Tag: Consolidated Financial Statements

Preferential payments refer to certain debts that are given priority over other unsecured liabilities at the time of liquidation of a company. These payments are made after secured creditors (to the extent of their security) but before unsecured creditors and shareholders. The concept of preferential payments ensures protection to specific classes of creditors whose claims are considered socially or economically important.

Meaning of Preferential Payments

Preferential payments are those payments which, under the provisions of the Companies Act, 2013, must be paid in priority to all other unsecured debts during the liquidation of a company. These include statutory dues, employee-related claims, and certain government obligations. The objective is to safeguard the interests of employees and the government and ensure fairness in the winding-up process.

Features of Preferential Payments

• Statutory in Nature

Preferential payments are created and governed by law, mainly under the Companies Act, 2013 and the Insolvency and Bankruptcy Code, 2016. The liquidator is legally bound to follow these provisions while distributing the assets of the company. These payments are not optional or discretionary; failure to comply may lead to legal consequences.

• Priority Over Unsecured Creditors

One of the most important features of preferential payments is that they are paid before unsecured creditors. After meeting liquidation expenses and secured creditors’ claims (to the extent of their security), preferential creditors are given priority. This ensures that socially and economically important claims are settled first.

• Protection of Employees’ Interests

Preferential payments primarily aim to safeguard the interests of employees and workers. Wages, salaries, holiday pay, gratuity, and provident fund contributions are given preferential status. This feature reflects the social responsibility of company law towards employees who depend on regular income for their livelihood.

• Limited Time Period Applicability

Preferential payments are allowed only for dues that have arisen within a specified period prior to liquidation, usually 12 months. This prevents old and stale claims from enjoying preferential treatment and ensures fairness among creditors. Only recent and relevant obligations qualify for priority payment.

• Subject to Prescribed Monetary Limits

Certain preferential payments, especially wages and salaries, are subject to maximum monetary limits prescribed by law. This feature ensures equitable distribution of assets and prevents disproportionate claims by a few individuals from exhausting the company’s resources.

• Applicable Only in Case of Liquidation

Preferential payments become relevant only when a company goes into liquidation. During normal business operations, all liabilities are treated as ordinary debts. This feature highlights that preferential payments are a special mechanism applicable exclusively during winding up.

• Paid Out of Company’s Assets

Preferential payments are made out of the general assets of the company. They are not charged against specific secured assets unless specified by law. The liquidator ensures that sufficient assets are available to meet these obligations before paying unsecured creditors.

• Ensures Fair and Orderly Distribution

Preferential payments promote fairness, discipline, and order in the liquidation process. By clearly defining the order of priority, they reduce disputes among creditors and ensure transparency. This feature contributes to the smooth completion of liquidation proceedings.

Types of Preferential Payments

Preferential payments are those payments which are given priority over unsecured creditors at the time of liquidation of a company. These payments are specified under the Companies Act, 2013 and relevant provisions of the Insolvency and Bankruptcy Code, 2016. The main types of preferential payments are explained below.

1. Government Dues

Government dues constitute an important category of preferential payments. These include taxes, duties, cess, and other statutory dues payable to the Central Government, State Government, or local authorities. Only those dues which have become payable within twelve months prior to the commencement of liquidation are treated as preferential. This provision ensures timely recovery of public revenue while preventing indefinite priority to old claims.

2. Wages and Salaries of Employees

Wages and salaries payable to employees and workers are treated as preferential payments. These include remuneration for services rendered during a specified period before liquidation, generally up to four months, subject to a prescribed monetary limit. This type of preferential payment protects employees who rely on regular income for their livelihood and ensures social justice during the liquidation process.

3. Accrued Holiday Remuneration

Accrued holiday remuneration refers to the payment due to employees for leave earned but not taken before liquidation. Such unpaid holiday pay is treated as a preferential claim. This ensures that employees receive compensation for benefits accumulated during their service period. It recognizes the contractual and statutory rights of employees even when the company is being wound up.

4. Contributions to Employee Welfare Funds

Amounts due from the company towards employee welfare funds such as Provident Fund, Pension Fund, Gratuity Fund, and other similar funds are treated as preferential payments. In many cases, these contributions are protected in full and may not form part of the company’s general assets. This reflects the importance given to employee welfare and long-term financial security.

5. Compensation Under Labour Laws

Compensation payable to employees under various labour laws is also treated as a preferential payment. This includes compensation for retrenchment, termination, or injury arising out of employment prior to liquidation. Such payments ensure compliance with labour legislation and safeguard the rights of workers during the winding-up process.

