Tag: Debentures

Management Notes

Underwriter, Functions, Advantages of Underwriting

indiafreenotesby indiafreenotes2

An underwriter is a financial institution or individual that guarantees the purchase of any unsold shares in a public offering, such as an Initial Public Offering (IPO) or a Rights Issue. Underwriters play a key role in ensuring that the company raising funds will meet its capital-raising goals, even if the public does not fully subscribe to the offering. They assess the risk, determine pricing, and market the securities. In return for assuming this risk, underwriters are paid a commission, which compensates them for their services and financial commitment to the issue.

Functions of Underwriter:

  • Risk Assessment

One of the primary functions of an underwriter is to assess the risk involved in a public offering. Before agreeing to underwrite an issue, the underwriter evaluates the financial health, market conditions, and business prospects of the issuing company. This assessment helps the underwriter determine the likelihood of the offering being successful and identify any potential risks that might affect the sale of shares. Based on this evaluation, they decide whether to underwrite the issue and the terms of underwriting.

  • Pricing of Securities

Underwriters play a crucial role in determining the price at which securities are offered to the public. This involves market research, understanding investor demand, and analyzing the company’s financial position. The underwriter sets the issue price to balance the issuer’s goal of raising capital and attracting investor interest. An accurately priced issue ensures that it is neither underpriced (leading to a loss of capital for the issuer) nor overpriced (leading to poor investor demand).

  • Marketing and Promotion

Marketing and promotion of the offering is another key function of the underwriter. They are responsible for creating an awareness campaign and ensuring that potential investors are well-informed about the company’s offering. This involves roadshows, presentations, and other promotional activities to generate interest. Underwriters leverage their relationships with institutional and retail investors to ensure the offering is adequately subscribed. Effective marketing directly impacts the success of the offering by creating demand and enhancing visibility.

  • Managing Subscription Process

The underwriter is responsible for managing the subscription process during an offering. This includes handling investor applications, collecting payments, and ensuring the shares are allocated correctly. The underwriter coordinates with stock exchanges and regulatory bodies to comply with all procedural requirements. They must ensure that the subscription is conducted smoothly, and that any oversubscription or undersubscription is dealt with effectively, including the allotment of shares to investors as per the rules and regulations.

  • Underwriting Commitment

Underwriters provide a guarantee to the issuing company that they will purchase any unsold shares in the event that the public does not fully subscribe to the offering. This is referred to as the underwriting commitment. If the offering is undersubscribed, the underwriter steps in and buys the remaining shares at the agreed-upon price. This commitment ensures that the issuer will raise the desired amount of capital, even if there is low investor interest in the offering.

  • Due Diligence

Underwriters are responsible for performing due diligence to ensure that the issuing company’s financials and disclosures are accurate and compliant with regulatory requirements. This includes verifying financial statements, business operations, and legal standing. Due diligence is crucial in protecting investors and ensuring that the information provided in the offer document is truthful and transparent. A thorough due diligence process reduces the risk of legal disputes and protects both the underwriter and the issuer from potential liabilities.

  • Stabilization of Market Price

After the securities are issued, the underwriter may be involved in stabilizing the price of the securities in the secondary market. This involves buying and selling shares to prevent excessive price fluctuations immediately after the offering. The underwriter’s role is to ensure that the market price of the shares remains stable and does not fall below the issue price. This helps maintain investor confidence and prevents volatility that could harm the issuer’s reputation and the investors’ interests.

Advantages of Underwriting:

  • Capital Guarantee

Underwriting ensures that the company raising capital will receive the full amount of money it requires, even if the public does not fully subscribe to the offering. This capital guarantee helps reduce uncertainty for the issuer, providing confidence that the financial objectives of the offering will be met, regardless of investor demand.

  • Expert Guidance

Underwriters bring in-depth market knowledge and expertise, helping the issuing company set the right price for the securities and strategize on how to attract investors. Their experience in market conditions, pricing, and risk management ensures the offering is attractive, thereby maximizing the chances of success for both the company and investors.

  • Enhanced Market Credibility

Having a reputable underwriter associated with an issue enhances the company’s credibility in the market. Investors often feel more confident in subscribing to an offering that has been underwritten by well-known financial institutions. This can help increase investor interest and trust, potentially leading to higher subscriptions and a successful offering.

