Tag: Buyback of Shares

Goodwill is an intangible asset representing the value of a business’s reputation, brand image, customer loyalty, efficient management, favourable location, and other advantages that enable it to earn higher profits compared to other firms in the same industry.

Unlike tangible assets such as buildings, machinery, or stock, goodwill cannot be physically seen or touched, but it significantly contributes to the earning potential of the business. It reflects the premium value that an acquiring company is willing to pay over and above the fair market value of the net assets of the acquired business.

In accounting terms, goodwill is recognised when a business is purchased for a price higher than the value of its net assets. The difference between the purchase price and the net asset value is recorded as goodwill in the books of the buyer.

Example:

If the net assets of a business are worth ₹50,00,000 and it is purchased for ₹60,00,000, the excess ₹10,00,000 is goodwill.

Goodwill can be:

• Purchased Goodwill: Arises when paid for during the acquisition.

• Self-generated Goodwill: Arises due to the firm’s efforts over time but is usually not recorded in the books as per accounting standards.

Circumstances When Goodwill is Valued:

Valuation of goodwill becomes necessary under several business situations, particularly when ownership or profit-sharing arrangements change. The key circumstances are:

• Sale of Business

When a business is sold as a going concern, the purchase price often includes an amount for goodwill. The buyer is willing to pay for the benefits of an established reputation, customer base, and other advantages that will generate profits in the future. In such cases, goodwill is valued to determine the total consideration.

• Admission of a New Partner

When a new partner joins a partnership firm, they get the right to share in the future profits of the business. Since the existing partners have worked to build the firm’s reputation and profit potential, the incoming partner usually compensates them for their share of the goodwill. The valuation ensures fairness in determining the amount payable.

• Retirement or Death of a Partner

When a partner retires or dies, they are entitled to receive their share of the goodwill, as they helped build the business’s reputation. Valuation ensures the outgoing partner (or their legal heirs) is fairly compensated for their contribution.

• Amalgamation of Companies

When two companies merge, the valuation of goodwill helps in deciding the share exchange ratio or purchase consideration. This ensures both sets of shareholders are treated fairly based on the relative worth of their companies, including intangible assets like goodwill.

• Change in Profit-Sharing Ratio

If partners in a firm decide to change their existing profit-sharing arrangement, the partner gaining a higher share compensates the partner losing a share of profits. Goodwill valuation helps determine this compensation amount.

• Conversion of a Partnership into a Company

When a partnership is converted into a company, goodwill is valued to determine the consideration payable to the partners, especially when the business is transferred as a going concern.

• Court Cases or Tax Purposes

In legal disputes, divorce settlements, inheritance cases, or tax assessments, goodwill valuation may be required to determine the fair market value of a business.

• Liquidation

Even during liquidation, goodwill may have a residual value if the brand name, customer contracts, or other intangible advantages can be sold separately.

Factors Affecting the Valuation of Goodwill:

The value of goodwill is not fixed—it varies depending on several qualitative and quantitative factors. These include:

• Nature of Business

The type of business has a major influence on goodwill. A business with stable demand, essential products, and a long-term customer base (e.g., FMCG, healthcare) will generally have higher goodwill compared to one operating in a volatile or seasonal market.

• Location of Business

A business located in a prime area with high footfall (e.g., near markets, busy streets, or transportation hubs) can attract more customers without significant advertising. Such businesses have higher goodwill because their location provides a competitive advantage.

• Reputation of the Business

A well-established reputation for quality, service, and reliability increases customer trust and loyalty, resulting in repeat business and higher goodwill. Negative publicity or poor customer service can reduce goodwill.

• Efficiency of Management

A capable and experienced management team improves productivity, reduces costs, and maintains consistent quality—factors that enhance profitability and goodwill. Poor management decisions, on the other hand, can damage goodwill quickly.

• Quality of Products or Services

High-quality products and services ensure customer satisfaction and retention, leading to strong word-of-mouth promotion and higher goodwill. Businesses known for substandard products may have low or even negative goodwill.

• Market Conditions

Favourable industry trends, low competition, and economic stability enhance goodwill, while recession, intense competition, or market saturation can reduce it.

• Access to Resources

Easy access to skilled labour, raw materials, finance, and advanced technology can increase a firm’s efficiency and profitability, thereby boosting goodwill.