6. Other Statutory Preferential Claims

Certain other statutory liabilities may also qualify as preferential payments if specified by law. These may include amounts payable to statutory authorities or regulatory bodies arising within the prescribed time period. The inclusion of such claims ensures adherence to legal obligations during liquidation.

The liquidation of a company refers to the legal process through which a company’s business is closed, its assets are realized, liabilities are paid, and the remaining amount is distributed among shareholders. Depending on who initiates the liquidation and under what authority, liquidation may be carried out through different methods. The main methods of liquidation are explained below.

1. Compulsory Liquidation (Liquidation by Tribunal)

Compulsory liquidation occurs when a company is wound up by an order of the National Company Law Tribunal (NCLT). This method is adopted when the company is unable to pay its debts, has acted against the interests of the state, or has committed fraudulent or unlawful acts. A petition for compulsory liquidation may be filed by creditors, contributories, the Registrar of Companies, or regulatory authorities.

Once the tribunal passes the winding-up order, an official liquidator is appointed. The liquidator takes custody of the company’s assets, prepares a statement of affairs, realizes assets, and pays liabilities in a legally prescribed order of priority. This method ensures strict legal supervision and safeguards the interests of creditors and other stakeholders.

2. Voluntary Liquidation

Voluntary liquidation is initiated by the company itself without direct intervention of the tribunal. It occurs when shareholders decide that the company should be wound up due to reasons such as completion of objectives, reorganization, or lack of profitability. The company passes a resolution in a general meeting and appoints a liquidator to carry out the process.

Voluntary liquidation is generally quicker and less expensive than compulsory liquidation. However, it must comply with statutory requirements. Voluntary liquidation can be classified into members’ voluntary liquidation and creditors’ voluntary liquidation, depending on the financial position of the company.

3. Members’ Voluntary Liquidation

Members’ voluntary liquidation is adopted when the company is solvent, meaning it can pay all its debts in full. Before initiating liquidation, the directors must make a declaration of solvency, stating that the company will be able to meet its liabilities within a specified period. This declaration must be supported by a statement of assets and liabilities.

Shareholders pass a special resolution for winding up and appoint a liquidator. The liquidator realizes assets, settles liabilities, and distributes the surplus among shareholders according to their rights. This method reflects an orderly and planned closure of the company.

4. Creditors’ Voluntary Liquidation

Creditors’ voluntary liquidation occurs when the company is insolvent and unable to pay its debts. In this case, directors cannot make a declaration of solvency. Although the liquidation is voluntary, creditors play a significant role in the process. A meeting of creditors is held, and they appoint the liquidator and may also form a committee of inspection.

The liquidator works primarily for the benefit of creditors. Shareholders have limited control, and any surplus after paying creditors is distributed among them. This method balances voluntary initiation with protection of creditors’ interests.

5. Liquidation under Insolvency and Bankruptcy Code (IBC), 2016

Under the Insolvency and Bankruptcy Code, 2016, liquidation is carried out in a time-bound and transparent manner. Liquidation may occur when the corporate insolvency resolution process fails or when a solvent corporate person opts for voluntary liquidation. A resolution professional or liquidator is appointed to manage the process.

The liquidator verifies claims, takes control of assets, sells them, and distributes proceeds according to the priority specified under the Code. This method aims at maximizing asset value and ensuring fairness among stakeholders.

6. Liquidation under Supervision of Tribunal

In this method, liquidation initially begins as a voluntary process but later comes under the supervision of the tribunal. The tribunal may order supervision if irregularities are noticed or if stakeholder interests require protection. The liquidator continues to function but under judicial oversight.

This method combines the flexibility of voluntary liquidation with the control of compulsory liquidation, ensuring accountability and legal compliance.

7. Summary Liquidation

Summary liquidation is applicable to small or defunct companies with limited assets and liabilities. The procedure is simplified to reduce time and cost. This method is particularly useful for companies that have ceased operations and have minimal financial complexity.

Liquidation of a company is an important concept in corporate accounting and company law. It represents the end stage of a company’s life, where its business operations are brought to a close and its assets are realized to settle liabilities. Unlike ordinary business situations where a company continues as a going concern, liquidation assumes that the company will cease to exist after completion of the process.

Liquidation generally arises due to financial failure, inability to pay debts, expiry of the company’s purpose, or a decision by shareholders to discontinue business. From an accounting perspective, liquidation requires preparation of special statements such as the Liquidator’s Statement of Account, as normal accounting principles of a going concern no longer apply. The objective shifts from profit measurement to realization and distribution of assets.