  • Risk Mitigation for Issuers

By assuming the risk of underwriting, underwriters protect the issuer from potential losses if the offering is undersubscribed. This is especially important during volatile market conditions where public interest may be lower than expected. The issuer is assured of receiving the required funds, even if the shares do not sell as anticipated.

  • Investor Protection

Underwriters perform due diligence to ensure that the information provided in the offer document is accurate, complete, and compliant with regulatory standards. This protects investors by ensuring they have access to reliable and truthful information when making investment decisions. It reduces the likelihood of fraud or misinformation, fostering a safer investment environment.

  • Market Liquidity

By underwriting the offering, financial institutions contribute to the liquidity of the stock market. They help ensure that shares are not only sold initially but that they are also available for subsequent trading. This liquidity helps maintain the efficiency and stability of the market, providing investors with opportunities to buy or sell securities as needed.

Disadvantages of Underwriting:

  • High Costs

Underwriting involves substantial fees, including commissions paid to the underwriters, as well as legal, administrative, and marketing expenses. These costs can be significant, especially for large public offerings. For smaller companies or those with limited capital, these expenses may be prohibitive and could diminish the funds raised through the offering.

  • Underwriter Risk

Underwriters assume a significant amount of financial risk, especially when market conditions are unfavorable. If the public does not subscribe to the offering as expected, the underwriter is left with unsold shares. This risk may lead to financial losses, particularly if the market price of the shares falls below the issue price, impacting the underwriter’s profitability.

  • Potential for Overpricing

Underwriters, in their role, set the issue price, which may sometimes be overestimated based on market conditions or overly optimistic projections. Overpricing can lead to poor investor demand, resulting in undersubscription. An improperly priced issue may also harm the company’s reputation, as investors may feel the offering was not accurately valued.

  • Conflicts of Interest

In some cases, underwriters may have conflicts of interest. They might prioritize their financial gain over the interests of the issuer or investors. For instance, underwriters may push for a higher issue price or aggressively market the shares to boost their commission, which can negatively affect the long-term success of the company and its stock performance.

  • Limited Control for Issuer

Once an underwriter is hired, the company may lose a degree of control over the terms of the offering. The underwriter typically takes the lead in setting the price, timing, and other key aspects of the issue. This can be problematic if the issuer’s vision does not align with the underwriter’s strategies or market approach.

  • Increased Regulatory Scrutiny

Underwritten offerings are subject to strict regulatory scrutiny, particularly regarding the due diligence process and disclosure requirements. While this ensures transparency, the complexity and compliance costs can be burdensome for the issuer. Regulatory bodies, such as SEBI in India or the SEC in the U.S., monitor the underwriting process closely, increasing the time and effort needed to complete the offering.

Management Notes

Introduction, Meaning Calculation of Sales Ratio Profit Prior to Incorporation

indiafreenotesby indiafreenotes1

In the lifecycle of a company, the phase before its legal incorporation is known as the pre-incorporation period. During this phase, promoters often initiate business activities like purchasing assets, hiring staff, and even making sales. However, a company legally comes into existence only after receiving a Certificate of Incorporation from the Registrar of Companies. This creates a distinction between pre-incorporation and post-incorporation periods for accounting purposes.

When a business is taken over by a newly incorporated company, profits earned during the pre-incorporation period are not considered the income of the company. This is because the company did not legally exist at that time. Therefore, such profits are called Profit Prior to Incorporation and are treated as capital profits. Conversely, profits earned after incorporation are revenue profits.

Meaning of Profit Prior to Incorporation:

Profit Prior to Incorporation refers to the profits or losses earned by a business during the period before the company was legally formed. Since the company is not a legal entity during this time, any profit earned cannot be distributed as dividends. Instead, it is transferred to a Capital Reserve.

The business may have been operated by promoters or taken over from an existing sole proprietor or partnership. The financial results for the full accounting period (before and after incorporation) are often given together, so it becomes necessary to apportion the profits between the pre-incorporation and post-incorporation periods.

