Valuation of Assets and Liabilities of a Company | Auditing

Some of the most frequently asked questions on valuation of assets and liabilities of a company are as follows:

Q.1. Examine the Factors that Effects the Valuation of Goodwill.

Ans. The factors affecting goodwill valua­tion are:

1. Profitability:

One who pays for goodwill looks to the future profits. The future profits which de­pend on a variety of factors (such as, nature of busi­ness, location, patents and trademarks protection, favourable markets, efficient management, etc.) in­fluence the value of goodwill.

2. General Reputation:

The image of a corpora­tion and the superiority of products or services and the continuing researches for new products and new markets have an edge over other firms belonging to the same industry ;

3. Yield:

A comparatively higher yield expected by investors in the industry to which a firm belongs attaches importance to the valuation of goodwill.

Q.2. State and Explain in brief the Methods of Valuing Goodwill.

Ans. Basically, there are two methods of valuing goodwill.

They are:

(i) Simple profit method and

(ii) Super profit method.

(i) Simple profit method:

It involves the valua­tion of goodwill on the basis of a certain number of years’ purchase of the average profits of the past few years.

Here, the average profits are subjected to the following adjustments:

(a) Expenses and losses unlikely to occur in the future are added back to profits;

(b) Expenses and losses expected to be borne in the future are deducted from profits ;

(c) Profits likely to come in the future are added; and

(d) ‘Profits unlikely to recur are deducted.

(ii) Super profit method:

Super profit represents the difference between the future maintainable prof­its of a firm and the normal profits for that firm. Here, the normal profit is ascertained in the light of normal rate of earning and the capital employed in the business.

 Thus, this method requires infor­mation regarding:

(a) the normal rate of return for the representative firms in the industry, and

(b) the fair value of capital employed.

Terms explained:

1. ‘Normal rate of earning’ is that rate which investors in general expect on their investments in the particular type of industry.

2. ‘Capital employed’ represents the aggregate of share capital and reserves less the amount of non-trading assets (such as, investments). This may also be determined by adding up the present value of trading assets and deducting all liabilities.

3. ‘Future maintainable profits’ is determined on the basis of past records after taking into con­sideration the objective factors like:

(a) past aver­age taxed earnings,

(b) projected future taxed prof­its, and

(c) adjustments of preferred rights and of subjective evaluation of other factors, like govern­ment policy, economy conditions, management’s capabilities, etc.

For the valuation of goodwill under super profit scheme, there are four methods as under:

1. ‘Purchase of super profit’ method: The for­mula is, Goodwill = Super profit x No. of years. Here, the number of years varies from firm to firm even in the same industry and is determined with reference to the probability of a business having the same rate of earnings.

2. Sliding-scale valuation of super profit: Prof. A.E. Cut forth advocates that it is generally diffi­cult to maintain the higher super profit in the future years and so super profit should be divided into 2 or 3 divisions, each division being multiplied by a different number of years’ purchase in descending order from the first division.

3. Annuity Method: The formula is:

Goodwill = Super profit X Annuity-of Re. 1 at the normal rate of return for a stated number of years.

Here, goodwill is the discounted value of the total amount calculated as per the purchase method.

4. Capitalisation method: The formula is:

Goodwill = (Estimated annual profit / Normal rate of return) X 100. This method is criticised on the ground that it puts a large value on goodwill. It can,” however, assist in proper valuation when the future maintainable profit is lower than the normal profit.

Q.3. State the circumstances that ne­cessitate the valuation of shares of a company.

Ans. The circumstances necessary for the valuation of shares of a company are:

1. Assessments under the Estate duty, Wealth tax or Gift tax Acts.

2. Formulating the schemes of amalgamation, absorption, etc.

3. Conversion of shares from one category to another; say, preference to equity.

4. Purchase of shares by company employees when they can hold shares up to their period of employment.

5. Purchase of a block of shares in another company.

6. Acquisition of internal control under a scheme of reconstruction.

The valuation of shares of a company by a valuer arises primarily when:

(i) Shares are unquoted,

(ii) Shares relate to a private limited com­pany,

(iii) Shares in large blocks are under transfer, and

(iv) The courts direct, the law requires, and the articles of association provide to this effect.

Q.4. State the factors affect­ing valuation of shares of a company.

Ans. The factors affecting valuation of shares of a company are:

(1) Assets employed and

(2) Earning capacity.

Ei­ther of the factors or both affect share valuation in the following cases:

(a) Assets form the basis for a company des­tined to be liquidated.

(b) Earning capacity constitutes the basis for the valuation of the professional firms of audi­tors, architects and engineers.

(c) Assets and earning capacity both are con­sidered for a going-concern business.

Q.5. Explain the methods used for share valuation.

Ans. There are three principal methods for share valuation.

They are:

(1) Yield on shares,

(2) Assets valua­tion, and

(3) An average of (1) and (2).

