Tag: Issue Of Securities

Management Notes

Problems relating to Underwriting of Shares and Debentures of Companies only

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Underwriting is an agreement by a company with an underwriter to pay a commission for subscribing to or guaranteeing the subscription of shares or debentures. If the public does not subscribe fully, the underwriter is liable to subscribe for the remaining shares/debentures.

Accounting Treatment for Underwriting of Shares

A. When the Issue is Fully Subscribed:

  • Only underwriting commission is paid to the underwriter.

  • Entry:

Share Capital A/C Dr
To Share Application A/C
(On allotment of shares)

Underwriters A/C Dr
To Cash/Bank A/C
(On payment of commission)

B. When the Issue is Partially Subscribed:

  • The underwriter pays for the unsubscribed shares.

Accounting Entry:

Share Application A/C Dr (to transfer received applications)
To Share Capital A/C
To Securities Premium A/C (if any)

Underwriters A/C Dr (for shares taken by underwriter)
To Share Capital A/C
To Securities Premium A/C

C. For Commission on Underwriting:

  • Commission is calculated on shares actually underwritten.

  • Entry:

Underwriting Commission A/C Dr
To Underwriters A/c

 

Key Formulas

  1. Commission of Underwriter:

Commission = No. of shares underwritten × Rate of commission

  1. Liability of Underwriter for Unsubscribed Shares:

Liability = Unsubscribed shares × Issue price per share

Bangalore City University B.Com Notes

Corporate Accounting Bangalore City University B.Com SEP 2024-25 3rd Semester Notes

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Unit 1 [Book]
Introduction, Meaning of Underwriting VIEW
SEBI Regulations regarding Underwriting VIEW
Underwriting Commission VIEW
Types of Underwriting Firm Underwriting, Open Underwriting VIEW
Marked and Unmarked Applications VIEW
Determination of Liability in respect of Underwriting Contracts: When Shares and Debentures are Fully and Partially Underwritten, with and without firm Underwriting VIEW
Problems relating to Underwriting of Shares and Debentures of Companies only VIEW
Unit 2 [Book]
Profit Prior to Incorporation VIEW
Calculation of Sales Ratio VIEW
Time Ratio VIEW
Weighted Ratio VIEW
Treatment of Capital and Revenue Expenditure VIEW
Ascertainment of Pre-Incorporation and Post Incorporation Profits by preparing Statement of Profit and Loss VIEW
Preparation of Balance Sheet (Vertical Format) as per Schedule III of Companies Act, 2013 VIEW
Unit 3 [Book]
Meaning and Factors influencing Goodwill, Valuation of Goodwill, Circumstances under which Goodwill is Valued VIEW
Methods of Valuation of Goodwill:
Average Profit Method VIEW
Capitalization of Average Profit Method VIEW
Super Profit Method, Capitalization of Super Profit Method VIEW
Annuity Method VIEW
Unit 4 [Book]
Valuation of Shares, Meaning and Need for Valuation VIEW
Factors affecting Valuation of Shares VIEW
Methods of Valuation:
Intrinsic Value Method VIEW
Yield Method VIEW
Fair Value Method VIEW
Valuation of Preference Shares VIEW
Unit 5 [Book]
Statutory Provisions regarding Preparation of Financial Statements of Companies as per Schedule III of New Companies Act 2013 VIEW
Statutory Provisions regarding Preparation of Financial Statements of Companies as per and IND AS-1 VIEW
Treatment of Special Items:
Tax deducted at Source VIEW
Advance Payment of Tax VIEW
Provision for Tax VIEW
Depreciation VIEW
Interest on Debentures VIEW
Dividends VIEW
Rules regarding payment of dividends VIEW
Transfer to Reserves VIEW
Preparation of Statement of Profit and Loss and Balance Sheet VIEW
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

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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

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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.

Management Notes

Valuation of Preference Shares

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Preference Shares are a type of share capital that provides shareholders a preferential right over equity shareholders in two key aspects: (1) Receiving dividends at a fixed rate before equity shareholders, and (2) Repayment of capital during winding up of the company. They usually do not carry voting rights, except in special cases. Preference shares may be cumulative, non-cumulative, redeemable, or convertible. They are considered a hybrid security, combining features of both equity and debt, offering stability to investors and flexible financing to companies.

Valuation of Preference Shares:

Valuation depends on whether preference shares are irredeemable or redeemable.

A. Irredeemable Preference Shares

  • These shares have no maturity date; holders get a fixed dividend forever.

  • Value is calculated as the present value of perpetual dividends.

Formula:

Value of Irredeemable Preference Share = Annual Preference Dividend / Required Rate of Return

B. Redeemable Preference Shares

  • These shares are repayable after a fixed period (say 5 or 10 years).

  • Value is based on the present value of dividends for n years plus present value of redemption value.

Formula:

Need of  Valuation of Preference Shares:

  • Investment Decision-Making

Valuation of preference shares helps investors decide whether to buy, hold, or sell such securities. Since preference shareholders receive fixed dividends and priority over equity shareholders, knowing the fair value ensures they do not overpay or undervalue their investment. By comparing the intrinsic value with the market price, investors can judge potential returns and risks. This process builds confidence in investment decisions, especially for risk-averse investors who prefer stable returns rather than uncertain equity dividends.

  • Corporate Financing Decisions

Companies issue preference shares as a source of capital, combining features of both debt and equity. Before issuing or redeeming such shares, firms must know their value to ensure cost-effective financing. Valuation helps management compare preference shares with other funding sources like debentures or equity. It also influences dividend payout policies and redemption strategies. Thus, correct valuation ensures balanced capital structure, reduces financing costs, and maintains investor trust, which is essential for smooth business operations and long-term sustainability.

  • Regulatory and Legal Requirements

Valuation of preference shares becomes necessary during mergers, acquisitions, liquidation, or restructuring of a company. Laws and accounting standards often require that shareholders, including preference shareholders, receive fair value for their holdings. Accurate valuation ensures compliance with statutory provisions and prevents disputes among stakeholders. It also helps in calculating compensation payable to preference shareholders when the company decides to redeem or convert their shares. Thus, valuation ensures transparency, fairness, and legal compliance in corporate financial transactions and governance.

  • Redemption and Conversion Decisions

Preference shares are often redeemable after a fixed period or convertible into equity shares. In both cases, valuation plays a vital role. For redemption, it helps determine the repayment amount and its impact on company finances. For conversion, valuation ensures fair exchange ratios between preference and equity shares, avoiding shareholder conflicts. This process safeguards the interests of both the company and investors. Therefore, proper valuation ensures smooth redemption or conversion, maintains fairness, and supports effective long-term financial planning.

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