Necessity of Calculating Profit Prior to Incorporation:

  1. Correct Profit Reporting: Ensures the company’s financials reflect only profits made during its legal existence.

  2. Dividend Distribution: Dividends can only be paid from revenue profits.

  3. Legal Compliance: Prevents distribution of capital profits as dividends, which is prohibited under the Companies Act.

  4. Tax Purposes: Helps determine taxable profits accurately.

Steps to Calculate Profit Prior to Incorporation:

  1. Ascertain Total Profit or Loss: Determine the profit for the entire period (before and after incorporation).

  2. Divide the Period: Identify the number of months before and after incorporation.

  3. Calculate the Sales Ratio: Used for apportioning items related to sales (e.g., gross profit).

  4. Calculate the Time Ratio: Used for apportioning time-based expenses (e.g., rent, salaries).

  5. Allocate Expenses and Incomes:

    • Allocate incomes and expenses between pre- and post-incorporation using appropriate ratios.

  6. Prepare a Statement: Show profit or loss for each period separately.

Calculation of Sales Ratio:

Sales Ratio is used to apportion sales-based items (e.g., gross profit, commission on sales). It is the ratio of sales made during the pre-incorporation and post-incorporation periods.

Formula:

Sales Ratio = Sales in Pre-Incorporation Period / Sales in Post-Incorporation Period

Steps to Calculate:

  1. Find Total Sales: Determine the total sales during the accounting period.

  2. Break Sales Period-Wise: Separate sales into pre- and post-incorporation periods.

  3. Calculate the Ratio: Divide sales of the respective periods to get the sales ratio.

Example:

If total sales from Jan 1 to Dec 31 are ₹12,00,000 and the company was incorporated on May 1:

  • Sales from Jan to April = ₹4,00,000 (Pre)

  • Sales from May to Dec = ₹8,00,000 (Post)

Then,

Sales Ratio = 4,00,000 : 8,00,000 = 1 : 2

Items Apportioned on Time Ratio vs Sales Ratio:

Basis Items
Time Ratio Rent, salaries (if fixed), depreciation, admin expenses
Sales Ratio Gross profit, selling commission, carriage outwards, sales-related advertisement

  • Preliminary expenses: Post-incorporation

  • Director’s fees: Post-incorporation

  • Interest on purchase consideration: Pre-incorporation

Treatment of Profit Prior to Incorporation:

  1. Capital Reserve: Profit prior to incorporation is transferred to Capital Reserve on the balance sheet.

  2. Cannot be Distributed as Dividend: As it is capital in nature.

  3. Can be Used for:

    • Writing off goodwill or preliminary expenses

    • Issuing bonus shares

    • Meeting capital losses

Format of Profit Prior to Incorporation Statement:

Particulars

Pre-Incorporation (₹)

Post-Incorporation (₹)

Gross Profit (based on Sales Ratio)

 XXXX XXXX
Less: Expenses (allocated) XXXX XXXX
Net Profit XXXX XXXX
Management Notes

Time Ratio Profit Prior to Incorporation

indiafreenotesby indiafreenotes1

When a newly incorporated company takes over an existing business, it is common for the business to have been operational even before the company was legally formed. In such cases, the total profit or loss for the entire period needs to be split between the Pre-incorporation period and the Post-incorporation period.

The profit earned before incorporation is known as Profit Prior to Incorporation. It is considered a capital profit and cannot be distributed as dividends. For an accurate and fair division of profits and expenses between the two periods, two essential tools are used:

  • Sales Ratio: Used for apportioning sales-related items.

  • Time Ratio: Used for apportioning time-based expenses.

This note focuses on the Time Ratio and how it is used in calculating Profit Prior to Incorporation.

What is Profit Prior to Incorporation?

Profit Prior to Incorporation refers to the portion of the net profit (or loss) earned by a business before it becomes a legally incorporated company. It arises in cases where a business is already operational and later taken over by a company from a specific date.

For example, if a business operates from January 1 and is incorporated on April 1, profits from January to March would be termed as Profit Prior to Incorporation, and profits from April onwards would be Revenue Profits.

Nature and Treatment of Profit Prior to Incorporation:

Capital Nature:

  • Treated as capital reserve, not as distributable profit.

  • Shown on the liabilities side of the Balance Sheet under Reserves and Surplus.

  • Can be used for:

    • Writing off preliminary expenses.

    • Writing off goodwill.

    • Issuing bonus shares.

    • Absorbing capital losses.

Revenue Profits:

  • Arise after incorporation.

  • Can be distributed as dividends to shareholders.

  • Shown in the Profit & Loss Account.

Time Ratio – Meaning and Importance:

Time Ratio is the ratio between the lengths of the pre-incorporation and post-incorporation periods. It is used to apportion time-based expenses and incomes that accrue evenly over time.

