Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK Prepared by: Gabriela H. Schneider, CMA; Grant MacEwan College 2

C H A P T E R 13 Appendix 13A Valuing Goodwill

Learning Objectives Explain various approaches to valuing goodwill.

The Excess Earnings Approach Capitalizes excess earnings of seller Steps: Calculate Excess Earnings: Average Earnings less Industry Earnings Exclude all extraordinary gains and losses Capitalize Excess Earnings: [Excess Earnings / DISCOUNT FACTOR %] Method is based on the assumption of perpetuity

The Excess Earnings Approach To apply this method, the following questions need to be answered What is the normal rate of return? How are expected future earning determined? What discount rate should be applied? Over what period of time should excess earnings be discounted?

Rate of Return Percentage of income to net assets, or shareholders’ equity Industry comparison employed; use of an industry average For example, if an industry average is determined to be 15%: Fair value of assets $350,000 Normal rate of return 15% Normal Earnings $ 52,500

Future Earnings Previous three to six years of earnings used to predict future earnings Normalizing earnings: Adjustments for accounting policies not in line with those of purchaser Any differences between carrying value and fair value of assets Extraordinary items are removed

Discount Rate Higher discount rate normally used: discounting future cash inflows higher discount rate will lower goodwill (conservatism) Factors to consider when determining discount rate: Stability of past earnings Speculative nature of business General economic conditions

Discount Period Discount period is based on: professional judgement estimation of how long the excess earnings are expected to last Alternative approach to estimating goodwill Determine the value of the company as a whole Based on total expected earnings Fair value of identifiable assets deducted from the value of the company Difference is goodwill

The Excess Earnings Approach: Example Given the following information regarding Tractor corporation, determine goodwill, if any: Net Identifiable assets: $ 500,000 Normal rate of return: 20% Earnings history (1997 - 2001): 1997: $ 100,000 1998: $ 130,000 1999: $ 120,000 2000: $ 140,000 2001: $ 150,000 Discount rate (proxies for risk): 15%

The Excess Earnings Approach: Example Average earnings: $640,000 / 5 = $128,000 Normal return = $ 500,000 X 20% = $ 100,000 Excess earnings = $28,000 Goodwill = $ 28,000 / 0.15 = $186,667

Other Valuation Method Number of Years Method Excess earnings multiplied by the number of years excess earnings expected to last Advantage: simple Disadvantage: does not consider time value of money Discounted Free Cash Flow Method Project the free cash flow over a 10-20 year period Free cash flow: that amount of cash greater than what is needed to maintain existing capacity Discount this amount Result is the value of the business

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