1. Yield on Shares:

The shares are valued on the basis of earnings per share multiplied by the Price Earnings Ratio (which is 100%/normal rate of re­turn).

The formula is as under:

Profit after tax ad preference dividend/No. of equity shares × PER

2. Assets Valuation:

This method basically in­volves the determination of Net Assets attributable to the ordinary shareholders. Such ‘Net assets’, thus, comprise the capital, reserves and profit attribut­able to the ordinary shareholders.

The formula is as under:

Net Assets/No. Ordinary shares = Total Assets – (Creditors + Debentures + Preference Shares)/No. of Ordinary Shares

3. Average Method:

It is a formula to bring the parties to an agreement as it takes care of both the factors. This method, however, finds favour with the government for valuing shares of investment companies for wealth tax purposes.

Q.6. Explain the different Methods of Valu­ation of (A) Current Assets, and (B) Fixed assets.

Ans. (A) Current Assets valuation:

Items of current assets:

1. Interest accrued on Investments.

2. Stores and Spare Parts

3. Stock-in-Trade

4. Loose Tools

5. Work-in-Progress

6. Sundry Debtors

7. Cash and Bank Balances

8. Marketable Securities

Methods of valuation:

1. Computation by reference to the date of acquisition/pur­chase of investments, account­ing date, etc.

2 & 3. First-in, first-out, Last- in, first-out, Average (simple or weighted), Base Stock. Standard Cost, Adjusted sell­ing price.

4. Cost of purchase or replace­ment cost.

5. First-in, first-out, Average Price, Standard Cost. In proc­ess industries, equivalent pro­duction in terms of completed units for opening or closing WIP is ascertained and valued by either of the methods above.

6. Realisable amount by col­lection in the ordinary course of business less provisions for doubtful debts and discounts allowable.

7. Book balances or realisable value. Balances held in foreign countries should be converted at the official exchange rates.

8. At cost, at market price, at lower of cost or market price.

(B) Fixed Assets:

These are valued at:

(i) Historical cost,

(ii) Replacement cost, and

(iii) Liquidation val­ues.

The first two methods are applied for a going- concern enterprise, whereas the last method is ap­plicable to a concern where earnings are non-exist­ent.

Q.7. How should the investments held by a company be valued for the purposes of its balance sheet? Discuss.

Ans. The investments held by a company may be in various forms. Generally, such investments include:

(1) Trust securities;

(2) Govt. securities;

(3) Shares, debentures, or bonds;

(4) Immovable properties; and

(5) Capital in partnership firms, etc.

For the purpose of the balance sheet of a lim­ited company, Schedule VI Part I of the Compa­nies Act, 1956 enjoins that the auditor should as­certain the aggregate amount of the company’s quoted investments, and market value. The aggre­gate amount of unquoted investments should also be disclosed.

Thus, the basic requirements are:

1. To ascertain that the investments are valued in accordance with the generally accepted account­ing principles;

2. To ensure that the valuation is consistent;

3. To see that the investments are appropriately classified and stated in the balance sheet of a com­pany.

Investments, which are acquired and held for earning income (e.g., securities, shares or deben­tures, partnership capital, etc.) should be stated in the balance sheet ‘at cost’ inclusive of cost of bro­kerage and other expenses, without any regard to their market values. But a provision may be neces­sary if the market values are lower than the cost. Where the company is in receipt of bonus shares against its investment in shares of other companies, no value is needed to be placed on the bonus shares but only the number of shares held are to be in­creased.

In case of any immovable property held as in­vestment but not used for the company’s business, normal depreciation should be provided with a view to showing the true and fair view of the profit or loss. In case of quoted shares and debentures, the current market prices can be found out from the economic journals, news papers, and the stock ex­changes. If at the balance sheet date, their market prices are abnormally below the amount shown in the books, a provision should be made for such ma­terial diminution in value.

Q.8. Under the existing law an auditor of a company can neither justify over­valuation nor under-valuation of the assets of the company? — Discuss.

Ans. The Companies Act, 1956 requires a statutory auditor to report:

(1) That the balance sheet and the Profit and Loss Account are in agreement with the books of account; and

(2) That the accounts give the information as required and give a true and fair view of:

(a) the state of affairs of the company in the case of balance sheet and

(b) the profit or loss of the company for the year in the case of the Profit and Loss Account.

Thus, we find that the valuation of different types of assets shown in the financial statements should be ‘true and fair’. That means, the accounts shown against the assets should neither be over­stated nor under-stated in order to exhibit a true and fair view of the financial position at the end of the relevant year.

For the term ‘value’, we may attach different meanings, e.g., cost (of acquisition), market value (price), liquidation value (price obtained by forced sale), replacement value, realisable value, quoted value, assessed value, etc. The pertinent question, therefore, arises as to which of these different types of ‘value’ should be accepted by an auditor for the financial statements.