  • Formula of Time Ratio

Time Ratio = Number of months (or days) in pre-incorporation period: Number of months (or days) in post-incorporation period

Example:

Items Apportioned Using Time Ratio:

Time-based items that are not directly linked to sales are divided using Time Ratio.

Examples:

Items Apportioned Using Time Ratio
Rent, rates, and taxes Yes
Depreciation (on fixed assets) Yes
General office expenses Yes
Salaries and wages Yes (if fixed monthly payments)
Insurance Yes
Telephone and internet charges Yes
Audit fees Sometimes (if period-based)

  1. Determine Total Profit or Loss for the full accounting period.

  2. Identify the Date of Incorporation and divide the period into:

    • Pre-incorporation period.

    • Post-incorporation period.

  3. Calculate Time Ratio for time-based expenses.

  4. Calculate Sales Ratio for sales-based incomes/expenses.

  5. Classify Expenses and Incomes into:

    • Time-based (use time ratio).

    • Sales-based (use sales ratio).

    • Specific to pre- or post-incorporation.

  6. Prepare a Profit Allocation Statement.

Format of Profit Prior to Incorporation Statement:

Particulars

Pre-Incorporation (₹)

Post-Incorporation (₹)

Gross Profit (Sales Ratio)

 XXXX

XXXX

Less: Rent, Salaries (Time Ratio)

 XXXX

XXXX

Less: Sales Commission (Sales Ratio)

 XXXX XXXX
Less: Director’s Remuneration (Post Only) – XXXX
Net Profit XXXX XXXX
Management Notes

Weighted Ratio Profit Prior to Incorporation

indiafreenotesby indiafreenotes3

When a company is formed by taking over a running business, its financial year often spans both pre-incorporation and post-incorporation periods. The profit earned before the date of incorporation is termed “Profit Prior to Incorporation”. This profit is considered capital profit and not available for dividend distribution. To calculate this profit accurately, time ratio and sales ratio are used. However, when expenses and income do not align proportionally with time or sales, the Weighted Ratio is applied for equitable apportionment.

Profit Prior to Incorporation

Profit prior to incorporation is the profit earned by a business before the company is legally formed. For example, if a business is acquired on January 1st but the company is incorporated on April 1st, then the profit from January 1 to March 31 is profit prior to incorporation.

This profit must be calculated separately because:

  • It is capital profit.

  • It is not available for dividend.

  • It is usually transferred to Capital Reserve.

Apportionment of Profit and Expenses:

To determine the correct amount of profit prior to incorporation, the total profit of the period (from acquisition to the end of the financial year) must be split between:

  • Pre-incorporation period: From acquisition date to incorporation date.

  • Post-incorporation period: From incorporation date to the end of the accounting period.

For accurate apportionment of income and expenses, three types of ratios are used:

  1. Time Ratio

  2. Sales Ratio

  3. Weighted Ratio

What is Weighted Ratio?

Weighted Ratio is a more refined method of apportioning expenses, particularly when both time and sales affect the distribution. It assigns weights to both the time and sales factors and then applies these weights to allocate items like salaries, rent, and other semi-variable expenses.

Weighted Ratio = Time × Sales

It is used in situations where neither the time ratio nor sales ratio alone gives a fair distribution.

When to Use Weighted Ratio:

Weighted ratio is used for:

  • Expenses affected by both time and activity level (sales).

  • Semi-variable or mixed expenses like salaries (increased post-incorporation due to more staff), advertisement, and office expenses.

Steps for Calculating Profit Prior to Incorporation Using Weighted Ratio

  1. Determine the total period (acquisition to end of financial year) and divide it into:

    • Pre-incorporation period

    • Post-incorporation period

  2. Calculate Time Ratio = Duration of each period in months.

  3. Calculate Sales Ratio = Sales in each period.

  4. Calculate Weighted Ratio = Time × Sales (for each period).

  5. Prepare a Statement of Profit and Loss:

    • Allocate incomes and expenses using:

      • Time ratio: for fixed expenses (e.g., rent, depreciation).

      • Sales ratio: for variable expenses (e.g., selling commission).

      • Weighted ratio: for semi-variable expenses (e.g., salaries, office expenses).

