1. TENTH CANADIAN EDITION Kieso Weygandt Warfield Young Wiecek McConomy INTERMEDIATE ACCOUNTING PREPARED BY: Dragan Stojanovic, CA Rotman School of Management, University of Toronto 1 CHAPTER 12 Appendix 12A Valuing Goodwill

2. 2 Copyright © John Wiley & Sons Canada, Ltd. The Excess Earnings Approach A widely used method to estimate goodwill in a business is the excess-earnings approach Steps: 1. Calculate company’s expected annual average “normalized” earnings 2. Calculate annual average earnings if company earned same return as the industry average 3. Calculate company’s excess earnings 4. Estimate the value of goodwill based on excess earnings

3. 3 Copyright © John Wiley & Sons Canada, Ltd. Company’s Average “Normalized” Earnings Given the following for Tractorling Corp.: Identifiable net assets (FV): $ 350,000 Earnings history (2009–2013): 2009: $ 60,000 2010: $ 55,000 2011: $110,000 2012: $ 70,000 20013: $ 80,000 Total earnings for the five years = $375,000

4. 4 Copyright © John Wiley & Sons Canada, Ltd. Company’s Average “Normalized” Earnings Average earnings:$375,000 = $75,000 5 years We now need to normalize the earnings for Tractorling Corp.

5. 5 Copyright © John Wiley & Sons Canada, Ltd. Company’s Average “Normalized” Earnings Normalized earnings is representative of future earnings Accounting policies applied should be consistent with that of the purchaser Future earnings should be based on fair value of the net assets rather than the carrying amount of the net assets Non-recurring amounts are adjusted out (e.g., extraordinary gains/losses, unusual items)

6. 6 Copyright © John Wiley & Sons Canada, Ltd. Company’s Average “Normalized” Earnings Average previous earnings$75,000 Add: Adjust for Inventory$2,000 Adjust for Amortization 3,000 5,000 80,000 Less: Gain on Discontinued Operations (average) 5,000 Patent amortization 1,000 6,000 Expected Future Earnings$74,000

7. 7 Copyright © John Wiley & Sons Canada, Ltd. Average Earnings Using Industry Average Expected earnings without goodwill Industry average rate of return: 15% Fair value of net identifiable assets$350,000 Industry average rate of return 15% Normal earnings (if no goodwill)$ 52,500

8. 8 Copyright © John Wiley & Sons Canada, Ltd. Excess Earnings Expected future earnings$74,000 Normal earnings 52,500 Excess earnings$21,500 Excess earnings must now be discounted to their present value

9. 9 Copyright © John Wiley & Sons Canada, Ltd. Discount Rate Higher discount rate normally used: –discounting future cash inflows that may be riskier –higher discount rate will lower goodwill Factors to consider when determining discount rate: –Stability of past earnings –Speculative nature of business –General economic conditions

10. 10 Copyright © John Wiley & Sons Canada, Ltd. Discount Period Discount period based on: –Professional judgement –Estimation of how long the excess earnings are expected to last

11. 11 Copyright © John Wiley & Sons Canada, Ltd. Value of Goodwill- Excess-Earnings Approach Rate of return required by purchaser = 15% Discount period = perpetuity Expected earnings= $74,000 Normal return = $52,500 Excess earnings= $21,500 Goodwill = $ 21,500 ÷ 0.15 = $143,333

12. 12 Copyright © John Wiley & Sons Canada, Ltd. Total-Earnings Approach Total-earnings approach is an alternative approach to estimating goodwill The value of the company as a whole is determined based on total expected earnings Fair value of identifiable net assets deducted from the value of the company Difference is goodwill

13. 13 Copyright © John Wiley & Sons Canada, Ltd. Total-Earnings Approach Goodwill = Fair value of Company – Fair value of identifiable net assets FV of Co. = $74,000 ÷ 0.15 = $ 493,333 FV of identifiable net assets 350,000 Goodwill $ 143,333

14. 14 Copyright © John Wiley & Sons Canada, Ltd. Other Valuation Methods 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

15. 15 Copyright © John Wiley & Sons Canada, Ltd. Other Valuation Methods Discounted Free Cash Flow Method –Project the free cash flow over a 10–20 year period –Free cash flow: that amount of cash from operations in excess of what is needed to maintain existing capacity –Discount this amount –Result is the value of the business

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