, stock exchange prices are generally taken as basis for valuation of those shares. • Where for special reasons, the market price does not reflect the true or intrinsic value of the shares.

28. Need For Valuation 1. Where companies amalgamate or are similarly reconstructed, it may be necessary to arrive at the value of shares hold by the members of the company being absorbed or taken over.2. Where shares are hold jointly by the partners in a company and partnership firm dissolved, it becomes necessary to value of shares.3. Where a portion of the shares is to be given by a member of proprietary company to another member as the member cannot sell it in the open market, it becomes necessary to certify the fair price of these shares by an auditor.4. When a loan advanced on the security of shares, it becomes necessary to know the value of shares on the basis of which loan has been advanced.5. When shares are given in a company as gift it may be necessary for the purpose of assessing gift tax, to place a value on the shares.6. When preference shares or debentures are converted into equity share it becomes necessary to value the equity shares for ascertaining the number of equity shares required to be issued for debentures or preference shares which are to be converted.7. When equity shareholders are to be compensated on the acquisition of their shares by the government under a scheme of nationalization then it is necessary to value the equity shares.

29. Factors Affecting Valuation of Shares 1. The nature of the business2. The income yielding capacity of the company3. The demand and supply of shares4. The percentage of dividend declared on shares5. The availability of sufficient assets over liabilities6. General economic condition e.g. availability of raw materials, possibility of new competitions.7. Financial, political and other factors affecting the business8. Reserves of the company

30. Methods of valuation of shares

31. Net asset method or Intrinsic value method • The value of shares is calculated by dividing the net assets of the business by the no. of equity shares. • All the assets from the asset side of balance sheet are summed up , then liabilities appearing on the liabilities side are deducted. Also less any probable loss or expenses . • The value arrived is the amount available for equity shareholders.

32. Points to remember • Non-Trading assets such as investments should also be included. • Fictitious assets are excluded. • All the assets should be taken at their market value. • If preference share capital appears in the balance sheet then the total amount of preference share capital and the payment of any type of dividend in arrears on them should also be deducted from the total value of assets. • If Net Assets including goodwill is to be calculated, calculate the value of goodwill according to methods done earlier.

33. Value of equity share according to net assets backing method

34. Example 1- From the following Balance Sheet of X Ltd. you are asked to-ascertain the value of each Equity Share of the company:

35. For the purpose of valuing the shares of the company, the assets were revalued as: Goodwill Rs. 50,000; Land and Building at cost plus 50%, Plant and Machinery Rs. 1, 00,000; Investments at book values; Stock Rs. 80,000 and Debtors at book value, less 10%. Additional Information: For the purpose of valuing the shares of the company, the assets were revalued as: Goodwill Rs. 50,000; Land and Building at cost plus 50%, Plant and Machinery Rs. 1, 00,000; Investments at book values; Stock Rs. 80,000 and Debtors at book value, less 10%.

37. Intrinsic Value of each share : = Funds available for Equity Shares/Total Number of Shares Intrinsic Value of shares = Rs. 3, 30,000/20,000 = Rs. 16.50.

38. Merits • It is very simple and logical method for calculating the value of shares. • This method is mostly used by taxation authorities. • Present value of goodwill is also considered under this method. • As the net realisable value of assets is taken into consideration this method is useful for company going into liquidation. • Preference share capital is given preference over equity and deducted from assets like other liabilities.

39. Demerits • As goodwill is taken into consideration, it is difficult to calculate the value of goodwill. • This method leads to personal biasness as the market price of the asset is to be quoted which is very difficult to ascertain. • This method is not reliable one, as it includes the intangible asset such as goodwill, trademarks etc.

40. Yield Valuation Method • This method is also known as Market value method. The word yield means a rate of return relating cash invested to cash received .

41. Earning yield • Under this method shares are valued on the basis of earning expected by using an average of recent years as the best indicator of what future earnings of the company will be. Calculation of expected rate of earnings: • Profits after tax X 100 Paid up value of shares 2. Value of equity shares: • Expected rate of earnings X Face value of share Normal Rate of Return

42. Example 2 - From the following information of J. Adams Co. Ltd. compute the value of its equity share by earning yield method:

43. Additional Information: • It is the usual practice of the company to transfer Rs. 30,000 every year to General Reserve. Assume rate of Taxation is at 50% and the rate of normal earnings at 12.5%.

45. Dividend yield method • This method of valuation of shares is suitable for small blocks of shares because small shareholders are usually interested in dividends. Calculation of expected rate of dividend: • Profits available for dividend to equity X 100 Paid up equity share capital 2. Value of equity shares: • Expected rate of return X Paid up value of share Normal Rate of Return

46. Calculate the value of each Equity Share from the following information:

48. Merits • This method is most reasonably accepted because this method is based upon comparison between expected rate of return with normal rate of return. • This method is useful incase of minority holdings since they are interested in the profits earned by the company and dividends paid to them. • It is best suited to the company which is a going concern.

49. Demerits • Problems while selecting the normal rate of return. • Major drawback is that it doesn’t take into consideration the value of net assets of the company. • It is not suitable for the company which is going into losses for the past few years. • The method contains various difficulties while application of this method. • Predicting the future maintainable profits is quite difficult.

50. Fair value method • It is average of value obtained by net asset method and yield method Fair Value of Shares = Intrinsic value + Yield value 2 • This method removes the disadvantages of both intrinsic method and yield method