Meaning of Liquidation of Company

Liquidation, also known as winding up, refers to the process by which a company’s affairs are completely settled. Under this process, the company’s assets are sold, liabilities are paid off, and any remaining surplus is distributed among the shareholders according to their rights. Once liquidation is completed, the company is dissolved and ceases to have legal existence.

In liquidation, a liquidator is appointed to take control of the company’s assets and records. The liquidator acts as a trustee for creditors and shareholders and ensures that assets are realized in an orderly manner. The process protects the interests of creditors by giving them priority over shareholders. Thus, liquidation ensures a fair and legal closure of the company’s business.

Definition of Liquidation

Various authorities have defined liquidation in different ways, emphasizing its legal and accounting aspects.

• According to Company Law,

“Winding up is a process whereby the life of a company is brought to an end and its property is administered for the benefit of its creditors and members.”

• According to Pickles,

“Liquidation is the process by which a company’s business is closed, its assets realized, and the proceeds distributed among those entitled.”

• According to Accounting perspective,

Liquidation is the systematic realization of assets and settlement of liabilities with the ultimate aim of dissolving the company.

Objectives of Liquidation

• To Bring an End to the Company’s Existence

One of the primary objectives of liquidation is to formally bring the company’s business activities and legal existence to an end. When a company is no longer able to operate profitably or fulfill its objectives, liquidation provides a lawful method to close operations. It ensures that the company does not continue to incur losses or liabilities and marks the final stage in the corporate life cycle.

• To Realise the Assets of the Company

Liquidation aims to convert all assets of the company into cash through sale or realization. Since the company ceases to be a going concern, assets are no longer held for use but for disposal. The liquidator ensures that assets are sold in an orderly and transparent manner to obtain the maximum possible value, thereby protecting the interests of creditors and shareholders.

• To Settle Liabilities and Pay Creditors

A major objective of liquidation is to settle all outstanding liabilities of the company. Creditors are paid in a legally prescribed order of priority, ensuring fairness and compliance with company law. Secured creditors, preferential creditors, and unsecured creditors are paid before any amount is distributed to shareholders. This objective safeguards creditor interests and maintains confidence in corporate systems.

• To Distribute Surplus Among Shareholders

After payment of all liabilities, if any surplus remains, liquidation aims to distribute it among shareholders according to their rights. Preference shareholders are paid first, followed by equity shareholders. This ensures equitable treatment and fair distribution of remaining funds. The objective is to return the residual value of the business to its rightful owners in a lawful manner.

• To Ensure Legal Compliance and Transparency

Liquidation ensures that the closure of the company takes place strictly according to legal provisions. The liquidator follows statutory procedures, prepares necessary statements, and submits reports to authorities. This objective promotes transparency, prevents misuse of assets, and ensures accountability. Proper compliance protects stakeholders and prevents future legal disputes related to the company’s closure.

• To Protect the Interests of Stakeholders

Another important objective of liquidation is the protection of interests of all stakeholders, including creditors, shareholders, employees, and the government. Employees’ dues, taxes, and statutory obligations are settled appropriately. By following an orderly process, liquidation avoids arbitrary decisions and ensures that no stakeholder is unfairly disadvantaged during the winding-up process.

• To Avoid Further Losses and Risks

Liquidation helps prevent further financial losses and accumulation of liabilities when a company is no longer viable. Continuing a loss-making business may worsen the financial position and harm creditors. Liquidation minimizes risk by stopping operations and settling obligations promptly. This objective helps preserve whatever value remains in the business for distribution.

• To Achieve Final Dissolution of the Company

The ultimate objective of liquidation is the dissolution of the company, which signifies the end of its legal identity. After completion of asset realization and settlement of claims, the company is removed from the register of companies. Dissolution provides finality, ensuring that the company no longer exists in the eyes of law and cannot enter into future obligations.

Types of Liquidation

Liquidation of a company may take place in different forms depending on the circumstances under which the company is wound up. The Companies Act recognizes various types of liquidation, each having distinct features, procedures, and legal implications. The major types of liquidation are explained below.

1. Compulsory Liquidation (Winding Up by Tribunal/Court)

Compulsory liquidation occurs when a company is wound up by an order of the National Company Law Tribunal (NCLT). It usually arises when the company is unable to pay its debts, has acted against the interests of the state, or has conducted business fraudulently. Creditors, contributories, or regulatory authorities may apply for compulsory winding up. The tribunal appoints an official liquidator who takes control of the company’s assets and affairs.

2. Voluntary Liquidation

Voluntary liquidation takes place when the company decides to wind up its affairs without court intervention. This type of liquidation is initiated by the shareholders through a resolution. Voluntary liquidation reflects the company’s own decision to discontinue business due to reasons such as expiry of purpose, reorganization, or loss of profitability. Voluntary liquidation can be further classified into two types: members’ voluntary liquidation and creditors’ voluntary liquidation.

