Valuation of Goodwill, Valuation of Shares, Cash Flow Statement, Dibrugarh University, Corporate Accounting, B.Com 2nd Semester (CBCS) B.Com 1st Year Notes, Unit 3- Myedu365


Unit 3


Part A

Valuation of Goodwill


1.What is Goodwill?

Ans.  Goodwill is an intangible asset of the business, cannot be seen or touched. Goodwill is the reputation of the business. It is created through various activities such as quality products at reasonable price, good relations with customer, quality service provided etc. Goodwill is the extra earning capacity of the business.

According to Eric L. Kohler,” Goodwill is the present value of expected future income in excess of a normal return on the investment in tangible assets.”  

2. What are the features of goodwill? 

Ans. Following are the features of goodwill:

1. Goodwill can be sold only with the entire business or it cannot be sold in part or in isolation except on admission or retirement of a partner when new partner compensate the old partners or the retiring partner gives up his rights in favour of remaining partners.

2. Goodwill is valuable only if it is capable of being transferred from one person to another. If it cannot be transferred then there will be no value of goodwill.

3. Goodwill represents a non-physical value over and above the physical assets.

4. 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.

5. The value of goodwill is based on subjective judgement of the valuer.

3. What are the types of Goodwill?

Ans: The goodwill is generally of two types i.e. purchased goodwill or non-purchased goodwill.

Purchased goodwill arises only when a business enterprise is acquired by another business enterprise and the price paid is more than the net assets acquired. Such goodwill is recognized by the accounting profession and is also shown in the balance sheet.

The main features of such goodwill are –

1. It arises only on purchase of business.

2. It is reflected by a purchase transaction.

3. Its cost could depend upon the future maintainable profits.

4. It can be shown on the balance sheet.

Non-purchased goodwill arises only when a business generates its own goodwill over a period of time due to various factors such as location, good management, good quality products, sales policies, good public image etc.

The main features of such goodwill are:

1. It is internally generated.

2. No cost can be placed on it.

3. Value of goodwill is based on the subjective judgement of the valuer.

4. It is not reflected by a purchase consideration.

5. It is not shown in the balance sheet.

4. What are the factors effecting the value of goodwill?

Ans. Following the factors affecting the value of goodwill:

(i) Location of business: - If the business is situated at a centrally located convenient place , it can attract more customers and hence its goodwill will be more .

(ii) Quality of the product: - In case the firm produces or deals in products of better quality it will have more goodwill.

(iii) Risk involved: - When the risk is less in the business it creates more goodwill but if the risk is more, it creates less goodwill.

(iv) Efficiency of management:- If the firm is managed and controlled by the experienced and efficient people, there will be economics in production , higher demand for goods as a result its profit will go on increasing consequently the value of goodwill will also increase .

(v) Reputation of the owner:- If the owners of the firm are known for their financial soundness, honesty, sincerity , customer friendliness and are socially conscious the business will earn super profit due to its popularity which will add to the value of goodwill.

5. What are the methods for valuation of goodwill?

Ans. Following are the methods for valuation of goodwill:

(i) Average profit method:-

    (a) Simple average profit method.

    (b) Weighted average profit method.

(ii) Super profit method.

(iii) Capitalization method:-

      (a). Capitalization of average profit.

      (b). Capitalization of super profit.

6. How would you calculate goodwill under average profit method?

Ans. The average profit of given number of past years multiplied by an agreed number is considered to be the value of goodwill.

Steps for calculating the value of goodwill under average profit method:

(i) Calculate the total profits of the agreed number of years.

(ii) Calculate the average total profit divided by number of years.

(iii) Calculate the value of goodwill = average profit x number of years purchase.

7.  How would you calculate goodwill under weighted average profit method?

Ans. Under this method, each year’s profit is multiplied by the respective number of weights e.g. 1, 2,3,4,5 etc. in order to find out value of product. The sum of the product is then divided by the total weights to get weighted average profits; the weighted average profit is then multiplied by number of year’s purchase.

8. How would you calculate goodwill under super profit method?

Ans. This method is based on the super profit earned by a firm. Super profit is the excess of actual profit over the normal profit of a firm. Under this method, the value of goodwill = super profit x number of year’s purchase or number of years the super profit is expected.

Following steps are involved in the valuation of goodwill under super profit method:

(i) Calculation of average profit.

(ii) Calculation of normal profit on capital employed on the basis of normal rate of return.

(iii). Calculation of super profit deducting the normal profit from average profit.

(iv) Calculation of goodwill by multiplying the super profits by the given number of year’s purchase.

9. How would you calculate goodwill under capitalization of super profit method?

Ans.  Under this method, the capitalized value of super profit is taken as the value of goodwill. Capitalised value is calculated by taking into account the normal rate of return.

