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Thursday, October 28, 2010

Calculating and Recording Goodwill



JOIN KHALID AZIZ

CRASH CLASSES ICMAP STAGE 1 & 2......B.COM 1 & 2
FRESH CLASSES ICAP MODULE B & D, MA-ECONOMICS
GUESS PAPERS OF B.COM AVAILABLE NOW.



A purchaser may attempt to forecast the future income of a target company in order to arrive at a logical purchase price. Goodwill is often, at least in part, a payment for above-normal expected future earnings. A forecast of future income may start by projecting recent years’ incomes into the future. When this is done, it is important to factor out “one-time” occurrences that will not likely recur in the near future. Examples would include the cumulative effect of changes in accounting principles, extraordinary items, discontinued operations, or any other unusual event.

Expected future income is compared to “normal” income. Normal income is the product of the appropriate industry rate of return on assets times the fair value of the gross assets (no deduction for liabilities) of the acquired company. Gross assets include specifically identifiable intangible assets such as patents and copyrights but do not include existing goodwill. The following calculation of earnings in excess of normal:

Expected average future income = $40,000

Less normal return on assets:
Fair value of total identifiable assets = $345,000
Industry normal rate of return = 10%
——– (x)

Normal return on assets = (34,500)

——-
Expected annual earnings in excess of normal = $ 5,500



There are several methods that use the expected annual earnings in excess of normal to estimate goodwill. A common approach is to pay for a given number of year’s excess earnings. For instance: Acquisitions Inc. might offer to pay for four years of excess earnings, which would total $22,000. Alternatively, the excess earnings could be viewed as an annuity. The most optimistic purchaser might expect the excess earnings to continue forever. If so, the buyer might capitalize the excess earnings as a perpetuity at the normal industry rate of return according to the following formula:

Goodwill:

Annual Excess Earning
——————————————-
Industry Normal Rate Of Return

$5,500/0.10 = $ 55,000



Another estimation method views the factors that produce excess earnings to be of limited duration, such as 10 years, for example. This purchaser would calculate goodwill as follows:

Goodwill = Discounted present value of a $5,500-per-year annuity for 10 years at 10%

= $5,500 x 10-year, 10% present value of annuity factor
= $5,500 x 6.145
= $33,798



Other analysts view the normal industry earning rate to be appropriate only for identifiable assets and not goodwill. Thus, they might capitalize excess earnings at a higher rate of return to reflect the higher risk inherent in goodwill.

All calculations of goodwill are only estimates used to assist in the determination of the price to be paid for a company. For example, Acquisitions might add the $33,798 estimate of goodwill to the $319,000 fair value of Royal Bali’s other net assets to arrive at a tentative maximum price of $352,798. However, estimates of goodwill may differ from actual negotiated goodwill. If the final agreed-upon price for Royal Bali’s assets was $350,000, the actual negotiated goodwill would be $31,000, which is the price paid less the fair value of the net assets acquired.

Question: Can you have negative goodwill, that is in the case of a bargain purchase where the acquisition price is less than the net book value of the assets. Example Total net asset value = $20mm Capital contrib - $17mm then negative goodwill of $3mm ?

Answer:You just picked a perfect example on how a negative goodwill arisen. That is common happened on business acquisitions. However, the term “negative goodwill” has been dropped from the standard, instead, it is described as the “excess of the acquirer’s interest in the net fair value of the acquiree’s identifiable assets, liabilities, and contingent liabilities over the cost” (IFRS 3, Business Combinations, 6.Goodwill). It does not mean that negative goodwill is prohibited. If it appears that negative goodwill has arisen, it must be recognized immediately in profit or loss (income statement). However, it is worth mentioning here; the IFRS assumes that negative goodwill would arise only in exceptional circumstances. Therefore, before determining that negative goodwill has arisen, the acquirer has to reassess the identification and measurement of the net assets and contingent liabilities acquired and also to look at the measurement of the cost of the business combination.