3. Members’ Voluntary Liquidation

Members’ voluntary liquidation occurs when the company is solvent, meaning it is able to pay all its debts in full. The directors make a declaration of solvency, stating that the company will be able to meet its liabilities within a specified period. Shareholders pass a special resolution for winding up, and a liquidator is appointed to realize assets and distribute surplus among shareholders after settling liabilities.

4. Creditors’ Voluntary Liquidation

Creditors’ voluntary liquidation takes place when the company is insolvent and unable to pay its debts. In this case, the directors cannot make a declaration of solvency. Although the winding up is voluntary, creditors play a significant role by appointing the liquidator and supervising the process. The interests of creditors are given priority, and shareholders have limited control in this type of liquidation.

5. Voluntary Liquidation under Insolvency and Bankruptcy Code (IBC)

Under the Insolvency and Bankruptcy Code, 2016, voluntary liquidation applies mainly to corporate persons who have not defaulted but wish to liquidate their assets. This process requires approval from shareholders and creditors. The objective is to provide a time-bound and transparent liquidation mechanism, ensuring orderly settlement of claims and dissolution of the company.

6. Liquidation Subject to Supervision of Tribunal

In this type, liquidation is initially carried out voluntarily, but later the tribunal supervises the process. The tribunal may intervene if irregularities are noticed or if protection of stakeholder interests becomes necessary. The liquidator continues operations under tribunal supervision. This type combines features of both voluntary and compulsory liquidation and ensures legal oversight where required.

7. Summary Liquidation

Summary liquidation is applicable to small or defunct companies where assets and liabilities are minimal. The procedure is simplified to save time and cost. This type of liquidation ensures speedy closure of companies that have ceased operations and have limited financial complexity.

Causes of Liquidation

• Continuous Losses and Financial Failure

One of the major causes of liquidation is continuous financial losses. When a company fails to generate sufficient profits over a long period, its financial position deteriorates. Persistent losses erode capital, reduce liquidity, and increase dependence on borrowed funds. When the company becomes unable to meet its operating expenses and financial obligations, liquidation becomes inevitable to prevent further losses and protect creditors’ interests.

• Inability to Pay Debts (Insolvency)

A company may be liquidated when it becomes insolvent, meaning it is unable to pay its debts as and when they fall due. Non-payment of creditors, defaults on loans, or failure to meet statutory dues are clear signs of insolvency. In such cases, creditors may approach the tribunal for winding up to recover their dues. Liquidation ensures orderly settlement of liabilities.

• Expiry of Company’s Purpose or Duration

Some companies are formed for a specific objective or fixed duration. Once the purpose for which the company was established is achieved, or the specified period expires, the company may no longer be required. In such cases, shareholders may decide to wind up the company voluntarily. Liquidation helps in legally closing the company and distributing its assets among stakeholders.

• Inefficient or Mismanagement

Poor management and inefficient administration often lead to liquidation. Lack of planning, improper financial control, corruption, or misuse of company funds can severely affect performance. When mismanagement results in losses, declining market position, or legal issues, the company may not be able to continue operations, making liquidation necessary to safeguard stakeholder interests.

• Changes in Market and Economic Conditions

Adverse changes in market conditions, such as reduced demand, increased competition, technological obsolescence, or economic recession, may render a company unviable. Government policy changes, inflation, or trade restrictions can also negatively impact operations. When a company fails to adapt to these changes, liquidation may be the only option to minimize losses.

• Legal and Statutory Reasons

A company may be liquidated due to legal or statutory reasons. Violation of company law provisions, failure to file statutory returns, fraudulent activities, or acting against national interest may lead to compulsory winding up by the tribunal. In such cases, liquidation acts as a corrective and disciplinary measure to enforce legal compliance.

• Internal Disputes and Loss of Confidence

Serious disputes among directors, shareholders, or promoters can disrupt the functioning of the company. Loss of mutual trust, deadlock in decision-making, or lack of coordination may paralyze operations. When internal conflicts cannot be resolved and business continuity is affected, liquidation becomes a practical solution to end disputes and distribute assets fairly.

• Reconstruction, Merger, or Reorganization

Liquidation may occur as part of corporate restructuring. During merger or reorganization, an existing company may be liquidated to transfer assets and liabilities to a new entity. In such cases, liquidation is not due to failure but is a strategic decision aimed at achieving operational efficiency, expansion, or better financial performance.