The financial statements in order to be accepted as reliable, relevant, con­sistent, accurate and free from bias-must meet the requirements of law in all respects including the application of methods and procedures. The Com­pany Law relating to the accounts and audit, for the purpose of their fair presentation, necessitates that the various assets and liabilities should be meaningfully grouped and classified and their amounts be stated so as to reflect the recorded facts.

Under the existing provisions, the law requires (ex­amples given below) that:

(i) The fixed assets should be stated at cost less depreciation.

(ii) The amount added or deducted, in case of revaluation of assets, should be shown for a period of five years.

(iii) The trade investments being fixed assets should be shown at cost and the fluctua­tions in their values be ignored. But in case of substantial diminution in value, it should be disclosed. This is necessary as because the balance sheet will cease to be ‘true and fair’ if otherwise stated.

(iv) The current assets should not be shown at more than realisable amounts and the fictitious assets should be shown sepa­rately.

(v) The closing stock of stores and spares, stock-in-trade and work-in-progress should be separately classified with the mode of valuation being stated.

Q.9. Write short notes on: (i) Intangible Assets, (ii) Fictitious Assets, (iii) Con­tingent Assets, (iv) Outstanding Li­abilities, (v) Unpaid Expenses, (vi) Wasting Assets, (vii) Floating As­sets, (viii) Unrealizable Assets, and (ix) Outstanding Assets.

Ans. (i) Intangible Assets:

They refer to those assets which have no physical existence and which cannot be seen or touched. Goodwill, patents, trademarks, copyrights, tenancy rights, etc. are the ex­amples of intangible assets. The auditing aspects usually covered are: basis of valuation, fair pres­entation in the balance sheet, adequacy of amorti­zation scheme, consistency in recordings, disclo­sure practices and their adequacy etc. The values of these assets are limited by rights and benefits available to the owners.

(ii) Fictitious Assets:

They refer to these expenses which are treated as assets till they are fully written off from the future profits as per the company law provisions. Preliminary expenses, share issue ex­penses, discount on the issue of shares, deferred revenue expenditure (e.g., expenses on advertising a new product), etc. are the examples. The total expenses incurred on such assets are required to be shown in the balance sheet till they are fully writ­ten off. The auditing procedures differ according to the nature and type of expenses.

(iii) Contingent Assets:

They refer to the possible future claims or services arising from the business performances proceeding to the balance sheet date.

The examples are:

(1) An option to apply for shares in another company on favourable terms,

(2) Un­called share capital of an undertaking,

(3) Refund of Octroi paid for goods which have been sent out later on, etc.

The Companies Act does not require these assets to be disclosed for the sake of the prin­ciple of conservatism. It is argued by some experts that the prosperity of a company is not depicted in tangible terms as these assets are not shown whereas the contingent liabilities are provided in the com­pany’s balance sheet.

(iv) Outstanding Liabilities:

They refer to those liabilities which have remained unpaid on the date of the balance sheet; e.g., unearned income and unpaid expenses. Unearned income refers here to the income received in advance which is due to be earned in the next year or years. The auditing steps in this case are to examine the relevant vouchers from the perspectives of determining how much amount to be credited to the current year’s P & L A/c and how much to be carried forward which will be earned during the next year.

(v) Unpaid Expenses:

Expenses, such as rent, rates, taxes, salaries and wages, audit fees etc. which are incurred during the year but whose payments will be made in the next year are called unpaid expenses. The auditing procedures in this regard include ex­amination of vouchers, invoices, receipts, etc. with a view to ascertaining those expenses which ought to have been debited to the current year’s P & L A/c.

(vi) Wasting Assets:

Natural resources, such as those from mines, quarries, timber tracts, or oil wells, are wasting assets in the sense that they are moving toward exhaustion or extinction as they are being physically removed from the property and becoming the product to be sold. Normally, these are valued at original cost less depletion according to estimated exhaustion of such assets.

(vii) Floating Assets:

They refer to those assets which are acquired for resale or manufactured for sale or converting them into cash. The examples of these types of assets are: stock, book debts, bills receivable, semi-finished goods, etc. They are val­ued at cost (original or historical) or market price whichever is lower for disclosure in the balance sheet. The auditing procedures differ according to the asset item in particular.

(viii) Unrealizable Assets:

These refer to those as­sets as items of expenditure of capital nature, such as preliminary expenses and pre-acquisition losses, discount and commission on the issue of shares and debentures, etc., which are not realisable but have to be fully written off to the Profit and Loss Ac­count within a few years after the commencement of commercial production. Till then, these assets should be shown in the Balance Sheet of a com­pany.

(ix) Outstanding Assets:

These are sometimes called intangible assets. The examples are: income receivable, prepaid expenses, deferred revenue expenditure. The procedures of audit vary with each of these assets as their accounting treatments are different.