• Risk Involved

Businesses with lower business risk (e.g., stable cash flows, diversified products) command higher goodwill. High-risk ventures (e.g., speculative trading) have lower goodwill valuations.

• Long-Term Contracts and Relationships

Securing long-term contracts with key customers or suppliers provides revenue stability and increases goodwill.

• Brand Value and Intellectual Property

Well-known trademarks, patents, and copyrights add to goodwill because they provide a unique competitive advantage.

• Monopoly or Favourable Agreements

Legal monopolies or government concessions can significantly enhance goodwill since they reduce competition and guarantee revenue streams.

• Synergy Benefits in Mergers

In the case of amalgamation or acquisition, expected cost savings, market expansion, or combined operational efficiency can increase the goodwill valuation.

Importance of Valuation of Goodwill:

The process of valuing goodwill is essential for:

• Ensuring fairness in partner compensation.

• Determining the correct purchase consideration in mergers/acquisitions.

• Presenting an accurate financial position in legal cases.

• Facilitating negotiations during business sale.

• Ensuring compliance with accounting standards (AS 26 in India, IFRS 3 globally).

Methods of Valuation of Goodwill:

The value of goodwill can be determined using various methods, depending on the nature of the business, purpose of valuation, and availability of data. The main methods are:

1. Average Profit Method

Goodwill is valued by multiplying the average maintainable profits by a certain number of years’ purchase.

• Formula:

Goodwill = Average Profit × Number of Years’ Purchase

• Steps:

  1. Determine past profits.

  2. Adjust for abnormal items.

  3. Calculate average profit.

  4. Multiply by agreed years’ purchase (e.g., 3, 4, or 5 years).

• Types:

  • Simple Average Profit Method – Uses arithmetic average.

  • Weighted Average Profit Method – Gives higher weight to recent profits to reflect current earning capacity.

2. Super Profit Method

Goodwill is calculated based on the “super profits” — the excess of average profit over the normal profit (which is based on the normal rate of return).

• Formula:

Goodwill = Super Profit × Number of Years’ Purchase

Where:

Super Profit = Average Profit − Normal Profit

Normal Profit = Capital Employed × Normal Rate of Return (NRR)

• Features:

  • Highlights the business’s earning capacity above industry standards.

  • Suitable when profits are higher than normal industry returns.

3. Capitalization Method

This method converts maintainable profits into total capital value, then deducts the actual capital employed to get goodwill.

a) Capitalization of Average Profits

• Formula:

Goodwill = [Average Profit × 100 / NRR] − Capital Employed

• Indicates how much more the business is worth compared to its actual capital invested.

b) Capitalization of Super Profits

• Formula:

Goodwill = [Super Profit × 100] / NRR​

• Focuses purely on capitalizing the extra profit above the normal level.

4. Annuity Method

Super profits are treated as an annuity receivable for a certain period, and goodwill is calculated as the present value of that annuity.

• Formula:

Goodwill = Super Profit × Present Value of ₹1 for n years at i%

• Use: Reflects the time value of money, making it suitable when super profits are expected only for a limited period.

5. Market Value Method

Used for companies whose shares are actively traded in the stock market. Goodwill is indirectly reflected in the market value of shares above their book value.

• Formula:

Goodwill = (Market Value per Share − Net Asset Value per Share) × Number of Shares

• Use: Common for valuing goodwill in publicly listed companies.

6. Purchase Consideration Method (Residual Method)

Goodwill is the difference between the purchase consideration paid for acquiring a business and the net assets acquired.

• Formula:

Goodwill = Purchase Consideration − Net Assets Acquired

• Use: Applicable in mergers, acquisitions, and business takeovers.

7. Rule of Thumb Method

Goodwill is valued as a fixed proportion (e.g., 1 year’s purchase) of turnover, gross profit, or some other financial measure.

• Use: Quick, but not precise; often used in small business sales (e.g., retail shops).

Holding Company is an entity that has control over one or more companies, known as subsidiaries. Control is typically exercised by owning more than 50% of the subsidiary’s equity share capital or by having the power to appoint or remove a majority of its directors. The holding–subsidiary structure allows the parent entity to influence strategic decisions, manage resources, and oversee operations without being directly involved in day-to-day activities.