Yield Method, also known as the Earnings Method, Profit-Earning Capacity Method, or Capitalisation Method, is a method of valuation of shares based on the earning capacity of a company. Under this method, the value of shares is determined by comparing the company’s expected earnings or dividends with the normal rate of return prevailing in the industry. The basic assumption is that the value of a share depends on the income it can generate for investors.

Unlike the Net Asset Method, which focuses on asset backing, the Yield Method emphasizes profitability and future income, making it more suitable for valuing shares of a going concern.

Concept and Rationale of Yield Method

The Yield Method is based on the principle that investors invest in shares to earn returns, either in the form of dividends or capital appreciation. A rational investor compares the return offered by a company with the return available from alternative investments carrying similar risk. If a company offers a higher yield than the normal rate, its shares are valued higher, and vice versa.

This method assumes that:

• Past profits are a reliable indicator of future profits

• Profits are stable or reasonably predictable

• The business will continue operations for the foreseeable future

Hence, the Yield Method measures the true earning power of a company.

Applicability of Yield Method

The Yield Method is particularly suitable in the following cases:

• Valuation of shares of profitable and going concerns

• Companies with stable and regular earnings

• Valuation for mergers, acquisitions, and takeovers

• Determination of share exchange ratio

• Valuation of unquoted equity shares

• Settlement of disputes among shareholders

It is less suitable where profits fluctuate widely or where assets play a dominant role.

Types of Yield Method

The Yield Method can be classified into two main types:

• Earnings Yield Method

• Dividend Yield Method

Both methods are explained in detail below.

1. Earnings Yield Method

Under the Earnings Yield Method, shares are valued based on the earning capacity of the company. The maintainable profits are capitalized at the normal rate of return to determine the value of shares. This method considers profits available to equity shareholders, irrespective of the dividend actually distributed.

Steps Involved in Earnings Yield Method

Step 1. Calculate maintainable profits by adjusting past profits for abnormal items.

Step 2. Deduct preference dividend and taxes, if required.

Step 3. Determine earnings available to equity shareholders.

Step 4. Calculate Earnings Per Share (EPS).

Step 5. Capitalize EPS at the normal rate of return.

Formula

Value per Equity Share = (Earnings per Share × 100) / Normal Rate of Return

Where,

Earnings per Share (EPS) = Profit available to equity shareholders / Number of equity shares

Illustrative Explanation

If a company earns ₹2,00,000 as maintainable profit, has 20,000 equity shares, and the normal rate of return is 10%:

EPS = 2,00,000 / 20,000 = ₹10
Value per share = (10 × 100) / 10 = ₹100

Merits of Earnings Yield Method

• Focuses on earning capacity

• Suitable for profitable companies

• Reflects investor expectations

• Simple and widely accepted

• Ideal for going concerns

Limitations of Earnings Yield Method

• Ignores asset backing

• Depends on estimation of maintainable profits

• Sensitive to changes in normal rate of return

• Not suitable for companies with fluctuating profits

2. Dividend Yield Method

Dividend Yield Method is a variation of the yield method where shares are valued based on the dividend-paying capacity rather than earnings. This method assumes that dividends are the primary source of return for investors. It is especially relevant where dividends are regular and stable.

Steps Involved in Dividend Yield Method

Step 1. Ascertain the expected dividend on equity shares.

Step 2. Calculate Dividend per Share (DPS).

Step 3. Capitalize DPS at the normal rate of return.

Formula

Value per Equity Share = (Dividend per Share × 100) / Normal Rate of Return

Where,
Dividend per Share (DPS) = Total equity dividend / Number of equity shares

Illustrative Explanation

If a company pays a dividend of ₹8 per share and the normal rate of return is 10%:

Value per share = (8 × 100) / 10 = ₹80

Merits of Dividend Yield Method

• Simple and practical

• Useful where dividends are stable

• Reflects actual cash return to shareholders

• Suitable for income-oriented investors

Limitations of Dividend Yield Method

• Ignores retained earnings

• Not suitable for growth companies

• Dividend policy may distort valuation

• May undervalue companies with high retention

Valuation of equity shares is the process of determining the fair or intrinsic value of shares based on the financial position, profitability, and future prospects of a company. Equity shares represent ownership in the company and may be fully paid-up or partly paid-up depending on the amount of share capital paid by shareholders. The valuation of these two types of shares differs mainly due to the existence of future payment liability in partly paid-up shares.

1. Fully Paid-Up Equity Shares

Fully paid-up equity shares are those shares on which the entire face value has been paid by the shareholders. There is no outstanding amount payable on these shares. Holders of fully paid-up shares enjoy full ownership rights, including voting rights, dividend entitlement, and transferability. Since there is no further financial obligation, the valuation of fully paid-up equity shares is simpler and more reliable.

