CHAPTER 13

VALUATION OF GOODWILL

LEARNING OUTCOMES
After studying this chapter, you will be able to:
▪ Understand the concept and significance of valuation.
▪ Familiarize with the bases of valuation.
▪ Learn the terminology of valuation models.
▪ Understand the implications of valuation of goodwill.
▪ Familiarize with the valuation approaches adopted for
valuation of goodwill.
▪ Compute Future Maintainable profit, Capital employed and
goodwill.

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 13.2 ADVANCED ACCOUNTING

CHAPTER OVERVIEW

Realizable
Value

Historical Valuation Present

cost
Bases value

Current
cost

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 VALUATION OF GOODWILL 13.3

Capitalisation Method

Methods
of
goodwill
Super Profit valuation annuity
Method method

1 INTRODUCTION
Valuation is the process of estimating what something is worth. Valuation can be
used as a very effective business tool by management for better decision making
throughout the life of the enterprise. Valuations are needed for many reasons
such as investment analysis, capital budgeting, merger and acquisition
transactions, financial reporting, determination of tax liability.
Companies are governed and valuations are influenced by the market supply -
demand life cycles along with product and technology supply-demand lifecycles.
Correspondingly, the value of an enterprise over the course of its life peaks with
the market and product technology factors. Both financial investors such as
venture capitalists and entrepreneurs involved in a venture would ideally like to
exit the venture in some form near the peak to maximize their return on
investment. Thus, valuation helps determine the exit value of an enterprise at that
peak. This exit value typically includes the tangible and intangible value of the
company’s assets. Tangible value would typically include balance sheet items
recorded as the book value of the enterprise. Intangibles would typically include
intellectual property, human capital, brand and customers, and others. In more
traditional companies considering the private equity markets, the value of
intangibles is much higher than the value of the tangible assets. Therefore, an
effective enterprise valuation methodology needs to be developed.
One can also define valuation as Measurement of value in monetary terms.
Measurement of income and valuation of wealth are two interdependent core
aspects of financial accounting and reporting. Wealth comprises of assets and

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 13.4 ADVANCED ACCOUNTING

liabilities. Valuation of assets and liabilities are made to portray the wealth
position of a firm through a balance sheet and to supply logistics to the measure
of the periodical income of the firm through a profit and loss account.
Again valuation of business and valuation of share are made through financial
statement analysis for management appraisal and investment decisions. Valuation
is pivotal in strategic, long term or short term decision making process in cases
like reorganization of company, merger and acquisition, extension or
diversification, or for launching new schemes or projects. As the application area
of valuation moves from financial accounting to financial management, the role of
accountant also undergoes a transition. That order of transition in the concept
and use of valuation process is followed in the subsequent units of this chapter.

2 CONCEPT OF VALUATION
Valuation means measurement of an item in monetary term. The subjects of
valuation are varied as stated below:
 Valuation of Tangible Fixed Assets
 Valuation of Intangibles including brand valuation and valuation of goodwill
 Valuation of Shares
 Valuation of Business
The objectives of valuation are again different in different areas of application in
financial accounting and in financial management.

3 NEED FOR VALUATION

Financial statements must give a “true and fair view” of the state of affairs of a
company as per provisions of the Companies Act. Proper valuation of all assets
and liabilities is required to ensure true and fair financial position of the business
entity. In other words, all matters which affect the financial position of the
business have to be disclosed. Under or overvaluation of assets may not only
affect the operating results and financial position of the current period but will
also affect these for the next accounting period. The present unit deals with
different principles involved in the valuation of different types of assets.
Assets can be classified as (i) Non- current assets and (ii) Current assets. Non-current
assets have been further sub-classified into (a) fixed assets i.e. tangible assets,
intangible assets, capital W.I.P. and intangible assets under development (b) non-
current investments (c) deferred tax assets (Net) (d) long term loans and advances

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 VALUATION OF GOODWILL 13.5

and (e) other non-current assets. Current assets have been further sub-classified into
(a) Current Investments (b) Inventories (c) Trade Receivables (d) Cash and Cash
Equivalents (e) Short Term Loans and Advances and (f) Other Current Assets.
The students are expected to learn the essence and modalities of valuation, a core
function in financial accounting. Valuation is done sometimes by the
Valuers/Engineers in cases where technical inputs and knowledge is required to
arrive at the Fair value and accepted by various Government and Statutory
Authorities. Students should be familiar with these valuation Reports and their
basis of valuation.
Different approaches to valuation of different kinds of assets and liabilities in
different perspectives have pushed the role of accountant to a complex position.
This chapter is aimed to differentiate the objectives, approaches and methods of
valuation in order to integrate them in a comprehensive logical frame.

4 BASES OF VALUATION
A number of different measurement bases are employed to different degrees and
in varying combinations in valuation of different assets in different areas of
application. They include the following:
(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents
paid or the fair value of the other consideration given to acquire them at the
time of their acquisition.
(b) Current cost. Assets are carried at the amount of cash or cash equivalents
that would have to be paid if the same or an equivalent asset were acquired
currently.
(c) Realizable (settlement) value. Assets are carried at the amount of cash or cash
equivalents that could currently be obtained by selling the asset in an orderly
disposal.
(d) Present value. Assets are carried at the present value of the future net cash
inflows that the item is expected to generate in the normal course of
business.
Other generally used valuation bases are as follows:
Net Realizable Value (NRV): This is same as the Realizable (settlement) value. This
is the value (net of expenses) that can be realized by disposing off the assets in an
orderly manner. Net selling price or exit values also convey the same meaning.

