INTERMEDIATE

ACCOUNTING
TENTH CANADIAN EDITION
Kieso Weygandt Warfield Young Wiecek McConomy

CHAPTER 12
Appendix 12A
Valuing Goodwill

PREPARED BY:

Dragan Stojanovic, CA
Rotman School of Management,
University of Toronto

The Excess Earnings

Approach
A widely used method to estimate goodwill in a
business is the excess-earnings approach
Steps:
1. Calculate companys expected annual average
normalized earnings
2. Calculate annual average earnings if company
earned same return as the industry average
3. Calculate companys excess earnings
4. Estimate the value of goodwill based on excess
earnings

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Companys Average
Normalized Earnings
Given the following for Tractorling Corp.:
Identifiable net assets (FV): $ 350,000
Earnings history (20092013):
2009: $ 60,000
2010: $ 55,000
2011: $110,000
2012: $ 70,000
20013: $ 80,000
Total earnings for the five years = $375,000
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Companys Average
Normalized Earnings
Average earnings: $375,000 = $75,000
5 years
We now need to normalize the earnings for
Tractorling Corp.

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Companys Average
Normalized Earnings
Normalized earnings is representative of future
earnings
Accounting policies applied should be
consistent with that of the purchaser
Future earnings should be based on fair value
of the net assets rather than the carrying
amount of the net assets
Non-recurring amounts are adjusted out (e.g.,
extraordinary gains/losses, unusual items)
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Companys Average
Normalized Earnings
Average previous earnings
$75,000
Add:
Adjust for Inventory
$2,000
Adjust for Amortization 3,000
5,000
80,000
Less:
Gain on Discontinued
Operations (average) 5,000
Patent amortization
1,000
6,000
Expected Future Earnings
$74,000

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Average Earnings Using

Industry Average
Expected earnings without goodwill
Industry average rate of return: 15%
Fair value of net identifiable assets $350,000
Industry average rate of return

15%

Normal earnings (if no goodwill) $ 52,500

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Excess Earnings
Expected future earnings $74,000
Normal earnings
52,500
Excess earnings
$21,500

Excess earnings must now be discounted to

their present value

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Discount Rate
Higher discount rate normally used:
discounting future cash inflows that may be
riskier
higher discount rate will lower goodwill
Factors to consider when determining discount
rate:
Stability of past earnings
Speculative nature of business
General economic conditions
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Discount Period
Discount period based on:
Professional judgement
Estimation of how long the excess earnings
are expected to last

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10

Value of GoodwillExcess-Earnings Approach

Rate of return required by purchaser = 15%
Discount period = perpetuity
Expected earnings
= $74,000
Normal return
= $52,500
Excess earnings
= $21,500
Goodwill = $ 21,500 0.15 = $143,333

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11

Total-Earnings Approach
Total-earnings approach is an alternative
approach to estimating goodwill
The value of the company as a whole is
determined based on total expected earnings
Fair value of identifiable net assets deducted
from the value of the company
Difference is goodwill

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12

Total-Earnings Approach
Goodwill = Fair value of Company
Fair value of identifiable net assets
FV of Co. = $74,000 0.15 = $ 493,333
FV of identifiable net assets
Goodwill
$ 143,333

350,000

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Other Valuation Methods

Number of Years Method
Excess earnings multiplied by the number of
years excess earnings expected to last
Advantage: simple
Disadvantage: does not consider time value
of money

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Other Valuation Methods

Discounted Free Cash Flow Method
Project the free cash flow over a 1020 year
period
Free cash flow: that amount of cash from
operations in excess of what is needed to
maintain existing capacity
Discount this amount
Result is the value of the business

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