Need for Valuation of Fully Paid-Up Equity Shares

The valuation of fully paid-up equity shares becomes necessary in several situations such as:

• Amalgamation and merger of companies

• Acquisition or takeover

• Issue of bonus shares

• Conversion of debentures into equity shares

• Transfer of shares in private companies

• Settlement of disputes among shareholders

In such cases, market price may not reflect true value, especially when shares are unquoted.

Methods of Valuation of Fully Paid-Up Equity Shares

Fully paid-up equity shares are valued using standard valuation methods:

• Net Asset Value Method

Under this method, the value of equity shares is based on the net assets available to equity shareholders.

Formula:

Value per fully paid-up equity share = Net assets available to equity shareholders / Number of equity shares

This method is suitable during liquidation or when asset strength is important.

• Yield or Earnings Method

This method values shares based on the earning capacity of the company.

Formula:

Value per fully paid-up equity share = (Earnings per share × 100) / Normal rate of return

It is suitable for going concerns and profitable companies.

• Fair Value Method

This method takes the average of values obtained under the Net Asset Method and Yield Method.

Formula:

Fair value per share = (Net asset value per share + Yield value per share) / 2

It is widely used because it considers both assets and profitability.

2. Valuation of Partly Paid-Up Equity Shares

Partly paid-up equity shares are those shares on which only a part of the face value has been paid, and the remaining amount is yet to be called by the company. Shareholders holding partly paid-up shares have a future liability to pay the unpaid amount when calls are made. Due to this additional risk and obligation, partly paid-up shares are valued lower than fully paid-up shares.

Reasons for Lower Valuation of Partly Paid-Up Shares

The valuation of partly paid-up equity shares is lower due to the following reasons:

• Existence of future payment obligation

• Higher risk to shareholders

• Limited transferability in some cases

• Dividend entitlement only on paid-up capital

• Possibility of forfeiture if calls are not paid

These factors reduce the attractiveness and value of partly paid-up shares.

Method of Valuation of Partly Paid-Up Equity Shares

The valuation of partly paid-up equity shares is generally derived from the value of fully paid-up equity shares.

• Proportionate Value Method

Under this method, the value of a partly paid-up share is calculated in proportion to the amount paid.

Formula:

Value of partly paid-up share = Value of fully paid-up share × (Paid-up value / Face value)

• Deduction Method

Alternatively, the unpaid amount is deducted from the value of a fully paid-up share.

Formula:

Value of partly paid-up share = Value of fully paid-up share – Unpaid amount per share

This method ensures that the shareholder’s future liability is fully adjusted.

Illustration of Valuation

Suppose the value of a fully paid-up equity share of ₹100 is ₹150. If ₹60 is paid and ₹40 is unpaid:

Using proportionate method:
Value = 150 × (60/100) = ₹90

Using deduction method:
Value = 150 – 40 = ₹110

In practice, the deduction method is commonly preferred as it fully accounts for the unpaid liability.

Valuation of shares refers to the process of determining the intrinsic or fair value of a company’s shares. Since market prices may not always reflect the true worth of shares, especially in the case of unquoted companies, different valuation methods are adopted depending on the purpose of valuation and nature of the business.

The important methods of valuation of shares are explained below:

1. Net Asset Value Method (Asset Backing Method)

Under this method, shares are valued based on the net assets of the company available for shareholders. All assets are valued at their realizable or fair values and liabilities are deducted to arrive at net assets. The net assets are then divided by the number of equity shares.

Formula:

Value per Equity Share = Net Assets available to Equity Shareholders / Number of Equity Shares

This method is suitable when the company is being wound up or where assets play a major role. However, it ignores earning capacity.

2. Yield Method (Earnings / Profit-Earning Capacity Method)

The Yield Method values shares based on the earning capacity of the company. It compares the company’s earnings with the normal rate of return prevailing in the industry. Expected maintainable profits are capitalized to determine share value.

Formula:

Value per Share = (Earnings per Share × 100) / Normal Rate of Return

This method is suitable for going concerns and emphasizes profitability rather than assets.

3. Dividend Yield Method

This method is a variation of the yield method and is based on the dividend-paying capacity of the company. The value of a share is determined by capitalizing the expected dividend at the normal rate of return.

Formula:

Value per Share = (Dividend per Share × 100) / Normal Rate of Return

This method is appropriate when dividends are stable and regular. However, it ignores retained earnings and growth potential.