  6. Calculate Profit Prior to Incorporation: Subtract the pre-incorporation expenses from the pre-incorporation revenue.

  7. Transfer the amount to Capital Reserve.

Items Treated Using Weighted Ratio

Nature of Item Example Basis of Apportionment
Semi-variable expenses Salaries, Office Expenses Weighted Ratio
Fixed Expenses Rent, Insurance, Audit Fees Time Ratio
Variable Expenses Selling Commission, Carriage Outward Sales Ratio

Treatment of Profit Prior to Incorporation

Particulars Treatment
Profit before incorporation Treated as Capital Profit
Use of this profit Transferred to Capital Reserve
Not used for Distribution of dividends
Management Notes

Treatment of Capital and Revenue Expenditure

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In accounting, every expenditure incurred by a business must be correctly categorized and treated to present a true and fair view of the financial position. Broadly, expenditures fall into two categories:

  • Capital Expenditure

  • Revenue Expenditure

Correct classification and accounting treatment are crucial because it impacts both the profit and loss account and the balance sheet. Misclassification may mislead stakeholders and lead to incorrect tax computations and profit reporting.

Capital Expenditure

Capital expenditure (CapEx) refers to money spent by a business to acquire, upgrade, or extend the life of long-term assets. These expenditures offer economic benefits beyond the current accounting period and are not incurred regularly.

Examples

  • Purchase of land, building, plant, and machinery

  • Cost of installation or delivery of fixed assets

  • Legal fees on the purchase of property

  • Major improvements or extension of assets

Characteristics

  • Non-recurring and long-term in nature

  • Provides benefit over several accounting periods

  • Increases the earning capacity of the business

  • Capitalized and shown on the assets side of the balance sheet

Revenue Expenditure

Revenue expenditure (RevEx) is the money spent on the daily operational needs of the business. It is incurred to maintain the existing earning capacity of the business and is consumed within the same accounting period.

Examples

  • Salaries and wages

  • Rent, electricity, and water charges

  • Repairs and maintenance

  • Office stationery and administrative expenses

  • Insurance premiums

Characteristics

  • Recurring and short-term in nature

  • Maintains the existing assets, does not increase efficiency

  • Fully charged to the profit and loss account in the year incurred

  • Necessary for the regular functioning of the business

Key Differences between Capital Expenditure and Revenue Expenditure

Particulars Capital Expenditure Revenue Expenditure
Nature Non-recurring, long-term Recurring, short-term
Benefit Duration More than one accounting period Only current accounting period
Impact on Assets Increases asset base Does not affect asset base
Financial Statement Effect Appears in Balance Sheet (as asset) Charged to Profit & Loss Account
Examples Purchase of equipment, land, building Rent, salaries, utilities

The treatment in the accounting books varies significantly based on the nature of the expense. Here’s a table showing the accounting treatment:

Expenditure Type Accounting Entry Impact on Financial Statements
Capital Expenditure Asset A/c Dr.
 To Bank A/c		 Asset added in Balance Sheet
Revenue Expenditure Expense A/c Dr.
 To Bank A/c		 Charged as expense in Profit & Loss Account
Depreciation (CapEx) Depreciation A/c Dr.
 To Asset A/c		 Depreciation charged in P&L A/c, asset value reduced
Deferred Revenue Exp. Deferred Exp. A/c Dr.
 To Bank A/c		 Shown as Asset initially, amortized in future P&L A/c

Deferred revenue expenditure is a revenue expenditure in nature but the benefit lasts more than one accounting period. Hence, instead of charging it off in one year, it is spread over several years.

Examples

  • Heavy advertisement for new product launch

  • Preliminary expenses

  • Development costs for new technology

Treatment

Initially shown on the asset side of the balance sheet and gradually written off in the profit and loss account.

At the time of incurring:
Deferred Revenue Exp. A/c Dr.
 To Bank A/c

At the time of amortization:
Profit & Loss A/c Dr.
 To Deferred Revenue Exp. A/c

Capitalized Revenue Expenditure

Certain revenue expenses, when directly related to bringing a capital asset into use, are capitalized.

Examples

  • Wages paid to workers installing machinery

  • Transportation cost for delivering machinery

Though they are revenue in nature, such costs are added to the value of the asset.

Accounting Treatment

Machinery A/c Dr.
 To Bank/Wages/Carriage A/c

Importance of Correct Treatment

Why It Matters

  • Ensures correct computation of profit

  • Proper representation of assets and expenses

  • Compliance with accounting standards (AS-10, AS-26)

  • Affects decision-making by management, investors, and regulators

  • Prevents overstatement or understatement of income

Errors in Classification: Consequences:

Misclassifying Capital as Revenue

  • Understatement of assets

  • Overstatement of current year’s expenses

  • Lower profit shown

Misclassifying Revenue as Capital

  • Overstatement of assets

  • Understatement of expenses

  • Artificially inflated profits

Both types of misclassification violate the principle of prudence and may lead to legal and audit complications.