Under the Companies Act, 2013, the definition is provided in Section 2(46). A holding company may be incorporated in India or abroad. It must comply with specific legal provisions relating to subsidiary relationships, financial reporting, corporate governance, and restrictions on layers of subsidiaries. This structure is often used for group companies, diversification, risk management, and regulatory benefits, while enabling centralized control over multiple business entities.

Types of Holding Companies

1. Pure

A holding company is described as pure if it was formed for the sole purpose of owning stock in other companies. Essentially, the company does not participate in any other business other than controlling one or more firms.

2. Mixed

A mixed holding company not only controls another firm but also engages in its own operations. It’s also known as a holding-operating company.

Holding companies that take part in completely unrelated lines of business from their subsidiaries are referred to as conglomerates.

3. Immediate

An immediate holding company is one that retains voting stock or control of another company, in spite of the fact that the company itself is already controlled by another entity. Put simply, it’s a type of holding company that is already a subsidiary of another.

4. Intermediate

An intermediate holding is a firm that is both a holding company of another entity and a subsidiary of a larger corporation. An intermediate holding firm might be exempted from publishing financial records as a holding company of the smaller group.

Benefits of a Holding Company

1. Greater control for a smaller investment

It gives the holding company owner a controlling interest in another without having to invest much. When the parent company purchases 51% or more of the subsidiary, it automatically gains control of the acquired firm. By not purchasing 100% of each subsidiary, a small business owner gains control of multiple entities using a very small investment.

2. Independent entities

If a holding company exercises control over several companies, each of the subsidiaries is considered an independent legal entity. It means that if one of the subsidiaries were to face a lawsuit, the plaintiffs have no right to claim the assets of the other subsidiaries. In fact, if the subsidiary being sued acted independently, then it’s highly unlikely that the parent company will be held liable.

3. Management continuity

Whenever a parent company acquires other subsidiaries, it almost always retains the management. It is an important factor for many owners of subsidiaries-to-be who are deciding whether to agree to the acquisition or not. The holding firm can choose not to be involved in the activities of the subsidiary except when it comes to strategic decisions and monitoring the subsidiary’s performance.

It means that the managers of the subsidiary firm retain their previous roles and continue conducting business as usual. On the other hand, the holding company owner benefits financially without necessarily adding to his management duties.

4. Tax effects

Holding companies that own 80% or more of every subsidiary can reap tax benefits by filing consolidated tax returns. A consolidated tax return is one that combines the financial records of all the acquired firms together with that of the parent company. In such a case, should one of subsidiary encounter losses, they will be offset by the profits of the other subsidiaries. In addition, the net effect of filing a consolidated return is a reduced tax liability.

Functions of a Holding Company

Successful entrepreneurs with multiple small businesses are typically concerned with limiting liability, streamlining management and retaining ownership control over each entity. Using a holding company can sometimes be the solution to all three concerns. The company works as an umbrella to give you centralized control over your endeavors while maintaining the liability firewall between each business.

1. Parent Company

A holding company is a corporation or limited liability company that holds a controlling ownership interest in other companies or the assets that those companies use. Typically, a holding company simply holds equity interests or assets, rather than actively engaging in business, such as selling goods or services. Another name for a holding company is a parent, and the companies under it are called operating companies or subsidiaries.

2. Centralized Control

Entrepreneurs who want to open multiple small businesses can use a holding company to centralize control. The entrepreneur can set up the holding company and designate himself as the sole owner. Each business can be set up separately with the holding company as the owner. In this way, the holding company is the central repository of the equity interests in those companies, and the entrepreneur can select executive management for each company while retaining the ability to direct each entity.

3. Limiting Investment

Using a holding company also enables you to raise money and create partnerships for each individual entity without losing overarching control of the business conglomerate. An equity investor can invest in one of the companies under the holding company without interfering with any of the others. If you had simply created a single company with multiple divisions or projects, an investor would take an interest in your whole business empire instead of just a single project that is set up as its own business.

4. Limiting Liability

One of the best uses of a holding company for small-business owners is to further limit liability. Creditors of a corporation or an LLC can go after anything that the entity owns. If you’re in a high-risk business, you can use a holding company to own all of the assets that your business needs to operate, such as real property, vehicles and equipment. The holding company leases those assets to the operating company, so if the operating company gets sued, it owns very little that can be used to satisfy a judgment. The operating company can easily be closed and declared bankrupt, and you can set up another business that leases the exact same assets from the holding company.

