1. 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

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

3. Learning Objectives
Explain various approaches to valuing goodwill.

4. 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

5. 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?

6. 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 % Normal Earnings $ 52,500

7. 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

8. 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

9. 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

10. 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: %
Earnings history ( ): : $ 100, : $ 130, : $ 120, : $ 140, : $ 150,000
Discount rate (proxies for risk): 15%

11. 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 / = $186,667

12. 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 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

13. COPYRIGHT
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