Accounting Standards Related:

AS-10 (Revised): Property, Plant and Equipment

  • Governs the treatment and recognition of capital assets.

  • Requires capitalization of all costs necessary to bring an asset to working condition.

AS-26: Intangible Assets

  • Applicable to intangible assets like trademarks, patents, and development costs.

  • Clarifies what can and cannot be capitalized.

Special Cases in Treatment

Expense Treatment

Repairs (extensive, long-term)

Capital Expenditure

Ordinary repairs

Revenue Expenditure

Legal charges for buying land

Capital Expenditure

Rent for office

Revenue Expenditure

Renovation increasing asset life

Capital Expenditure

Advertisement (ordinary)

Revenue Expenditure

Advertisement (for long-term impact, e.g., brand building)

Deferred Revenue Expenditure
Management Notes

Ascertainment of Pre-incorporation and Post-incorporation Profits by Preparing Statement of Profit and Loss (Vertical Format) as per Schedule III of Companies Act, 2013

indiafreenotesby indiafreenotes3

When a company is formed during the course of a financial year, it often takes over a running business. The profits earned before the date of incorporation are termed pre-incorporation profits, and the profits earned after incorporation are known as post-incorporation profits.

✅ Pre-incorporation profit is treated as a capital profit (not available for dividend).
✅ Post-incorporation profit is treated as a revenue profit (available for dividend, subject to law).

To ascertain both, we use the vertical format of the Statement of Profit and Loss as per Schedule III of the Companies Act, 2013 and split items based on Time Ratio, Sales Ratio, or Weighted Ratio, depending on the nature of income or expense.

📊 Format of Statement of Profit and Loss (Vertical Format)

As per Schedule III – Division I of the Companies Act, 2013, applicable to non-Ind AS companies.

ABC Ltd.

Statement of Profit and Loss for the year ended 31st March 2025

(Figures in ₹)

Particulars Total Pre-incorporation Post-incorporation
I. Revenue from operations 10,00,000 2,50,000 7,50,000
II. Other Income 50,000 5,000 45,000
III. Total Revenue (I + II) 10,50,000 2,55,000 7,95,000
– – – –
IV. Expenses: – – –
(a) Cost of materials consumed 3,00,000 75,000 2,25,000
(b) Purchase of stock-in-trade 50,000 15,000 35,000
(c) Changes in inventories of finished goods 30,000 8,000 22,000
(d) Employee benefit expenses 1,00,000 20,000 80,000
(e) Finance costs (Interest on debentures, etc.) 40,000 – 40,000
(f) Depreciation and amortisation expenses 60,000 – 60,000
(g) Other expenses (rent, admin, etc.) 1,20,000 40,000 80,000
Total Expenses (IV) 7,00,000 1,58,000 5,42,000
V. Profit before tax (III – IV) 3,50,000 97,000 2,53,000
Less: Income Tax (only on post-incorp. profit) – 65,000
VI. Profit for the year 3,50,000 97,000 1,88,000
Particulars Pre-incorporation Post-incorporation
Classification Capital profit Revenue profit
Transfer to Capital Reserve (in Balance Sheet) Retained earnings / Dividend
Income Tax applicability Not taxable Taxable
Use Cannot be distributed as dividend Can be distributed
Item Basis Remarks
Sales Sales Ratio Based on turnover before and after incorporation
Cost of Goods Sold Sales Ratio Linked to volume of sales
Administrative Expenses Time Ratio Incurred uniformly
Salaries, Rent Time Ratio Fixed and recurring expenses
Selling and Distribution Sales Ratio Sales-based allocation
Depreciation Post-incorporation Applied only after incorporation
Interest on Capital/Debentures Post-incorporation Only after company is formed
Management Notes

Average Profit Method of Valuation of Goodwill

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Under the Average Profit Method, goodwill is valued on the basis of the average maintainable profits of past years. The assumption is that a business will continue to earn similar profits in the future.