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Economic value: This is same as the present value. The other name of it is value to
business.
Replacement (cost) value: This is also same as the current cost.
Recoverable (amount) value: This is the higher of the net selling price and value in
use.
Deprival value: This is the lower of the replacement value and recoverable
(amount) value.
Liquidation value: This is the value (net of expenses), that a business can expect to
realize by disposing of the assets in the event of liquidation. Such a value is
usually lower than the NRV or exit value. This is also called break-up value.
Fair value: This is not based on a particular method of valuation. It is the
acceptable value based on appropriate method of valuation in context of the
situation of valuation. Thus fair value may represent current cost, NRV or present
value as the case may be.
In financial accounting ‘An asset is recognised in the balance sheet when it is
probable that the future economic benefits associated with it will flow to the
enterprise and the asset has a cost or value that can be measured reliably.’ ‘The
measurement basis most commonly adopted by enterprises in preparing their
financial statements is historical cost. This is usually combined with other
measurement bases.
The requirements of regulations and accounting standards as to recognition of
assets, reliability of measurement and disclosure in financial reports have set
certain limitations to the freedom of valuation so far as financial accounting is
concerned.

5 TYPES OF VALUE
The following are six types of value:
 Going-concern value is the value of a firm as an operating business.
 Liquidation value is the projected price that a firm would receive by selling its
assets if it were going out of business.
 Book value is the value of an asset as carried on a balance sheet. In other
words, it means (i) the cost of an asset minus accumulated depreciation (ii)
the net asset value of a company, calculated by total assets minus intangible
assets (patents, goodwill) and liabilities (iii) the initial outlay for an
investment. This number may be net or gross of expenses such as trading

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 VALUATION OF GOODWILL 13.7

costs, sales taxes, service charges and so on. It is the total value of the
company’s assets that shareholders would theoretically receive if a company
were liquidated. By being compared to the company’s market value, the book
value can indicate whether a Inventory is under or overpriced. In personal
finance, the book value of an investment is the price paid for a security or
debt investment. When an inventory is sold, the selling price less the book
value is the capital gain (or loss) from the investment.
 Market value is the price at which buyers and sellers trade similar items in an
open market place. It is the current quoted price at which investors buy or
sell a share of common Inventory or a bond at a given time. The market
capitalization plus the market value of debt, sometimes referred to as “total
market value”. In the context of securities, market value is often different
from book value because the market takes into account future growth
potential.
 Fair market value is the price that a given property or asset would fetch in the
market place, subject to the following conditions: (i) Prospective buyers and
sellers are reasonably knowledgeable about the asset; they are behaving in their
own best interests and are free of undue pressure to trade. (ii) A reasonable time
period is given for the transaction to be completed. Given these conditions, an
asset’s fair market value should represent an accurate valuation or assessment of
its worth. Fair market values are widely used across many areas of
commerce. For example, municipal property taxes are often assessed based on
the fair market value of the owner’s property. Depending upon how many years
the owner has owned the home, the difference between the purchase price and
the residence’s fair market value can be substantial. Fair market values are often
used in the insurance industry as well. For example, when an insurance claim is
made as a result of a car accident, the insurance company covering the damage
to the owner’s vehicle will usually cover damages up to the fair market value of
the automobile.
 Intrinsic value is the value at which an asset should sell based on applying data
inputs to a valuation theory or model. The actual value of a company or an asset
based on an underlying perception of its true value including all aspects of the
business, in terms of both tangible and intangible factors. This value may or may
not be the same as the current market value. Value investors use a variety of
analytical techniques in order to estimate the intrinsic value of securities
in hopes of finding investments where the true value of the investment
exceeds its current market value. For call options, this is the difference between
the underlying Inventory’s price and the strike price. For put options, it is the

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 13.8 ADVANCED ACCOUNTING

difference between the strike price and the underlying Inventory’s price. In the
cases, if the respective difference value is negative, the intrinsic value is given as
zero. For example, value investors that follow fundamental analysis look at both
qualitative (business model, governance, target market factors etc.) and
quantitative (ratios, financial statement analysis, etc.) aspects of a business to see
if the business is currently out of favour with the market or is really worth much
more than its current valuation.
 Extrinsic value is another variety. It is the difference between an option’s price
and the intrinsic value. For example, an option that has a premium price of `
10 and an intrinsic value of ` 5 would have an extrinsic value of ` 5. Denoting
the amount that the option’s price is greater than the intrinsic value, the
extrinsic or time value of the option declines as the expiration date of an
option draws closer.
These types of values can differ from one another. For example, a firm’s going-
concern value is likely to be higher than its liquidation value. The excess of going-
concern value over liquidation value represents the value of the operating firm as
distinct from the value of its assets. Book value can differ substantially from
market value. For example, a piece of equipment appears on a firm’s books at
cost when purchased but decreases each year due to depreciation charges. The
price that someone is willing to pay for the asset in the market may have little
relationship with its book value. Market value reflects what someone is willing to
pay for an asset whereas intrinsic value shows what the person should be willing
to pay for the same asset.

6 APPROACHES OF VALUATION
Three generally accepted approaches to valuation are as follows:
(1) Cost Approach: e.g. Adjusted Book Value
(2) Market Approach: e.g. Comparables
(3) Income Approach: e.g. Discounted Cash Flow
Each approach has advantages and disadvantages. Generally there is no “right”
answer to a valuation problem. Valuation is very much an art as much as a
science! These approaches can be briefly discussed as:
Cost Approach
This technique involves restating the value of individual assets to reflect their fair
market values. It is useful for valuing holding companies where assets are easy to

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value (for example, securities) and less useful for valuing operating businesses.
The value of an operating company is generally greater than that of its assets. The
difference between that value of the expected cash flows and that of its assets is
called the “going concern value”. It is a useful approach when the purpose of the
valuation is that the business will be liquidated and Trade payables must be
satisfied. While doing this valuation following adjustments to book value can be
made:
 Inventory undervaluation
 Bad debt reserves
 Market value of plant and equipment
 Patents and franchises
 Investments in affiliates
 Tax-loss carried forward
Market Approach: The market approach, as the name implies, relies on signs
from the real market place to determine what a business is worth. It is to be
understood that business does not operate in vacuum. If what one does is really
great, then chances of others doing the same or similar things are more. If one is
looking to buy a business, one decides what type of business he is interested in
and then looks around to see what the "going rate" is for businesses of this type.
If one is planning to sell business, he will check the market to see what similar
businesses sell for. So the market approach to valuing a business is a great way to
determine its fair market value - a monetary value likely to be exchanged in an
arms-length transaction, when the buyer and seller act in their best interest.
Income approach
The income approach considers the core reason for running a business ie. making
money. Here the so-called economic principle of expectation applies. Since the
business value must be established in the present, the expected income and risk
must be translated to today. The income approach generally uses two ways to do
this translation: (i) Capitalization and (ii) Discounting.

