12 C h a p t e r Valuation of Goodwill & Shares June 2010 [2(a)] Write a short note on: Phases of generation of intangible assets Short Notes To assess whether an internally generated intangible asset meets the criteria for recognition, an enterprise classifies the generation of the asset into: (a) Research phase and (b) Development phase If an enterprise cannot distinguish the research phase from the development phase of an internal project to create an intangible asset, the enterprise treats the expenditure on that project as if it were incurred in the research phase only. 1. Research Phase No intangible asset arising from research (or from the research phase of an internal project) should be recognized. Expenditure on research (or on the research phase of an internal project) should be recognized as an expense when it is incurred. 2. Development Phase An intangible asset arising from development (or from the development phase of an internal project) should be recognized if, and only if, an enterprise can demonstrate all of the following: (a) The technical feasibility of completing the intangible asset so that it will be available for use or sale. (b) Its intention to complete the intangible asset and use or sell it. (c) Its ability to use or sell the intangible asset. (d) How the intangible asset will generate probable future economic benefits. Among other things, the enterprise should demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset. 150
Valuation of Goodwill & Shares 151 (e) The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset. (f) Its ability to measure the expenditure attributable to the intangible asset during its development reliably. Dec 2011 [4(b)] Write a short note on: Purposes Valuation of shares The valuation of the shares of a company involves use of judgment, experience and knowledge. The accountant undertaking this work should possess knowledge of the analysis and interpretation of financial statements backed by a practical appreciation of business affairs and investments. A valuation based on quantitative information alone will not be adequate for a real valuation. It should also be recognized that the method of valuation of shares would vary, depending on the purpose for which it is to be used. The following is an illustrative list of the circumstances which call for a value to be placed upon shares in companies: Purposes of share valuation: (1) Assessments under the Wealth Tax Law. (2) Purchase of a block of shares for acquiring a controlling interest in the company. (3) Purchase of shares by employees of the company where the retention of such shares is limited to the period of their employment. (4) Formulation of schemes of amalgamation, absorption, etc. (5) Acquisition of interest of dissenting shareholders under a scheme of reconstruction. (6) Compensating shareholders, on the acquisition of their shares, by the Government under a scheme of nationalization. (7) Conversion of preference into equity shares. (8) Advancing a loan on the security of shares. Dec 2011 [4(b)] Write a short note on: Fair value of shares Fair value is the average of the intrinsic value and yield value. It is argued that average of book value and yield based value incorporates the advantages of both the methods. That is why such average is called the fair value of share. intrinsic value + Yield value Value per share = 2 Dec 2013 [2(a)(iii)] Write a note on super profit method of valuation of goodwill. The valuation of goodwill is often based on the customs of the trade and generally calculated as number of year s purchase of average profits or super-profits. Super-profit method: Super profit is the excess of actual profit over the normal profit. Under this method, super profits are taken as the basis for calculating goodwill in place of average profit. Goodwill is calculated as follows:
152 Valuation of Goodwill & Shares Step 1 Step 2 Step 3 Step 4 Step 5 Calculate capital employed Calculate normal return Normal Return = Capital employed Rate of normal return Calculate future maintainable profit Calculate super profit Future Maintainable Profit xxxx Less: Normal Return (xxx) Super Profit xxxx Goodwill = Super profit No. of years purchases Capitalization of super profits method: Under this method, goodwill is calculated by capitalizing super-profits at agreed rate. The goodwill is calculated directly by applying the following formula: Super Profit Goodwill = Capitalization rate 100 Descriptive Questions Dec 2009 [2(a)] What is amortization period of intangible assets? Can useful life of the intangible assets exceed the period of legal rights? (6 Marks) 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. Amortization should commence when the asset is available for use. As the future economic benefits embodied in an intangible asset are consumed over time, the carrying amount of the asset is reduced to reflect that consumption. This is achieved by systematic allocation of the cost of the asset, less any residual value, as an expense over the asset s useful life. Amortization is recognized whether or not there has been an increase in, for example, the asset s fair value or recoverable amount. Given the history of rapid changes in technology, computer software and many other intangible assets are susceptible to technological obsolescence. Therefore, it is likely that their useful life will be short. If control over the future economic benefits from an intangible asset is achieved through legal rights that have been granted for a finite period, the useful life of the intangible asset should not exceed the period of the legal rights unless: (a) The legal rights are renewable and (b) Renewal is virtually certain. The following factors, among others, indicate that renewal of a legal right is virtually certain: (a) The fair value of the intangible asset is not expected to reduce as the initial expiry date approaches, or is not expected to reduce by more than the cost of renewing the underlying right. (b) There is evidence (possibly based on past experience) that the legal rights will be renewed. (c) There is evidence that the conditions necessary to obtain the renewal of the legal right (if any) will be satisfied.