5. Considerations

Creating an interlocking ownership structure for multiple small businesses using a holding company is a sophisticated endeavor with significant tax consequences that are tied to your legal structure choices and tax elections. For example, special personal holding company tax rules apply to corporations but not necessarily LLCs that are used as holding companies. Consult with qualified legal and tax professionals before setting up your businesses.

Holding Companies Legal Requirements under Companies Act, 2013:

The Companies Act, 2013 lays down the following legal requirements:

1. Definition (Section 2(46)): A holding company includes any body corporate controlling a subsidiary.

2. Restriction on Layers (Section 2(87) & Rules): A holding company cannot have more than two layers of subsidiaries, except in certain cases (e.g., foreign subsidiaries).

3. Consolidated Financial Statements (Section 129): Must prepare and present consolidated accounts for itself and all subsidiaries.

4. Disclosure in Accounts: Details of subsidiaries’ performance must be disclosed in the Board’s Report.

5. Restriction on Loans & Investments (Section 186): Compliance required for inter-corporate loans, guarantees, and investments.

6. Related Party Transactions (Section 188): Deals with subsidiaries are treated as related party transactions, requiring approvals.

7. Annual Return (Section 92): Must include details of subsidiaries, associates, and joint ventures.

8. Audit Requirements: Subsidiaries’ accounts must be audited and considered in consolidated reports.

Subsidiary Company is an entity that is controlled by another company, known as the holding company. Control is generally established when the holding company owns more than 50% of the subsidiary’s equity share capital or has the power to appoint or remove a majority of its directors. This control can be direct or indirect, including through another subsidiary (step-down subsidiary). The relationship allows the holding company to influence key decisions and policies of the subsidiary without necessarily being involved in its daily operations.

Under the Companies Act, 2013 (Section 2(87)), subsidiaries are subject to specific legal requirements relating to structure, reporting, and compliance. A company cannot have more than two layers of subsidiaries, except in certain permitted cases, such as foreign subsidiaries with overseas holdings. Subsidiaries must prepare their own financial statements, which are then consolidated into the holding company’s accounts. This structure is widely used for business expansion, risk segregation, and managing diverse operations under a single corporate group.

Types of Subsidiary Company

1. Partly Owned

The parent company owns 50% or more but less than 100% shares in the holding company. Such a subsidiary is partly owned. Here parent company does not get full control over the subsidiary company.

2. Wholly Owned

The parent company holds 100% shares & controls in the subsidiary company. Though, A wholly-owned subsidiary company is not a merger.

A holding company can have more than one subsidiary company. But a subsidiary company can have one and only one holding company. However, a subsidiary can have a subsidiary or more of its own.

The parent company can be larger or smaller than the subsidiary. It need not be more powerful than the subsidiary. The size of the firm or employees does not decide the relationship. The only control over ownership is the key factor.

Also, the location or type of business of both companies does not matter.  They may or may not be in the same location or same business line.

Structure of Subsidiary Company

1. Formation

The parent company has to register with the state registrar of the state in which the company operates. The ownership & stake details are to be defined during this process.

2. Operation

Normally, the parent company just oversees the operations of the subsidiary company. However, in certain cases, the parent company may supervise day to day operations of a subsidiary company.

Subsidiaries are separate legal entities. They have their own concerns regarding the handling of taxation, regulations & liabilities. Subsidiary companies can sue & be sued separate from the parent company. the obligations of a subsidiary may or may not be obligations of the parent company. One of these companies can be undergoing legal proceedings, bankruptcy, tax delinquency or be under investigation without affecting other companies directly. though affecting public image is altogether an intangible thing.

How Does a Subsidiary Work?

Subsidiaries are common in some industries, particularly real estate. A company that owns real estate and has several properties with apartments for rent may form an overall holding company, with each property as a subsidiary. The rationale for doing this is to protect the assets of the various properties from each other’s liabilities. For example, if Company A owns Companies B, C, and D (each a property) and Company D is sued, the other companies can not be held liable for the actions of Company D.

A subsidiary is formed by registering with the state in which the company operates. The ownership of the subsidiary and the type of corporate entity such as a limited liability company (LLC) are spelled out in the registration.

How Are Subsidiaries Accounted For?

From an accounting standpoint, a subsidiary is a separate company, so it keeps its own financial records and bank accounts and track its assets and liabilities. Any transactions between the parent company and the subsidiary must be recorded.