7 DEFINITION OF INTANGIBLES
An intangible asset is an identifiable non-monetary asset, without physical
substance, held for use in the production or supply of goods or services, for rental
to others, or for administrative purposes (as per AS 26 “Intangible Assets”). It is
important to note that Intangible assets are the major contributors for the

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disparity between company value according to accounting records and company

value as per market capitalization. Therefore, understanding the concept of an
intangible asset from the angle of an accountant is necessary. Enterprises usually
expend resources, or incur liabilities, on the acquisition, development,
maintenance or enhancement of intangible resources such as scientific or
technical knowledge, design and implementation of new processes or systems,
licences, intellectual property, market knowledge and trademarks (including
branch names and publishing titles) at regular intervals of time. Common
examples of items encompassed by these broad headings are computer software,
patents, copyrights, motion picture films, customer lists, mortgage servicing
rights, finishing licences, import quotas, franchises, customer or supplier
relationships, customer loyalty, market share and marketing rights. Goodwill is
another example of an item of intangible nature which either arises on acquisition
or is internally generated. Intangible fixed assets can be classified as identifiable
intangibles and not identifiable intangibles. The identifiable intangibles include
patents, trademarks and designs and brands whereas the not identifiable
intangibles are clubbed together as goodwill. To be identifiable, it is necessary
that the intangible asset is clearly distinguished from goodwill. An intangible
asset can be clearly distinguished from goodwill if the asset is separable.

8 RECOGNITION
AS 26 “Intangible Assets” establishes general principles for the recognition and
measurement of Intangible Assets. An intangible asset should be recognised in
the financial statements if, and only if:
(a) It is probable that the future economic benefits that are attributable to the
asset will flow to the enterprise; and
(b) The cost of the asset can be measured reliably.
These recognition criteria apply to both costs incurred to acquire an intangible
asset and those incurred to generate an asset internally. The Standard imposes
additional criteria, however, for the recognition of internally-generated intangible
assets. if an intangible asset is acquired separately:
Cost of the intangible asset can usually be measured reliably and such intangible
asset is recognized and valued at cost in the same manner as in case if the
tangible fixed assets.
If the intangible asset is internally generated:
The standards prohibit the recognition of internally generated goodwill as an

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asset. Brands, Mastheads, Publishing titles, Customer Lists etc. are all internally
generated assets. However, when such assets are purchased either individually or
as part of an amalgamation in the nature of a purchase, they may meet the
general recognition criteria for intangible assets and, therefore, potentially may
be recognized. This difference means that intangible assets such as brands can be
capitalized if acquired, but will be expensed if they are generated internally.
The Standard distinguishes between two phases in the generation of an
intangible asset internally, namely, the research phase and the development
phase. Capitalization is only permitted during the development phase.
Research is defined as original and planned investigation undertaken with the
prospect of gaining new scientific or technical knowledge and understanding.
Development is the application of research findings or other knowledge to a plan
or design for the production of new or substantially improved materials, devices,
products, processes, systems or services prior to the commencement of
commercial production or use.
If it is not possible to distinguish the research phase from the development phase
of an internal project to create an intangible asset, the expenditure on that
project is treated as relating only to the research phase.
Subsequent expenditure on an intangible asset after its purchase or its
completion should be added to the cost of the intangible asset if:
(a) It is probable that the expenditure will enable the asset to generate future
economic benefits in excess of its originally assessed standard of
performance; and
(b) the expenditure can be measured and attributed to the asset reliably.
Designs which are acquired separately, valuation would be made at initial cost of
acquisition (with subsequent addition to cost, if any). If they are generated
internally and are not recognized then no valuation shall be made. However for
internally generated recognized, valuation would be made at cost (with
subsequent addition to cost, if any).
The depreciable amount of an intangible asset should be allocated on a
systematic basis over the best estimate of its useful life. There is a rebuttable
presumption that the useful life of an intangible asset will not exceed ten years
from the date when the asset is available for use. Amortisation should commence
when the asset is available for use.

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9 GOODWILL
Goodwill is said to be that element arising from reputation, connection or other
advantages possessed by a business which enables it to earn greater profits than
the return normally to be expected on the capital represented by net tangible
assets employed in the business. In considering the return normally to be
expected, regard must be had to the nature of the business, the risk involved, fair
management remuneration and other relevant circumstances.
Goodwill of a business may arise in two ways. It may be inherent to the business
that is generated internally or it may be acquired while purchasing any concern.
Purchased goodwill can be defined as being the excess of fair value of the
purchase consideration over the fair value of the separable net assets acquired.
The value of purchased goodwill is not necessarily equal to the inherent goodwill
of the business acquired as the purchase price may reflect the future prospects of
the entity as a whole.
Goodwill in financial statements arises when a company is purchased for more
than the fair value of the identifiable net assets of the company. The difference
between the purchase price and the sum of the fair value of the net assets is by
definition the value of the "goodwill" of the purchased company. The acquiring
company must recognize goodwill as an asset in its financial statements and
present it as a separate line item on the balance sheet, according to the current
purchase accounting method. In this sense, goodwill serves as the balancing sum
that allows one firm to provide accounting information regarding its purchase of
another firm for a price substantially different from its book value. Goodwill can
be negative, arising where the net assets at the date of acquisition, fairly valued,
exceed the cost of acquisition. Negative goodwill is recognized as a gain to the
extent that it exceeds allocations to certain assets. Under current accounting
standards, it is no longer recognized as an extraordinary item. For example,
a software company may have net assets (consisting primarily of miscellaneous
equipment, and assuming no debt) valued at ` 1 million, but the company's
overall value (including brand, customers, intellectual capital) is valued at ` 10
million. Anybody buying that company would book ` 10 million in total assets
acquired, comprising ` 1 million physical assets, and ` 9 million in goodwill.