Valuation of Goodwill & Shares 153 June 2014 [1(c)] What are the different circumstances under which valuation of shares become necessary? Please refer to Answer of Dec 2011 [4(b)] in heading Short Notes. Dec 2014 [1(b)] How will you deal with internally generated intangible assets in the books of account? As per AS 26, to assess whether an internally generated intangible asset meets the criteria for recognition, an enterprise classifies the generation of the asset into: (a) Research Phase (b) Development Phase Research Phase: No intangible asset arising from research (or from the research phase of an internal project) should be recognized. Expenditure on research (or on the research phase of an internal project) should be recognized as an expense when it is incurred. Development Phase: An intangible asset arising from development (or from the development phase of an internal project) should be recognized if, and only if, an enterprise can demonstrate all of the following: (a) The technical feasibility of completing the intangible asset so that it will be available for use or sale (b) Its intention to complete the intangible asset and use or sell it; (c) Its ability to use or sell the intangible asset; (d) How the intangible asset will generate probable future economic benefits. Among other things, the enterprise should demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset; (e) The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and (f) Its ability to measure the expenditure attributable to the intangible asset during its development reliably. June 2015 [2(c)] Discuss the circumstances under which valuation of shares is necessary? Please refer to Answer of Dec 2011 [4(b)] in heading Short Notes. Dec 2015 [2(e)] Explain the method of valuation of equity shares based on price-earnings ratio. Valuation based on price earnings ratio: This method is suitable for ascertaining the market value of shares which are quoted on a recognized stock exchange. According to this method, the shares are valued on the basis of earning per share multiplied by price earnings ratio. Thus, Market value of share = P/E Ratio EPS Profit available for equity shareholders EPS = no. of shares
154 Valuation of Goodwill & Shares P/E Ratio = Market value per share eps Practical Questions June 2006 [3(b)] Following is the balance sheet of Danny Ltd. as on 31 st March, 2005: EQUITIES & LIABILITIES Shareholder s Funds: 3,000, 6% Preference shares of ` 100 each, fully paid-up 3,00,000 1,30,000 Equity shares of ` 10 each, fully paid-up 13,00,000 Profit & Loss Account 9,00,000 Current Liabilities: 8% Debentures 6,00,000 Sundry Creditors 4,78,500 35,78,500 ASSETS Non-Current Assets: Goodwill 1,00,000 Free-hold Property 7,50,000 Plant and machinery less depreciation 7,00,000 Current Assets: Stock 7,40,000 Debtors 7,98,500 Cash & Bank Balances 4,90,000 35,78,500 The following are additional information: (i) The profit after tax for the three financial years 2002-2003, 2003-2004 and 2004-2005, after charging debenture interest, were ` 4,41,000, ` 6,45,000 and ` 4,80,000 respectively. (ii) The normal rate of return is 10% on the net assets attributed. (iii) The value of freehold property is to be ascertained on the basis of 8% return. The current rental value is ` 1,00,800. (iv) The rate of tax applicable is 40%. (v) 10% of profits for the financial year 2003-2004 referred to above arose from a transaction of non-recurring nature. (vi) A provision of ` 31,500 on sundry debtors was made in the financial year 2004-2005 which is no longer required; profit for the year 2004-2005 is to be adjusted for this item. (vii) A claim of ` 16,500 against the company is to be provided and adjusted against profit for the financial year ended on 31 st March, 2005. (viii) Goodwill may be calculated at 3 times adjusted average profits of the 3 years. (ix) Capital employed may be taken as on 31 st March, 2005. You are required to ascertain the value of goodwill of the company. (10 Marks) `
Valuation of Goodwill & Shares 155 Step 1: Calculate capital employed: Particulars ` - Freehold Property (1,00,800/8) 100 12,60,000 - Plant & Machinery 7,00,000 - Stock 7,40,000 - Debtors (7,98,500 + 31,500) 8,30,000 - Cash & Bank Balances 4,90,000 Less: - 8% Debentures (6,00,000) - Sundry Creditors (4,78,500) - Outstanding Claim (16,500) Capital Employed (shareholders funds approach) 29,25,000 Step 2: Calculate normal return: Normal return = 29,25,000 10% = 2,92,500 Step 3: Calculate future maintainable profit: Particulars 2002-2003 2003-2004 2004-2005 Reported profits after tax 4,41,000 6,45,000 4,80,000 40 (+) Tax reported Profit 60 2,94,000 4,30,000 3,20,000 Profits before tax 7,35,000 10,75,000 8,00,000 Adjustments: - 10% profits of non-recurring nature - (1,07,500) - - A provision on debtors no longer required - - 31,500 - Omission of claim (now provided) - - (16,500) 7,35,000 9,67,500 8,15,000 (-) Tax @ 40% (2,94,000) (3,87,000) (3,26,000) Corrected profit after tax 4,41,000 5,80,500 4,89,000 4,41,000 + 5,80,500 + 4,89,000 Average profit = 3 = 5,03,500 Step 4: Calculate super profit: Future maintainable profit (Average profit) 5,03,500 (-) Normal return (2,92,500) Super profit 2,11,000 Step 5: Calculate goodwill Method 1: Goodwill = Super profit No. of years purchases = 2,11,000 3 = 6,33,000