Capitalised value of super profit = super profit X 100/normal rate of return

Value of goodwill = Capitalised value of super profit

10.  How would you calculate goodwill under capitalization of average profit method?

Ans: - Under this method, the average profits are capitalized on the basis of normal rate of return. The figure ascertained is known as value of business. From this the net assets of business is deducted, the balance left is called goodwill.

Capitalised value of Business = Average profit x 100/Normal rate

Capital Employed = Total assets – outside liabilities.

Goodwill = Capitalized value of business – Net assets or capital employed.

 

Part B

Valuation of Shares


1. What are the needs for valuation of shares?

Ans: Following are the circumstances where need for valuation of shares arises:

1. Where companies amalgamate or are similarly reconstructed, it may be necessary to arrive at the value of the shares held by the members of the company being absorbed or taken over. This may also be necessary to protect the rights of dissenting shareholders under the provisions of the companies Act, 2013.

2. Where shares are held by the partners jointly in a company and dissolution of the firm takes place, it becomes necessary to value the shares for proper distribution of the partnership properly among the partners.

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 or accountant.

4. When a loan is 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 preference shares or debentures are converted into equity shares, 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.

6. When equity shareholders are to be compensated on the acquisition of their shares by the government under a scheme of nationalization, then it becomes necessary to value the equity shares for reasonable compensation to be given to their holders.

2. What are the different methods for valuation of shares?

Ans: Following are the different methods of valuation shares:

1. Net assets basis (or Intrinsic value or Breakup value) method.

2. Earning capacity (or Yield basis or market value) method.

3. Dual (or Fair value) method.

4. Exchange rate method.

Factors affecting the valuation of shares:

1. The nature of the business.

2. The income yielding capacity of the company.

3. The demand and supply of the shares.

4. The percentage of dividend declared on shares.

5. The availability of sufficient assets over liabilities.

6. General economic condition e.g. availability of raw materials, possibility of new competitions.


Part C

Cash Flow Statement


1. What is Cash Flow Statement? What are its objectives?

Ans: Cash flow statement is a statement which describes the inflows and outflows of cash and cash equivalents in an enterprise during a specified period of time. A cash flow statement summarises the causes of changes in cash position of a business enterprise between dates of two balance sheets. According to AS-3 (Revised), an enterprise should prepare a cash flow statement and should present it for each period for which financial statements are prepared.

Following are the objectives of Cash Flow Statements:

a. To recognise the sources from operation, investing and financing activities from where cash and cash equivalent are generated.

b.To recognises the uses by operating, investing and financing activities for which cash and cash equivalents were used by the enterprise.

c. To compute the net changes in cash and cash equivalents indicating the difference between sources and uses from operating, investing and financing activities between the dates of two balance sheets.

2. What are the uses and significance of cash flow statement?

Ans:- Following are the uses and significance of cash flow statement:

1. Cash flow statement is based on the cash basis of accounting; it is very useful in the evaluation of cash position of a firm.

2. Cash flow statement is prepared in order to know the future cash position of a concern so as to enable a firm to plan and coordinate its financial operations properly.

3. Cash flow statement helps in planning the repayment of loans, replacement of fixed assets and other similar long term planning of cash.

4. Cash flow statement provides information of all activities classified under operating, investing and financing activities.

5. Cash flow statement is prepared according to AS-3 (Revised) is more suitable for making comparisons than the funds flow statement as there is no standard format used for the same.

6. A series of intra-firm and inter-firm cash flow statements reveals whether the firm’s liquidity is improving or deteriorating over a period of time and in comparison to other firms over a period of time.

7. Cash flow statements provide information of all activities classified under operating, investing and financing activities. The fund flow statement even when prepared on cash basis, did not disclose cash flows from such activities separately, thus, cash flow statement is more useful than the funds flow statements.

3. What are the limitations of Cash flow statement?

Ans: - Following are the limitations of Cash flow statement:

1. Cash flow statement is based on cash basis of accounting; it ignores the basic accounting concept of accrual basis.

2. Cash flow statement is not suitable for judging the profitability of a firm as non-cash charges are ignored while calculating cash flows from operating activities.

3. Cash flow statement is not a substitute of an income statement; it is complementary to an income statement. Net cash flow does not mean the net income of a firm.

4. Cash flow statement is also not a substitute of funds flow statement which provides information relating to the causes that lead to increase or decrease in working capital.

5. A comparative study of cash flow statements may give misleading results.

6. Some people feel that as working capital is a wider concept of funds, a funds flow statement provides a more complete picture than cash flow statement.

4. State the procedure for preparing a cash flow statement. Or how cash flow statement is prepared?

Ans: Cash flow statement is not a substitute of income statement, i.e., a profit and loss account, and a balance sheet. It provides additional information and explains the reasons for changes in cash and cash equivalents, derived from financial statements at two points of time. The procedure for preparing a cash flow statement is different from the procedure followed in respect of profit and loss account and balance sheet. It is prepared with the help of financial statements. The basic information required for the preparation of a cash flow statement is obtained from the following three sources:

(i) Comparative balance sheets at two points of time, i.e. in the beginning and at the end of the accounting period.