10 VALUATION OF GOODWILL
There are basically two accounting methods for goodwill valuation. These are:

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(i) Capitalisation Method and (ii) Super Profit Method. A third method called
annuity method is a refinement of the super profit method of goodwill valuation.
10.1 Capitalisation method
Under this method future maintainable profit is capitalised applying normal rate
of return to arrive at the normal capital employed. Goodwill is taken as the
excess of normal capital employed over the actual capital employed.
Future maintainab le profit
Normal Capital employed =
Normal rate of return
Goodwill = Normal Capital Employed – Actual Closing Capital Employed
Factors considered in this method are:
(i) Future maintainable profit;
(ii) Actual capital employed in the business enterprise for which goodwill is to be
computed;
(iii) Normal rate of return in the industry to which the business enterprise
belongs.
For example, Capital employed in X Ltd. is ` 17,00,000, future maintainable
profit is ` 3,00,000 and normal rate of return is 15%.
` 3,00,000
So goodwill = – ` 17,00,000 = ` 3,00,000
0.15
Naturally, if normal capital employed becomes less than actual capital employed
there arises negative goodwill.
It is to be noted that under Capitalisation method the actual capital employed is
to be taken at (closing) balance sheet date.
10.2 Super profit method
Excess of future maintainable profit over normally expected profit is called super
profit. Under this method goodwill is taken as the aggregate super profit of the
future years for which such super profit is expected to be maintained.
Factors considered in this method are:
(i) Future maintainable profit;
(ii) Actual capital employed;
(iii) Normal rate of return;
(iv) Period for which super profit is projected.

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Super profit = Future maintainable profit minus (Actual Capital employed ×

Normal rate of return)
Goodwill = Super profit × No. of years for which Super Profit can be maintained.
10.3 Annuity method
It is a refinement of the super profit method. Since super profit is expected to
arise at different future time periods, it is not logical to simply multiply super
profit into number of years for which that super profit is expected to be
maintained. Further future values of super profits should be discounted using
appropriate discount factor. The annuity method got the nomenclature because
of suitability to use annuity table in the discounting process of the uniform super
profit. In other words, when uniform annual super profit is expected, annuity
factor can be used for discounting the future values for converting into the
present value. Here in addition to the factors considered in super profit method,
appropriate discount rate is to be chosen for discounting the cash flows.
Example
Super Profit of X Ltd. ` 95,000 p.a. can be maintained for 5 years. Discount rate is
15%.
Goodwill = ` 95,000 × 3.352 = ` 3,18,440
There are atleast two frequently used approaches for arriving at the Capital
employed:
(i) based on a particular Balance Sheet and (ii) average of Capital employed at
different balance sheet dates.
Capital employed is determined using historical cost values available at the
balance sheet date. However if revalued figures are given that should be
considered.

11 DETERMINATION OF CAPITAL EMPLOYED

Conventionally ‘Capital Employed’ means Total Assets Minus non-trading assets
i.e. assets not used in the business Minus miscellaneous expenditure and losses
Minus all outside liabilities.
As per this concept capital employed becomes equivalent to net worth less non-
trading assets. But this concept has its own shortcomings:
(i) This approach ignores other long term fund in the business;

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(ii) On the other hand, it considers preference share capital which bears fixed rate
of dividend.
The argument in favour of adopting this approach is to count only such fund
which is attributable to the shareholders. Alternatively, by capital employed one
can mean long term capital employed. However, leverage gives some advantage
as well as riskiness. Use of lower amount of owned fund results in higher return
because of using borrowed fund advantageously. This is called leverage effect.
By taking only ‘shareholders fund’ as capital employed, one can give weightage to
leverage while calculating goodwill.
Example
Balance Sheet of X Ltd.
Liabilities ` in lakhs Assets ` in lakhs
Share Capital 80 fixed assets 1,80
P & L A/c 20 Inventory 40
13% Debentures 1,20 Trade receivables 20
Trade payables 40 Cash & Bank 20
2,60 2,60

Capital employed (shareholders’ fund approach)

` 260 lakhs – ` 160 lakhs outside liabilities = ` 100 lakhs.
Capital employed (long term fund approach):
` 260 Lakhs – ` 40 lakhs Trade payables = ` 220 lakhs
Suppose normal return on shareholders’ fund is 20% and normal return on long
term fund is 18%
Also suppose Future Maintainable Profit (before interest) of X Ltd. is ` 38.4 lakhs.
Future Maintainable Profit (after interest) of X Ltd. is
` 22.8 lakhs i.e. (` 38.4 lakhs –` 15.6 lakhs debenture interest)
If long term fund approach is followed value of goodwill as per Capitalisation
method is i.e.,
38.4 lakhs
-220 lakhs
0.18
` 213.33 lakhs – ` 220 lakhs
i.e., (-) ` 6.67 lakhs, negative goodwill.

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If shareholders’ fund approach is followed, value of goodwill as per capitalisation

method is,
22.8 lakhs
-100 lakhs
0.20
` 114 lakhs – ` 100 lakhs
i.e., ` 14 lakhs, positive goodwill.
In this example, when long term capital employed was considered there was
negative goodwill, but it became positive when shareholders’ fund was
considered. In the second approach leverage advantage has been taken into
consideration. Thus, in goodwill valuation generally shareholders’ fund approach
is preferred.
Non-trading assets are ignored while computing capital employed. This is
because surplus fund invested outside does not influence the future maintainable
profit. Particularly, Non-trade investments are not counted while computing
capital employed, but trade investments should be taken into consideration.
Another important aspect is often discussed regarding valuation of capital
employed. What value should the accountant put for fixed assets and inventory.
Since historical cost is not true indicator of the value of these assets, then it is
suggested to take current cost of such assets. Current cost represents the cost
for which asset can be replaced at its present state. However, if the asset cannot
be replaced at its present state because of obsolescence, then cost at which its
best substitute is available may be taken as current cost.
Capital employed may be determined using the value given by the latest balance
sheet or taking simple average of the capitals employed at the beginning of the
accounting period as well as at the end.
Illustration 1
Balance Sheets of X Ltd.
As on 31st March 2014 and 31st March 2015
(` In lakhs)