4. Fair Value Method

The Fair Value Method combines both asset-based and earning-based approaches. The value of shares is calculated as the average of the values obtained under the Net Asset Value Method and Yield Method.

Formula:

Fair Value per Share = (Net Asset Value per Share + Yield Value per Share) / 2

This method is widely accepted as it considers both financial strength and earning capacity.

5. Market Price Method

Under this method, the stock exchange quoted price of shares is taken as the value. Generally, the average of the market price over a reasonable period is considered.

This method is applicable only when shares are actively traded on a recognized stock exchange. It reflects investor perception but may be influenced by speculation and market fluctuations.

6. Capitalisation Method

In the Capitalisation Method, the value of the entire business is determined by capitalizing its expected profits at the normal rate of return. The total value is then divided by the number of shares to arrive at the value per share.

Formula:

Capitalised Value = Expected Profit × 100 / Normal Rate of Return

Value per Share = Capitalised Value / Number of Shares

This method is suitable for stable businesses with predictable earnings.

7. Intrinsic Value Method

The Intrinsic Value Method focuses on the true worth of a share based on financial statements, assets, liabilities, and earning potential. It is commonly used by investors for long-term investment decisions.

This method requires careful analysis and judgment, making it more complex but reliable.

Goodwill represents the ability of a business to earn profits in excess of the normal return on capital employed. Since goodwill is an intangible asset, its valuation requires the application of appropriate methods based on profits, capital, or super profits. The commonly used methods of valuation of goodwill are discussed below.

1. Average Profit Method

Under the Average Profit Method, goodwill is valued on the basis of the average maintainable profits of the business. Past profits of a certain number of years are adjusted for abnormal items and averaged. Goodwill is then calculated by multiplying the average profit by an agreed number of years’ purchase.

Formula:

Goodwill = Average Profit × Number of Years’ Purchase

This method is simple and widely used when profits are stable. However, it ignores the normal rate of return and capital employed, making it less suitable where profits fluctuate significantly.

2. Weighted Average Profit Method

The Weighted Average Profit Method is an improvement over the simple average profit method. Here, greater weight is assigned to recent profits on the assumption that recent performance better reflects future earning capacity. Profits of past years are multiplied by predetermined weights, and the weighted average profit is calculated.

Formula:

Weighted Average Profit = Total of (Profit × Weight) / Total Weights

Goodwill = Weighted Average Profit × Number of Years’ Purchase

This method is useful when profits show a rising or declining trend, but it still does not consider capital investment.

3. Super Profit Method

Under the Super Profit Method, goodwill is valued based on excess profits earned over normal profits. Normal profit is calculated by applying the normal rate of return to the capital employed. The difference between average maintainable profit and normal profit is known as super profit.

Formula:

Super Profit = Average Maintainable Profit – Normal Profit

Goodwill = Super Profit × Number of Years’ Purchase

This method is logical and widely accepted because goodwill arises only when a firm earns above-normal profits.

4. Annuity Method of Super Profits

The Annuity Method is a refined version of the super profit method. It considers the time value of money by discounting future super profits. The present value of super profits for a specified number of years is calculated using annuity tables.

Formula:

Goodwill = Super Profit × Present Value of Annuity Factor

This method is more scientific and realistic, especially when super profits are expected to continue for a limited period. However, it is complex and requires accurate estimation of discount rates.

5. Capitalisation of Average Profits Method

Under this method, goodwill is calculated by capitalising the average profits at the normal rate of return. The capitalised value of the business is compared with the actual capital employed.

Formula:

Capitalised Value = Average Profit × 100 / Normal Rate of Return

Goodwill = Capitalised Value – Capital Employed

This method is suitable when profits are stable and the normal rate of return is known. It reflects the total value of the business but depends heavily on accurate estimation of the normal rate.

6. Capitalisation of Super Profits Method

In this method, goodwill is valued by capitalising the super profits instead of average profits. Super profits are divided by the normal rate of return to arrive at the value of goodwill.

Formula:

Goodwill = Super Profit × 100 / Normal Rate of Return

This method directly links goodwill with excess earning capacity. It is simple and widely used in practice, especially during partnership changes and business acquisitions.

7. Purchase of Past Profits Method

Under the Purchase of Past Profits Method, goodwill is calculated as a multiple of past profits without adjusting for future expectations or normal return. The number of years’ purchase is determined through negotiation.

Formula:

Goodwill = Past Profits × Agreed Number of Years’ Purchase

This method is easy to apply but is considered less reliable as it does not consider future profitability, capital employed, or industry conditions.