A subsidiary may also be its own separate entity for taxation purposes. Each subsidiary has its own employer identification number and may pay its own taxes, according to its business type.

However, many public companies file consolidated financial statements, including the balance sheet and income statement, showing the parent and all subsidiaries combined. And if a parent company owns 80% or more of shares and voting rights for its subsidiaries, it can submit a consolidated income tax return that can take advantage of offsetting the profits of one subsidiary with losses from another. Each subsidiary must consent to being included in this consolidated tax return by filing IRS Form 1122.

Holding Company vs. Parent Company

Most holding companies’ sole purpose is to hold ownership of subsidiaries. If that’s the case, the company is referred to as a “pure” holding company. If it also conducts business operations of its own, it’s called a “mixed holding company.5 One example of a pure holding company is publicly traded Alphabet Inc., whose purpose is to hold Google and other, lesser-known subsidiaries like Calico and Life Sciences.6 YouTube is, in turn, a subsidiary of Google.

Subsidiary vs. Branch or Division

You may have seen the terms “branch” or “division” used as synonyms for “subsidiary,” but they are not one and the same. A subsidiary is a separate legal entity, while a branch or division is a part of a company that is not considered to be a separate entity.

A branch is usually defined as a separate location within the company, like the Pittsburgh branch of a company whose headquarters is in New York. A division is part of a company that performs a specific activity, such as the wealth management division of a larger financial services company.

Subsidiary Companies Legal Requirements under Companies Act, 2013:

• Definition (Section 2(87))

A subsidiary company is one in which another company (holding company) controls more than 50% of the total share capital or has the right to control the composition of its board of directors. This control may be direct or through another subsidiary. The definition also includes step-down subsidiaries. The Companies (Restriction on Number of Layers) Rules, 2017 limit the number of subsidiary layers, ensuring transparency. This definition is crucial for determining compliance obligations, reporting requirements, and corporate governance rules applicable to both the holding and subsidiary.

• Restriction on Layers

Under the Companies (Restriction on Number of Layers) Rules, 2017, a company cannot have more than two layers of subsidiaries. This restriction is aimed at preventing complex corporate structures that could hide ownership and financial transactions. Exceptions are allowed if the subsidiary is a foreign company with subsidiaries outside India. The rule promotes corporate transparency, facilitates regulatory oversight, and ensures that ownership structures remain simple, making it easier for stakeholders and regulators to trace control and financial relationships within the corporate group.

• Financial Statement Requirements (Section 129)

A subsidiary must prepare its own standalone financial statements as per Schedule III and applicable accounting standards. The holding company is required to consolidate these statements into consolidated financial statements (CFS). This ensures a complete financial picture of the group as a whole. The subsidiary must share its financial data promptly with the holding company for consolidation. The board of the holding company is responsible for ensuring accuracy and compliance with Indian Accounting Standards (Ind AS) or other applicable accounting rules.

• Disclosure in Board’s Report

A subsidiary’s performance, major decisions, and overall contribution to the group must be disclosed in the holding company’s Board’s Report. This includes financial highlights, operations, and any significant events affecting the subsidiary. Such disclosures enable shareholders and investors to assess the subsidiary’s role and performance within the group structure. The requirement improves transparency, accountability, and trust among stakeholders by giving them access to vital subsidiary-related information as part of the holding company’s annual reporting obligations under the Companies Act, 2013.

• Audit Requirements

Every subsidiary company must get its financial statements audited annually by a statutory auditor appointed under the provisions of the Companies Act. The audit ensures the accuracy, fairness, and compliance of accounts with legal and accounting standards. The audited financials are then shared with the holding company for consolidation. For certain classes of companies, internal audit may also be mandatory. The audit process enhances stakeholder confidence, ensures regulatory compliance, and safeguards against financial irregularities within the subsidiary company’s operations.

• Related Party Transactions (Section 188)

Transactions between a holding company and its subsidiary are considered related party transactions. These include the sale or purchase of goods, services, property, or any other arrangements. Such transactions require prior board approval, and in some cases, shareholders’ approval, especially if they exceed prescribed limits. The purpose is to prevent conflict of interest and ensure fairness in dealings between related entities. Proper disclosure of these transactions in financial statements is mandatory to promote transparency and protect minority shareholders’ interests.