Liabilities 31.3.14 31.3.15 Assets 31.3.14 31.3.15

Share Capital 18,00 18,00 Fixed assets 24,00 26,00
General Reserve 6,00 6,00 Investments 1,00 2,00
Profit &Loss A/c 6,80 9,40 Inventory 6,00 5,50
12% Debentures 2,00 2,00 Trade receivables 3,00 3,50

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18% Term Loan 3,00 3,20 Cash and Bank 4,00 3,40
Cash Credit 1,20 80
Trade payables 70 60
Tax Provision 30 40
38,00 40,40 38,00 40,40

Non-trade investments were 75% of the total investments. Find capital employed
as on 31.3.14 and as on 31.3.15 and average capital employed.
Solution
Computation of capital employed
(` in lakhs)
31.3.14 31.3.15
Total Assets as per
Balance Sheet 38,00 40,40

Less: Non-trade Investments (75) (1,50)

37,25 38,90
Less: Outside Liabilities:
12% Debentures 2,00 2,00
18% Term Loan 3,00 3,20
Cash Credit 1,20 80
Trade payables 70 60
Tax Provision 30 7,20 40 7,00
Capital employed 30,05 31,90
30,05 lakhs+31,90 lakhs
Average capital employed = = ` 3,097.5 lakhs.
2
Illustration 2
Balance Sheet of AP Ltd. as on 31st March, 2015
Liabilities ` in lakhs Assets ` in lakhs
Share Capital Land & Building 51,20
Equity Shares of ` 10 each 90,00 Plant & Machinery 108,70
8½% Preference Shares 20,00 Furniture 27,00
General Reserve 10,50 Vehicles 2,00

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 13.18 ADVANCED ACCOUNTING

Profit & Loss A/c 30,00 Inventory 7,00

18% Term Loan 45,00 Trade receivables 4,50
Cash Credit 5,60 Cash & Bank 23,40
Trade payables 2,00
Provision for Taxation
(net of advance tax) 1,00
Proposed Dividend:
Equity 18,00
Preference 1,70 _____
223,80 223,80
Other information
Balance as on 1.4.14
Profit and Loss A/c ` 4,80 Lakhs
Reserve ` 4,50 Lakhs
Find out average capital employed of AP Ltd.
Solution
Computation of Average Capital Employed
` in lakhs ` in lakhs
Total of Assets as per Balance Sheet as on 31.3.2015 223,80
Less: Outside Liabilities:
18% Term Loan 45,00
Cash Credit 5,60
Trade payables 2,00
Provision for Taxation 1,00 (53,60)
Capital employed as on 31.3.15 170,20
Less: 1/2 of profit earned
Increase in Reserve balance 6,00
Increase in Profit & Loss A/c 25,20
Proposed Dividend 19,70
50,90 25,45
Average capital employed 144,75

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 VALUATION OF GOODWILL 13.19

12 FUTURE MAINTAINABLE PROFIT

We have seen earlier while discussing various methods of goodwill valuation that
estimation of average maintainable profit is another important step in goodwill
valuation. Future maintainable profit is ascertained taking either simple or
weighted average of the past profits or by fitting trend line. Generally, profits of
past three to five years are considered.
(i) Simple Average of Past Profits: If the past profits do not have any definite
trend, average is taken to arrive at the future maintainable profit.
Example
Profits of the past five years of XX Ltd. are given below:
Year ` ’000
2011 71,20
2012 87,20
2013 75,70
2014 82,70
2015 78,90
In this case no trend of past profit is available. So, simple average is best suitable
method to arrive at a figure which may be taken as future maintainable profit.
7,120  87,20  75,70  82,70  78,90
Future maintainable profit (` in ’000) = = 79,14
5
(ii) Trend Equation: If the past profits show increasing or decreasing trend,
linear trend equation gives better estimation of the future maintainable
profit.
Example
B K Ltd. gives the following profit figures for the last five years:
Year Profits
` ’000
2011 37,20
2012 42,00
2013 47,50
2014 53,50
2015 57,20

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 13.20 ADVANCED ACCOUNTING

Since, past profits show increasing trend, time series trend may be used to
determine future maintainable profit. Applying Linear trend equation three to five
years profit may be predicted and average of such future profits may be taken as
future maintainable profit.
Year X Y XY 2
X
2011 –2 37,20 –74,40 4
2012 –1 42,00 –42,00 1
2013 0 47,50 0 0
2014 1 53,50 53,50 1
2015 2 57,20 114,40 4
0 237,40 51,50 10

A=
Y = 237, 40
=47,48
n 5

b=
 XY = 51,50
= 51,5
X 2
10

Trend Equation is given by:

Y = 4748 + 515 X
Alternatively, using trend equation, estimated profit will be:
Estimated Profit:
2016 4748 + 515 (3) = ` 62,93
2017 4748 + 515 (4) = ` 68,08
2018 4748 + 515 (5) = ` 73,23
Average of the Future Profit ` 68,08
i.e., Future Maintainable Profit ` 68,00 (say)
(iii) Weighted average of past profits: If the past profits show increasing or
decreasing trend, then more weights are given to the profit figures of the
immediate past years and less weight to the profit figures of the furthest
past.
Example
Profits of the past five years of BB Ltd. are given below:

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 VALUATION OF GOODWILL 13.21

Year Profits
(’000 `)
2011 71,20
2012 82,50
2013 87,00
2014 92,00
2015 95,00
In this example past profits showed an increasing trend. Weighted average of
past profits may be used in such cases to arrive at future maintainable profit.
Derivation of weighted average of the past profits:
Year Profits (P) Weight (W) PW
’000 `
2011 71,20 1 71,20
2012 82,50 3 247,50
2013 87,00 5 435,00
2014 92,00 7 644,00
2015 95,00 9 855,00
25 22,52,70

Weighted average profit =

PW = 22,52,70
W 25
i.e. ` 9010.80 thousand.
12.1 Adjustments needed with past profits
Since past profits are used to make an estimation about the future maintainable
profit, it is necessary to make appropriate adjustments for better projection. The
following adjustments generally become necessary:
(i) Elimination of abnormal loss arising out of strikes, lock-out, fire, etc.
Profit/loss figures which contain abnormal loss should either be ignored or
eliminated. Similarly, if there is any abnormal gain included in past profits
that needs elimination.
(ii) Interest/dividend or any other income from non-trading assets needs
elimination because ‘capital employed’ used for valuation of goodwill
comprises only of trading assets.