8. Market Value Method

The Market Value Method values goodwill based on the difference between the market value of shares and the book value of net assets. It is mainly used for joint-stock companies whose shares are quoted on the stock exchange.

Formula:

Goodwill = Market Value of Company – Net Assets at Fair Value

This method reflects investor perception and market confidence but is influenced by stock market fluctuations and speculation.

9. Global Valuation Method

Under the Global Valuation Method, the entire business is valued as a whole based on expected future earnings, market conditions, and risk. From this total valuation, the fair value of net tangible assets is deducted to arrive at goodwill.

Formula:

Goodwill = Total Business Value – Net Tangible Assets

This method is suitable for mergers and acquisitions but requires expert valuation and professional judgment.

Accounting standards prescribe specific rules for the recognition, measurement, treatment, and impairment of goodwill to ensure uniformity and transparency in financial reporting. The major provisions relating to goodwill under different accounting standards are explained below.

1. AS 14 – Accounting for Amalgamations (Indian GAAP)

AS 14 governs the treatment of goodwill arising from amalgamations. Goodwill arises only when the amalgamation is in the nature of purchase and the purchase consideration exceeds the net value of assets acquired. Such goodwill is recorded as an asset in the balance sheet. AS 14 recommends that goodwill should be amortised over a reasonable period, normally not exceeding five years, unless a longer period is justified. If the purchase consideration is less than net assets, the difference is treated as capital reserve, not goodwill.

2. AS 26 – Intangible Assets

AS 26 deals with accounting for intangible assets, including goodwill. It clearly states that internally generated goodwill is not recognised because its cost cannot be measured reliably. Only purchased goodwill can be recognised as an asset. AS 26 requires goodwill to be amortised systematically over its useful life. If the useful life cannot be estimated reliably, it should not exceed ten years. The standard also emphasizes periodic review to assess impairment, ensuring that goodwill is not overstated.

3. AS 10 (Revised) – Property, Plant and Equipment

AS 10 (Revised) does not directly prescribe accounting treatment for goodwill but provides important clarification. It states that goodwill is not a tangible asset and therefore cannot be classified as property, plant, or equipment. Any expenditure that leads to internally generated goodwill cannot be capitalised. This reinforces the principle that goodwill is an intangible asset, governed by AS 26 or AS 14. The standard indirectly supports conservative accounting by preventing improper capitalization of goodwill-related expenditure.

4. Ind AS 103 – Business Combinations

Ind AS 103 provides comprehensive guidance on goodwill arising from business combinations. Goodwill is recognised as the excess of consideration transferred over the fair value of identifiable net assets acquired. Unlike AS 14, Ind AS 103 prohibits amortisation of goodwill. Instead, goodwill is subject to annual impairment testing. If the consideration is less than net assets, it results in a bargain purchase gain, which is recognised in profit or loss after reassessment, ensuring fair value-based accounting.

5. Ind AS 36 – Impairment of Assets

Ind AS 36 specifically governs the impairment testing of goodwill. Goodwill acquired in a business combination must be allocated to one or more cash-generating units (CGUs). The standard requires goodwill to be tested for impairment at least annually, irrespective of whether there is any indication of impairment. If the carrying amount exceeds the recoverable amount, an impairment loss is recognised in profit or loss. Importantly, impairment losses on goodwill cannot be reversed, ensuring prudence.

6. IAS 38 – Intangible Assets (International Standard)

IAS 38 lays down international principles for accounting for intangible assets, including goodwill. It strictly prohibits recognition of internally generated goodwill due to measurement uncertainty. Purchased goodwill is recognised only when it arises from a business combination under IFRS. IAS 38 clarifies that goodwill cannot be separated or sold independently and therefore does not permit subsequent revaluation. This standard ensures that goodwill reflects future economic benefits without overstating asset values.

7. IFRS 3 – Business Combinations

IFRS 3 governs the recognition and measurement of goodwill at the international level. It defines goodwill as the future economic benefits arising from assets that are not individually identifiable. IFRS 3 disallows amortisation of goodwill, adopting an impairment-only model. Goodwill is tested annually for impairment under IAS 36. Any bargain purchase is recognised immediately as income in profit or loss. These provisions promote transparency and fair valuation in global financial reporting.

8. Comparative and Conceptual Overview

Traditional Indian Accounting Standards (AS) permit amortisation of goodwill, while Ind AS and IFRS prohibit amortisation and require impairment testing. All standards uniformly disallow recognition of internally generated goodwill. The shift from amortisation to impairment reflects a move toward fair value and economic substance over conservative cost-based accounting. This evolution improves the relevance of financial statements by ensuring goodwill represents real future benefits rather than arbitrary write-offs.