Goodwill = Average Profit × Number of Years’ Purchase

Steps in Valuation

  1. Collection of Past Profits: Collect the profit figures of the past 3 to 5 years (as agreed).

  2. Adjustment of Profits: Adjust for abnormal items:

    • Deduct abnormal gains (e.g., profit from sale of fixed assets).

    • Add back abnormal losses (e.g., loss due to fire, one-time expenses).

    • Adjust for changes in depreciation, salary, or interest not previously recorded.

  3. Calculation of Average Profit: Compute average profits by summing the adjusted profits and dividing by the number of years.

  4. Selection of Years’ Purchase: Decide the number of years’ purchase depending on industry practice, stability of business, and mutual agreement.

  5. Valuation of Goodwill: Multiply average profit by years’ purchase to get goodwill.

Types of Average Profits

Simple Average Profit:

All years’ profits are given equal weight.

Simple Average = Total of adjusted profits / Number of years

Weighted Average Profit:

Profits of recent years are given more importance because they are more relevant for future expectations.

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

Management Notes

Super Profit Method, Capitalization of Super Profit Method

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The Super Profit Method is based on the idea that goodwill arises when a business earns more than the normal expected profit. The difference between the actual (or average) profit and the normal profit is called Super Profit. Goodwill is then valued as a multiple of this super profit.

Goodwill = Super Profit × Years’ Purchase

Steps

  1. Calculate Average Profit of the business (adjust past profits for abnormal items).

  2. Compute Normal Profit:

Normal Profit = Capital Employed × Normal Rate of Return / 100

4. Find Super Profit = Average Profit – Normal Profit.

5. Multiply Super Profit by Years’ Purchase to get goodwill.

Capitalization of Super Profit Method

This method capitalizes the super profit at the normal rate of return to calculate goodwill. Instead of multiplying super profit by years’ purchase, we directly calculate how much capital is required to earn that excess profit at the normal rate of return.

Goodwill = [Super Profit×100] / Normal Rate of Return

Steps:

  1. Calculate Average Profit.

  2. Calculate Normal Profit = Capital Employed × NRR.

  3. Find Super Profit = Average Profit – Normal Profit.

  4. Capitalize the Super Profit at the normal rate of return.

Difference Between the Two Methods

Basis Super Profit Method Capitalization of Super Profit Method
Formula Goodwill = Super Profit × Years’ Purchase Goodwill = (Super Profit × 100) ÷ NRR
Approach Multiplies excess profit by fixed years Converts excess profit into capitalized value
Result Based on years’ purchase decided by agreement Based on industry’s normal return rate
Usefulness Simpler and more common More accurate, used in detailed valuations
Management Notes

Capitalization of Average Profit Method of Valuation of Goodwill

indiafreenotesby indiafreenotes2

The Capitalization of Average Profit Method is one of the important approaches to valuing goodwill. Unlike the simple Average Profit Method, which multiplies average profit by a certain number of years’ purchase, this method converts average profit into capital employed (or the value of business) and then calculates goodwill as the excess of this capitalized value over the actual capital employed in the business.

It reflects the idea that a business is worth the capital required to generate its maintainable average profit at a normal industry rate of return.

Formula

Goodwill = Capitalized Value of Business − Net Assets (Capital Employed)

Where,

Capitalized Value of Business = [Average Profit / Normal Rate of Return] × 100

Steps in Valuation

  1. Calculate Average Profit: Adjust past profits for abnormal items and calculate the average.

  2. Determine Normal Rate of Return (NRR): Industry standard rate of return is used (e.g., 10%, 12%).

  3. Find Capitalized Value of Business:

Capitalized Value = [Average Profit × 100] / NRR

4. Calculate Capital Employed: Total assets (excluding goodwill and fictitious assets) minus outside liabilities.

5. Compute Goodwill: Deduct capital employed from capitalized value of business.

illustration:

A firm earns an average profit of ₹2,00,000. The normal rate of return in the industry is 10%. The firm’s capital employed is ₹15,00,000. Find goodwill using the Capitalization of Average Profit Method.

Step 1: Capitalized Value of Business

Capitalized Value = 2,00,000 × 10010 = ₹20,00,000

Step 2: Goodwill

Goodwill = 20,00,000 − 15,00,000 = ₹5,00,000

Thus, the goodwill of the firm is ₹5,00,000.