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 13.22 ADVANCED ACCOUNTING

(iii) If there is a change in rate of tax, tax charged at the old rate should be added
back and tax should be charged at the new rate.
(iv) Effect of change in accounting policies should be neutralised to have profit
figures which are arrived at on the basis of uniform policies.
Illustration 3
PPX Ltd. gives the following information about past profits:
Year Profits
(` ’000)
2011 21,70
2012 22,50
2013 23,70
2014 24,50
2015 21,10
On scrutiny it was found that upto 2013, PPX Ltd. followed FIFO method of finished
inventory valuation thereafter adopted LIFO method.
Given below the details of Inventory valuation: (Figures in` ’000)
Year Opening Inventory Closing Inventory
FIFO LIFO FIFO LIFO
2011 40,00 39,80 46,00 41,20
2012 46,00 41,20 49,20 47,90
2013 49,20 47,90 38,90 39,10
2014 38,90 39,10 42,00 38,50
2015 42,00 38,50 45,00 43,10
Determine future maintainable profits that can be used for valuation of goodwill.
Solution
Past profits of PPX Ltd. showed an increasing trend excepting in year 2015. But
the effects of changes in accounting policies should be eliminated to ascertain
the true nature of trend. Since the company has adopted LIFO method of
Inventory valuation, profits may be recomputed applying these policies
consistently in all the past years. Re-computation of profits following uniform
accounting policies are shown below:

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 VALUATION OF GOODWILL 13.23

(Figures in ’000)

Year Book Profits Effect of LIFO on Profits after elimination of the

Valuation of effect of change in Accounting
Inventory. policies

2011 21,70 – 4,60 17,10

2012 22,50 + 3,50 26,00
2013 23,70 + 1,50 25,20
2014 24,50 –20 24,30
2015 21,10 — 21,10

After elimination of the effect of change in accounting policies, increasing trend

disappeared. Rather profits were oscillating during the last four years excepting
2011. So a simple average may be taken of the last 4 years profits to arrive at the
future maintainable profits:
26,00 + 25,20 + 24,30 + 21,10
Future Maintainable Profit (’000 ) = = 24,15
4

Working Note:
Effect of LIFO Valuation:

2011 Increase in Inventory as per FIFO valuation 6,00

Less: Increase in Inventory per LIFO valuation (1,40)
Reduction in profit 4,60
2012 Increase in Inventory as per FIFO valuation 3,20
Less: Increase in Inventory as per LIFO valuation (6,70)
Increase in profit 3,50
2013 Decrease in Inventory as per FIFO valuation 10,30
Less: Decrease in Inventory as per LIFO valuation (8,80)
Increase in profit 1,50
2014 Opening Inventory as per FIFO valuation 38,90
Less: Opening Inventory as per LIFO valuation (39,10)
Reduction in profit 20

© The Institute of Chartered Accountants of India

 13.24 ADVANCED ACCOUNTING

13 NORMAL RATE OF RETURN

Apart from capital employed and future maintainable profit, the third important
step in valuation of goodwill is determination of normal rate of return. It
comprises of:
(i) the risk-free rate, i.e., the pure interest rate prevailing in the concerned
economy; (the rate of return on long term government securities or fixed
deposit in bank may be taken as risk-free rate)
(ii) the premium for business risks appropriate for the industry to which the
firm/company belongs.
If the industry is well established and yielding profits steadily the rate of return
that will satisfy entrepreneurs will be rather low though higher than the risk-free
rate. Higher the business risk, higher will be the normal rate of return.
For practical purposes industry average return is taken as normal rate of return.
Illustration 4
On the basis of the following information, calculate the value of goodwill of Gee
Ltd. at three years’ purchase of super profits, if any, earned by the company in the
previous four completed accounting years.
Summarised Balance Sheet of Gee Ltd. as at 31st March, 2015

Liabilities ` in lakhs Assets ` in lakhs

Share Capital: Goodwill 310
Authorised 7,500 Land and Buildings 1,850
Issued and Subscribed Machinery 3,760
5 crore equity shares of Furniture and Fixtures 1,015
` 10 each, fully paid up 5,000 Patents and Trade Marks 32
Capital Reserve 260 9% Non-trading Investments 600
General Reserve 3,293 Inventory 873
Surplus i.e. credit balance Trade receivables 614
of Profit and Loss 457 Cash in hand and at Bank 546
(appropriation) A/c
Trade payables 568
Provision for Taxation (net) 22 ____
9,600 9,600

© The Institute of Chartered Accountants of India

 VALUATION OF GOODWILL 13.25

The profits before tax of the four years have been as follows:
Year ended 31st March Profit before tax in lakhs of `
2011 3,190
2012 2,500
2013 3,108
2014 2,900
The rate of income tax for the accounting year 2010-2011 was 40%. Thereafter it
has been 38% for all the years so far. But for the accounting year 2014-2015 it will
be 35%.
In the accounting year 2010-2011, the company earned an extraordinary income of
` 1 crore due to a special foreign contract. In August, 2011 there was an earthquake
due to which the company lost property worth ` 50 lakhs and the insurance policy
did not cover the loss due to earthquake or riots.
9% Non-trading investments appearing in the above mentioned Balance Sheet were
purchased at par by the company on 1st April, 2012.
The normal rate of return for the industry in which the company is engaged is 20%.
Also note that the company’s shareholders, in their general meeting have passed a
resolution sanctioning the directors an additional remuneration of ` 50 lakhs every
year beginning from the accounting year 2014-2015.
Solution
(1) Capital employed as on 31st March, 2015
(Refer to ‘Note’)
` in lakhs
Land and Buildings 1,850
Machinery 3,760
Furniture and Fixtures 1,015
Patents and Trade Marks 32
Inventory 873
Trade receivables 614
Cash in hand and at Bank 546
8,690
Less: Trade payables 568
Provision for taxation (net) 22 590
8,100

