Methods for Valuing Minority Interest and Goodwill - Essay Example

METHODS FOR VALUING MINORITY INTEREST AND GOODWILL Lecturer: Introduction By the norm of business practice, there may be portions of the subsidiary’s stock that may not be owned by the parent company and thus not part of the controlling interest of the parent corporation. Such non-controlling interests are referred to as minority interest of the parent company, which is often less than 50% of outstanding shares. In several accounting contexts, the minority interest and goodwill of the company are discussed hand-in-hand due to the similarities they offer to the parent company. This is because goodwill has been explained to be intangible assets that come from the business connections or reputation of the company gained through several variables including competent management, customer acceptance, favourability of location, efficient production systems, among others (Ammar et al., 2001). The similarity here is that in both cases, the parent company does not have direct control of what the asset manoeuvring of these two but the two are reported on the consolidated balance sheet of the parent company as a means of reflecting the claim of assets to the company and other non-controlling shareholders (Chaney, Mead & Schermann, 2002). Because of the place of these two in the consolidated balance sheet of the parent company and the subsidiary, the methods that go into the valuation of these two have often been an area of interest to stakeholders. The paper discusses three methods that have been proposed as part of the valuation of minority interest and goodwill. Average Profits Method The average profit method has often been used to value the goodwill of the company as reported in the balance sheet but this calculation could be done to incorporate the minority interest as well. For example in calculating goodwill based on this method, an average profit is found with an agreed number of past years’ profits. The average is then multiplied by the agreed number of years to know the goodwill in a very simple mood (Gauthier, 2007). From the description given, Goodwill = (average profits) x (number of years of purchase) Horrigan (1968) however noted that the issue of minority interest comes in ahead of the utilisation of the formulation given above since any abnormal profits are expected to be deducted from the net profits of the various years. Again, abnormal losses are also expected to be deducted, as well as non operating incomes such as those incomes made from non-accruing investments (Sohl et al., 2009). In all three deductions, minority interest plays a major role because even though consolidated balance sheets are prepared to appear as though the parent company fully owned the partially owned subsidiaries, net income to common shareholders and common equity are excluded. In effect, average profit method is used after the effect of minority interest has been acknowledged and deducted from the resulting profit of the company. Super Profits Method Again, super profits method may be discussed as a method for valuing goodwill but in real essence, it captures the method for valuing minority interest because unless the three forms of deductions that were previously identified are applied and removed, the outcome of the super profit method will be incorrect (Tufte, 2006). To calculate the goodwill by the use of the super profits method, the profits that were made by the company above the normal profits of the company are calculated (Gauthier, 2007). In the given circumstance, normal profits can be said to be equal to the capital invested in the company multiplied by the normal rate of return divided by 100. With this normal profit known, the super profit is found by simply deducting the normal profits from the actual profit of a given period. To know the goodwill in this instance, the super profits will be multiplied by the agreed number of years of purchase. (a) Normal profits = (capital invested) x (normal rate of return)/100 (b) Super profits = (actual profits) – (normal profits) (c) Goodwill = (super profits) x (number of agreed years of purchase) From the formula given, it would be understood that once an investor wants to know the goodwill of the company in order to make any investment in it or purchase a percentage of it, the investor would require knowledge of how much of the actual profits and normal rate of return are influenced by the earnings from non-controlling interests. This way, the real goodwill of the parent company can be known. Capitalisation Methods Capitalisation may be calculated on both the average profits method and super profits method to know the goodwill of the company. At this point, it would simply be understood that due to the influence of minority interest already outlined in using the average profit method and super profits method, the capitalisation method will automatically capture the effect of the minority interest. Sohl et al. (2009) explained that in order to use the capitalisation method, the capital needed for earning either the average profits or super profits are first calculated. This capital is also known as the capitalised value of profits. To do this, the formula given below is used; Capitalised value of profits = (average profits or super profit) x (100/normal rate of return) With the capitalised value of average profits found, the capital employed, which is the difference between assets and liabilities are also calculated, after which the resulting goodwill is given as follows: Goodwill = capitalised value of profits – capital employed. When using the capitalisation method, one important area where the values for minority interests play major role in is with the capital employed. This is because as reflected in the explanation for minority interest, it is expected that the non-controlling interest of the parent company will be known and deducted before the real value of goodwill can be found. Conclusion In the running of publicly traded companies, subsidiaries are often created to serve a number of purposes, including the need to represent the parent company in the delivery of the same set of products and services that the parent company would be expected to deliver in international markets. The paper has however showed that in accounting practices, the dynamics in dealing with such subsidiaries vary greatly. This is because to know the real value of goodwill, it is important that the minority interest in any subsidiary company that is reported in the consolidated balance sheet be known and subsequently deducted before the real goodwill valuation can be made with the methods found in the paper. Ahead of the application of the methods however, the inclusion of minority interest cash flow can be justified as a means by which assets belonging to all shareholders in the company can be duly claimed. References Ammar, S., Duncombe, W., Hou, Y, Jump, B., & Wright, R. (2001). ‘Using Fuzzy Rule-Based Systems to Evaluate Overall Financial Performance of Governments: An Enhancement to the Bond Rating Process’, Public Budgeting and Finance, Vol. 21 No. 4, pp. 1-110. Chaney, B.A., Mead, D., & Schermann, K.R. (2002). ‘The New Governmental Financial Reporting Model’, The Journal of Governmental Financial Management, Vol. 51 No. 1, pp. 26-31. Gauthier, S.J. (2007). ‘Interpreting Local Government Financial Statements’, Government Finance Review, Vol. 23 No. 3, pp. 8-14. Horrigan, J.O. (1968). ‘A Short History of Financial Ratio Analysis’, The Accounting Review. Vol. 43 No. 2, pp. 284 – 294. Sohl, S., Peddle, M.T., Thurmaier,K, Wood, C.H., & Kuhn, G. (2009). ‘Measuring the Financial Position of Municipalities: Numbers Do Not Speak for Themselves’, Public Budgeting & Finance, Vol. 29 No. 3, pp. 74-96. Tufte, E. (2006). Beautiful Evidence. Cheshire: Graphics Press LLC. Read More