(ii) Income statement of the current accounting period or the profit and loss account.

(iii) Some selected additional data to extract the hidden transactions.

The preparation of a cash flow statement involves the following steps:

1. Compute the net increase or decrease in cash and cash equivalents, by making a comparison of these accounts given in the comparative balance sheets.

2. Calculate the net cash flow provided (used in) operating activities: Operating activities are the principal revenue producing activities of the enterprise. The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise pay dividends, repay loans, and make new investments without recourse to external sources of financing. There are two methods of reporting cash flows from operating activities: the direct method and the indirect method.

3. Calculate the net cash flow from (used in) investing activities: Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. The separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

4. Calculate the net cash flow from (used in) financing activities: Financing activities are activities that result in changes in the size and composition of the owner’s capital and borrowings of the enterprise. Cash flows arising from financing activities are important because it is useful in predicting claims on future cash flows by providers of funds to the enterprise.

5. Prepare a formal cash flow statement highlighting the net cash flow from (used in) operating, investing and financing activities separately.

6. Make an aggregate of net cash flows from the three activities and ensure that the total net cash flow is equal to the net increase or decrease in cash and cash equivalents as calculated in step one.

5. What are the differences between Fund Flow Statement and Cash Flow Statement?

Ans: Following are the differences between Fund Flow Statement and Cash Flow Statement:

Basis of difference

Fund Flow Statement

Cash Flow Statement

1. Basis of concept

It is based on a wider concept of funds, i. e., working capital.

It is based on a narrower concept of funds , i.e., cash.

2. Basis of accounting

It is based on accrual basis of accounting.

It is based on cash basis of accounting.

3. Schedule of changes in working capital

Schedule of changes in working capital is prepared to show the changes in current assets and current liabilities.

No such schedule of changes in working capital is prepared.

4. Method of preparing

Fund Flow Statement reveals the sources and application of funds. The net difference between sources and applications of funds represents net increase or decrease in working capital.

It is prepared by classifying all cash inflows and outflows in terms of operating, investing and financing activities. The net difference represents the net increase or decrease in cash and cash equivalents.

5. Basis of usefulness

It is useful in planning intermediate and long term financing.

It is more useful for short-term analysis and cash planning of the business.

6. Basis of Improvement

Improvement in funds position of a firm does not necessarily lead to improvement in cash position.

Improvement in cash position results in improvement of funds position of the firm.

7. Cash and cash equivalent

The opening and closing balances of cash are included in the schedule of changes in working capital.

The balances of cash and cash equivalents at the beginning and at the end of the period are shown in the cash flow statement.

6. Write short notes on:

1. Funds from operation: Trading profits or the profits from operations of the business are the most important and major source of funds. Sales are the main source of inflow of funds into the business as they increase current assets but at the same time funds flow out of business for expenses and cost of goods sold. Thus, the net effect of operations will be a source of funds if inflow from sales exceeds the outflow for expenses and cost of goods sold and vice-versa.

2. Cash flows from operating activities: Operating activities are the principal revenue producing activities of the enterprise. The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise pay dividends, repay loans, and make new investments without recourse to external sources of financing. There are two methods of reporting cash flows from operating activities: the direct method and the indirect method.

3. Cash flows from investing activities: Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. The separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

4. Cash flows from financing activities: Financing activities are activities that result in changes in the size and composition of the owner’s capital and borrowings of the enterprise. Cash flows arising from financing activities are important because it is useful in predicting claims on future cash flows by providers of funds to the enterprise.

7. What are the distinction between Cash Flow Statement and Cash Budget?

Ans: Following  are the distinction between Cash Flow Statement and Cash Budget:

Basis of Distinction

Cash Flow Statement

Cash Budget

1. Meaning

It means inflows and outflows of cash and cash equivalents. However, this statement excludes movements between items that constitute cash and cash equivalents.

It is estimated receipts and payments of cash over a period of time.

2. Preparation

It is prepared from Balance Sheet and Income Statement from the logical data.

It is prepared on estimated data on the basis of forecasts.

3. Objectives

It is prepared to explain to management the sources of cash and its uses during a particular period of time. It provides information that compliments profit and loss account or statement of profit or loss and balance sheet.

The objective of preparing this budget is to show the probable cash position as a planned operation. This helps in arranging short-term borrowings in advance to meet the shortage of cash.

4. Use

It is a useful technique of past analysis.

It is an indispensable technique of future financial forecasting.

5. Period

It covers a particular period of one year or one month.

It is broken into monthly, weekly segments.

6. Emphasis on source

It does not emphasis on a particular source and use.

Its emphasis is on the financial pattern to meet seasonal or temporary cash needs.

7. Form

It is generally prepared in statement form.

The form of cash budget contains several column depending upon months for which the budget is prepared.

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