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 13.26 ADVANCED ACCOUNTING

(2) Future maintainable profit

(Amounts in lakhs of `)
2010-2011 2011-2012 2012-2013 2013-2014
` ` ` `
Profit before tax 3,190 2,500 3,108 2,900
Less: Extraordinary
income due to (100)
foreign contract
Add: Loss due to 50
earthquake
Less: Income from non-
trading investments (54) (54)
3,090 2,550 3,054 2,846

As there is no trend, simple average profits will be considered for calculation

of goodwill.
Total adjusted trading profits for the last four years = ` (3,090 + 2,550 +
3,054 + 2,846)
= ` 11,540 lakhs
 ` 11,540 lakhs 
Average trading profit before tax =   = ` 2,885 lakhs
 4 
Less: Additional remuneration to directors (50) Lakh
2,835 Lakh
Less: Income tax @ 35%(approx.) (992) (Approx.)
1,843 Lakh

(3) Valuation of Goodwill on Super Profits Basis

` in lakh
Future maintainable profits 1,843
Less: Normal profits (20% of ` 8,100 lakhs) (1,620)
Super profits 223
Goodwill at 3 years’ purchase of super profits = 3 x ` 223 lakhs = ` 669 lakhs
Note: In the above solution, goodwill has been calculated on the basis of closing
capital employed (i.e. on 31 st March, 2015). Goodwill should be calculated on the

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 VALUATION OF GOODWILL 13.27

basis of ‘average capital employed’ and not ‘actual capital employed’ as no trend
is being observed in the previous years’ profits. The average capital employed
cannot be calculated in the absence of details about profits for the year ended
31st March, 2015. Since the current year’s profit has not been given in the
question, goodwill has been calculated on the basis of capital employed as on
31st March, 2015.
Illustration 5
Find out Leverage effect on Goodwill in the following case:

(i) Current cost of capital employed ` 10,40,000

(ii) Profit earned after current cost adjustments ` 1,72,000
(iii) 10% long term loan ` 4,50,000
(iv) Normal rate of return:
On equity capital employed 15.6%
On long-term capital employed 13.5%

Solution

`
a Profit for equity fund after current cost adjustment 1,72,000
b Profit (as per Long-term fund approach)
Profit for equity fund 1,72,000
Add: Interest on Long-term loan 45,000 2,17,000
(4,50,000 x 10%)
c Current cost of capital employed (by Equity 10,40,000
approach)
d Capital employed as per Long-term fund approach
Current cost of capital employed (by Equity 10,40,000
approach)
Add: 10% Long term loan 4,50,000 14,90,000
e Value of Goodwill
(A) By Equity Approach
Capitalised value of Profit as per equity 11,02,564

© The Institute of Chartered Accountants of India

 13.28 ADVANCED ACCOUNTING

1,72,000
approach = ×100
15.60
Less: Capital employed as per equity approach (10,40,000)
Value of Goodwill 62,564
(B) By Long-Term Fund Approach
Capitalized value of Profit as per Long-term
2,17,000 16,07,407
fund approach = ×100
13.5
Less: Capital employed as per Long-term fund
approach (14,90,000)
Value of Goodwill 1,17,407

Leverage effect on Goodwill:

Adverse Leverage effect on goodwill is ` 54,843 (i.e. ` 1,17,407 – ` 62,564).

SUMMARY
Goodwill is a thing which is not so easy to describe but in general words
good-name, reputation and wide business connection which helps the
business to earn more profits than the profit could be earned by a newly
started business. The monetary value of the advantage of earning more
profits is known as goodwill. Goodwill is an attractive force, which brings in
customers to old place of business. Goodwill is an intangible but valuable
asset.
Future maintainable profit is ascertained taking either simple or weighted average
of the past profits or by fitting trend line. If the past profits do not have any
definite trend, average is taken to arrive at the future maintainable profit. If the
past profits show increasing or decreasing trend, linear trend equation gives
better estimation of the future maintainable profit. If the past profits show
increasing or decreasing trend, then more weights are given to the profit figures
of the immediate past years and less weight to the profit figures of the furthest
past.
The following adjustments from past profits are generally made:
(i) Elimination of abnormal loss arising out of strikes, lock-out, fire, etc.
Profit/loss figures which contain abnormal loss should either be ignored or

© The Institute of Chartered Accountants of India

 VALUATION OF GOODWILL 13.29

eliminated. Similarly, if there is any abnormal gain included in past profits

that needs elimination.
(ii) Interest/dividend or any other income from non-trading assets needs
elimination because ‘capital employed’ used for valuation of goodwill
comprises only of trading assets.
(iii) If there is a change in rate of tax, tax charged at the old rate should be added
back and tax should be charged at the new rate.
(iv) Effect of change in accounting policies should be neutralised to have profit
figures which are arrived at on the basis of uniform policies.

TEST YOUR KNOWLEDGE

MCQs

1. Liquidation value is also called

(a) NRV
(b) Breakup value.
(c) Exit value.
(d) Replacement value.
2. Replacement value is also known as
(a) Current cost.
(b) Breakup value.
(c) Exit value.
(d) Recoverable value.
3. Recoverable (amount) value is
(a) same as Current cost.
(b) Value in use.
(c) Higher of the net selling price and value in use.
(d) Lower of the net selling price and value in use.
4. Capital employed by X Ltd. ` 17,00,000, Future maintainable profit ` 3,50,000,
Normal rate of return 15%, Super profit can be maintained for 5 years.
Goodwill is
(a) 4,75,000.