Advantages of Capitalization of Average Profit Method:

  • Considers Normal Industry Returns

This method is more realistic as it compares the firm’s maintainable profits with the normal rate of return (NRR) prevailing in the industry. If a business earns higher profits than the expected industry return, the difference reflects goodwill. Thus, it ensures that the valuation is not arbitrary but benchmarked against the industry, giving a fair and logical estimate of goodwill value.

  • Reflects True Earning Capacity

Unlike methods that merely average past profits, this approach emphasizes the earning capacity of the business in proportion to the capital employed. It highlights how effectively the business is utilizing its capital compared to expected returns. Hence, goodwill is valued based on the excess earnings potential, making the result more reliable, especially for investors, buyers, and sellers considering mergers, acquisitions, or partnership changes.

  • Suitable for Capital-Intensive Businesses

This method is particularly advantageous for firms with heavy investments in assets and infrastructure. Since it directly relates profits to capital employed, it provides an accurate measure of whether the business is generating adequate returns on its invested funds. Such businesses often have goodwill arising from efficiency, scale, or brand reputation, and the method captures these advantages better than simple profit-based methods.

  • Provides Logical Valuation Framework

The Capitalization of Average Profit Method offers a systematic and logical framework for valuing goodwill. By linking profits, capital employed, and normal return rates, it eliminates guesswork and arbitrary multipliers used in other methods. This makes it highly suitable for negotiations, legal disputes, or financial reporting where rational justification is required. The structured process ensures transparency and reduces chances of conflict between interested parties.

Disadvantages of Capitalization of Average Profit Method:

  • Difficulty in Determining Normal Rate of Return (NRR)

One of the biggest limitations of this method is deciding the appropriate normal rate of return. The NRR varies widely depending on industry, economic conditions, competition, and risk factors. A small difference in the assumed rate can lead to a large variation in the calculated goodwill, making the valuation subjective. This uncertainty reduces the reliability of the method unless accurate and up-to-date industry benchmarks are available.

  • Complex Calculation of Capital Employed

Accurate computation of capital employed is often challenging because it requires careful adjustments of assets and liabilities. Non-operating assets, fictitious assets, intangible assets, and contingent liabilities must be excluded, which involves judgment. Any miscalculation may result in misleading goodwill figures. Unlike simpler methods, this one demands detailed analysis of the balance sheet, which may not always be possible due to lack of transparency in financial records.

  • Unsuitable for Firms with Fluctuating Profits

This method assumes that average profit is a fair representation of future maintainable profits. However, in businesses where profits fluctuate significantly due to seasonal demand, market volatility, or irregular performance, the average profit may not reflect the true earning capacity. In such cases, the goodwill valuation may be misleading and either undervalues or overstates the actual potential of the firm, reducing its reliability for decision-making.

  • Time-Consuming and Technical

Compared to the Simple Average Profit Method, the Capitalization of Average Profit Method is more technical and time-consuming. It requires detailed profit adjustments, determination of average profit, accurate calculation of capital employed, and selection of normal rate of return. Small errors at any step can distort results. For small firms or routine transactions, this detailed approach may be impractical, making simpler methods more preferable in such situations.

Management Notes

Annuity Method of Valuation of Goodwill

indiafreenotesby indiafreenotes4

The Annuity Method is a refined version of the Super Profit Method. Instead of simply multiplying super profits by years’ purchase, this method considers the time value of money. Since future profits will be earned year after year, their present value should be calculated. Under this method, goodwill is the present value of super profits treated as an annuity over a certain number of years, discounted at a normal rate of return.

Formula:

Goodwill = Super Profit × Present Value of Annuity Factor (PVAF)

Where:

  • Super Profit = Average Profit – Normal Profit

  • PVAF = Present value of ₹1 received annually for a given period, discounted at the normal rate of return

Steps

  1. Calculate Average Profit (adjust past profits).

  2. Find Normal Profit = Capital Employed × NRR ÷ 100.

  3. Compute Super Profit = Average Profit – Normal Profit.

  4. Find PVAF (from annuity tables or by formula):

5. Multiply Super Profit by PVAF to get goodwill

Advantages:

  1. Considers the time value of money, making valuation more realistic.

  2. More accurate than simple or super profit methods.

  3. Fair representation of goodwill when profits are expected to be earned over a definite period.

Limitations:

  1. Requires annuity tables or present value calculations, which makes it more complex.

  2. Assumes super profits will remain constant over the period, which may not always be true.

  3. Not widely used in small businesses due to complexity.

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