© The Institute of Chartered Accountants of India

 13.30 ADVANCED ACCOUNTING

(b) 4,50,000.
(c) 5,00,000.
(d) 2,50,000.
5. Non-trading assets are ignored while computing capital employed because
(a) Surplus fund invested outside the business does not influence the future
maintainable profit.
(b) They are not the part of the business assets.
(c) It is difficult to estimate its realizable value.
(d) There is no generation of revenue from it.
Theoretical Questions
Question 1
Explain significant measurement bases in brief.
Question 2
What is meant by Capital Employed?
Practical Problems
Question 1
Find out the average capital employed of ND Ltd. from its summarized Balance
Sheet as at 31 st March, 2017:

Liabilities (` in lakhs) Assets (` in lakhs)

Share Capital: Fixed Assets:
Equity shares of ` 10 each 50.00 Land and buildings 25.00
9% Preference shares fully 10.00 Plant and machinery 80.25
paid up
Reserve and Surplus: Furniture and fixture 5.50
General reserve 12.00 Vehicles 5.00
Profit and Loss 30.40 Investments 10.00
Secured loans: Inventory 6.75
16% Debentures 5.00 Trade Receivables 4.90
16% Term loan 18.00 Cash and bank 10.40
Cash credit 13.30

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 VALUATION OF GOODWILL 13.31

Trade Payables 2.70

Provision for taxation 6.40
147.80 147.80

Non-trade investments were 20% of the total investments.

Balances as on 1.4.2016 to the following accounts were:
Profit and Loss account ` 8.20 lakhs, General reserve ` 6.50 lakhs.
Question 2
The summarized Balance Sheet of R Ltd. for the year ended on 31 st March, 2013,
2014 and 2015 are as follows:

(` in thousands)
Liabilities 31.3.2013 31.3.2014 31.3.2015
3,20,000 equity shares of ` 10 each, fully 3,200 3,200 3,200
paid
General reserve 2,400 2,800 3,200
Profit and Loss account 280 320 480
Trade Payables 1,200 1,600 2,000
7,080 7,920 8,880
Assets
Goodwill 2,000 1,600 1,200
Building and Machinery less, depreciation 2,800 3,200 3,200
Inventory 2,000 2,400 2,800
Trade Receivables 40 320 880
Bank balance 240 400 800
7,080 7,920 8,880

Additional information:
(a) Actual valuations were as under:
Building and machinery less, 3,600 4,000 4,400
depreciation
Inventory 2,400 2,800 3,200
Net profit (including opening balance

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 13.32 ADVANCED ACCOUNTING

after writing off depreciation, goodwill,

tax provision and transferred to 840 1,240 1,640
general reserve)

(b) Capital employed in the business at market value at the beginning of 2012-13
was ` 73,20,000 which included the cost of goodwill. The normal annual
return on average capital employed in the line of business engaged by R Ltd.
is 12½%.
(c) The balance in the general reserve on 1 st April, 2012 was ` 20 lakhs.
(d) The goodwill shown on 31.3.2013 was purchased on 1.4.2012 for ` 20 lakhs
on which date the balance in the Profit and Loss account was ` 2,40,000.
(e) Find out the average capital employed in each year. Also compute Goodwill,
to be valued at 5 year’s purchase of Super profit (Simple average method).

ANSWERS/ HINTS
MCQs

[1. (b), 2. (a), 3. (c); 4. (a); 5. (a)]

Theoretical Questions
Answer 1
Main Measurement bases are: Historical cost.; Current cost; Realizable (settlement)
value; Present value.
Answer 2
Capital employed means Total Assets Minus non-trading assets i.e. assets not
used in the business Minus miscellaneous expenditure and losses Minus all
outside liabilities.
Practical Problems
Answer 1
Computation of Average Capital employed
(` in lakhs)
Total Assets as per Balance Sheet 147.8
Less: Non-trade investments (20% of ` 10 lakhs) (2.00)
145.80

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 VALUATION OF GOODWILL 13.33

Less: Outside Liabilities:

16% Debentures 5.00
16% Term Loan 18.00
Cash Credit 13.30
Trade Payables 2.70
Provision for Taxation 6.40 (45.40)
Capital Employed as on 31.03.2017 100.40
Less: ½ of profit earned:
Increase in Reserve balance 5.50
Increase in Profit & Loss A/c 22.20
27.70
50% of Total 13.85
Average capital employed 86.55

Answer 2
Capital Employed at the end of each year

31.3.2013 31.3.2014 31.3.2015

` ` `
Goodwill 20,00,000 16,00,000 12,00,000
Building and Machinery (Revaluation) 36,00,000 40,00,000 44,00,000
Inventory (Revalued) 24,00,000 28,00,000 32,00,000
Trade Receivables 40,000 3,20,000 8,80,000
Bank Balance 2,40,000 4,00,000 8,00,000
Total Assets 82,80,000 91,20,000 104,80,000
Less: Trade Payables (12,00,000) (16,00,000) (20,00,000)
Closing Capital 70,80,000 75,20,000 84,80,000
Add: Opening Capital 73,20,000 70,80,000 75,20,000
Total 1,44,00,000 1,46,00,000 1,60,00,000
Average Capital 72,00,000 73,00,000 80,00,000

Since the goodwill has been purchased, it is taken as a part of Capital

employed.

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 13.34 ADVANCED ACCOUNTING

Valuation of Goodwill

(i) Future Maintainable Profit 31.3.2013 31.3.2014 31.3.2015

Net Profit as given 8,40,000 12,40,000 16,40,000
Less: Opening Balance (2,40,000) (2,80,000) (3,20,000)
Adjustment for Valuation of Opening - (4,00,000) (4,00,000)
Inventory
Add: Adjustment for Valuation of 4,00,000 4,00,000 4,00,000
closing inventory
Goodwill written off - 4,00,000 4,00,000
Transferred to General Reserve 4,00,000 4,00,000 4,00,000
Future Maintainable Profit 14,00,000 17,60,000 21,20,000
Less: 12.50% Normal Return (9,00,000) (9,12,500) (10,00,000)
(ii) Super Profit 5,00,000 8,47,500 11,20,000

(iii) Average Super Profit = ` (5,00,000+8,47,500+11,20,000)÷3 = ` 8,22,500

(iv) Value of Goodwill at five years’ purchase= ` 8,22,500 × 5 = ` 41,12,500.

© The Institute of Chartered Accountants of India