The Standard says that any negative goodwill recognized would probably be the result of one of these factors:

• Potential errors in the measurement of the fair value of either the cost of the business combination or the identifiable assets, liabilities, or contingent liabilities
• A requirement in an accounting standard to measure the net assets at an amount that is not fair value; for example, deferred taxation and balances recognized on acquisition will not be discounted
• It is a genuine bargain [added: of business] purchase.

Thursday, October 21, 2010

Perpetual vs. Periodic Inventory System Journal Entries

CRASH CLASSES ICMAP STAGE 1 & 2....B.COM 1 & 2
JOIN KHALID AZIZ
0322-3385752
KARACHI


A. The Sale and Purchase of Products

Perpetual inventory systems show all changes in inventory in the "Inventory" account. Purchase accounts are not used in a perpetual inventory system.


Periodic inventory systems keep the inventory balance at the same value that it was at the beginning of the year. At year end, the inventory balance is adjusted to a physical count. To account for inventory purchases in a periodic inventory system, an account called "Purchases" is used rather than debiting "Inventory".

Example: (Unit cost is held constant to avoid the necessity of a using
a cost flow assumption)

Beginning inventory 100 units @ $6 = $ 600
Purchases 900 units @ $6 = $5,400
Sales 600 units @ $12 = $7,200
Ending inventory 400 units @ $6 = $2,400


Perpetual Inventory System | Periodic Inventory System
----------------------------------------------------------------------
1. Beginning inventory 100 units at $600
----------------------------------------------------------------------
Inventory account shows | Inventory account shows
$600 in inventory. | $600 in inventory.
----------------------------------------------------------------------
2. Purchase of 900 units at $6 per unit
----------------------------------------------------------------------
Inventory 5,400 | Purchases 5,400
Acc. Payable 5,400| Acc. Payable 5,400
----------------------------------------------------------------------
3. Sale of 600 units at a selling price of $12 per unit
----------------------------------------------------------------------
Acc. Receivable 7,200 | Acc. Receivable 7,200
Sales 7,200| Sales 7,200
|
Cost of Goods Sold 3,600 | No entry
Inventory 3,600|
----------------------------------------------------------------------
4. End-of-period entry for inventory adjustment
----------------------------------------------------------------------
No entry needed. | Inventory 1,800
The ending balance of inventory | Cost of Goods Sold 3,600
shows $2,400. | Purchases 5,400
----------------------------------------------------------------------
Note: The periodic inventory adjustment in transaction 4 adjusts
inventory to the physical count, closes out any purchase accounts,
and runs any difference through cost of goods sold.


B. Cost of Goods Sold in a Periodic Inventory System

Perpetual inventory systems record cost of goods sold and keep inventory at its current balance throughout the year. Therefore, there is no need to do a year-end inventory adjustment unless the perpetual records disagree with the inventory count. In addition, a separate cost of goods sold calculation is unnecessary since cost of goods sold is recorded whenever inventory is sold.


The inventory account in a periodic inventory system keeps its beginning balance until the end of period adjustment to the physical inventory count. Therefore, a separate cost of goods sold calculation is necessary. The following calculation shows the calculation for the preceding example.

Beginning Inventory 600
Net Purchases 5,400
-------
Goods Available for Sale 6,000
Ending Inventory 2,400
-------
Cost of Goods Sold 3,600
=======

C. Purchase Returns and Allowances and Purchase Discounts

"Purchases" has a normal debit balance since it replaces the debit to "Inventory". It has two contra accounts known as "Purchase Discounts" (Purch. Disc.) and "Purchase Returns and Allowances" (Purch. R&A) that reduce it to determine "Net Purchases". The balance of these two contra accounts is a credit because "Purchases" is a debit. Remember that contra accounts always have a normal balance that is opposite to what they are contra to. Purchase-type accounts are temporary accounts (i.e., they are closed at year end) and only appear in a periodic inventory system. They simply serve to replace the corresponding inventory portion of an entry that exists in a perpetual inventory system. The following entries illustrate purchase returns and discounts in perpetual and periodic inventory systems:


Perpetual Inventory System | Periodic Inventory System
-----------------------------------------------------------------------
1. Ace Company returned $600 of damaged merchandise and received a
price reduction allowance of $100 on the portion of the merchandise
they retained.
-----------------------------------------------------------------------
Acc. Payable 700 | Acc. Payable 700
Inventory 700 | Purch. R&A 700
-----------------------------------------------------------------------
2. In a previous transaction, Ace purchased merchandise on account at
a cost of $1,000. The credit terms were 2/10, n/30. Ace paid for
the merchandise within the discount period.
-----------------------------------------------------------------------
Acc. Payable 1,000 | Acc. Payable 1,000
Inventory 20 | Purch. Disc. 20
Cash 980 | Cash 980
-----------------------------------------------------------------------


D. Sales Returns and Allowances and Sales Discounts

Sales has two contra accounts known as "Sales Discounts" (Sales Disc.) and "Sales Returns and Allowances" (Sales R&A) that reduce it. The normal balance for these two contra accounts is a debit. Sales and its contra accounts may appear with either a perpetual or periodic inventory system. The following entries illustrate the accounts in perpetual and periodic inventory systems. The entries assume the gross method.


Perpetual Inventory System | Periodic Inventory System
-----------------------------------------------------------------------
1. Sam Company received $600 of damaged merchandise from their customer
Ace. They also gave Ace a $100 allowance for some of the damaged
merchandise that Ace retained. The original cost of the merchandise
returned to Sam was $400.
-----------------------------------------------------------------------
Sales R&A 700 | Sales R&A 700
Acc. Receivable 700 | Acc. Receivable 700
|
Inventory 400 | No entry
Cost of Goods Sold 400 |
-----------------------------------------------------------------------
2. Sam received a customer payment for a prior sale on account of $1,000
subject to credit terms of 2/10, n/30. The customer made payment
within the discount period.
-----------------------------------------------------------------------
Cash 980 | Cash 980
Sales Disc. 20 | Sales Disc. 20
Acc. Receivable 1,000| Acc. Receivable 1,000
-----------------------------------------------------------------------


Sales on the income statement should be shown net of its contra accounts. For example, if a company has $980,000 in sales, $3,400 in sales returns and allowances, and $2,200 in sales discounts; net sales would be $974,400.

Wednesday, October 20, 2010

Measures of national income and output

A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), gross national product (GNP), and net national income (NNI). All are specially concerned with counting the total amount of goods and services produced within some "boundary". The boundary may be defined geographically, or by citizenship; and limits on the type of activity also form part of the conceptual boundary; for instance, these measures are for the most part limited to counting goods and services that are exchanged for money: production not for sale but for barter, for one's own personal use, or for one's family, is largely left out of these measures, although some attempts are made to include some of those kinds of production by imputing monetary values to them. Mr Ian Davies defines development as 'Simply how happy and free the citizens of that country feel.'

National accounts

Arriving at a figure for the total production of goods and services in a large region like a country entails a large amount of data-collection and calculation. Although some attempts were made to estimate national incomes as long ago as the 17th century,[2] the systematic keeping of national accounts, of which these figures are a part, only began in the 1930s, in the United States and some European countries. The impetus for that major statistical effort was the Great Depression and the rise of Keynesian economics, which prescribed a greater role for the government in managing an economy, and made it necessary for governments to obtain accurate information so that their interventions into the economy could proceed as much as possible from a basis of fact.

Market value

Main article: Market value
In order to count a good or service it is necessary to assign some value to it. The value that the measures of national income and output assign to a good or service is its market value – the price it fetches when bought or sold. The actual usefulness of a product (its use-value) is not measured – assuming the use-value to be any different from its market value.

Three strategies have been used to obtain the market values of all the goods and services produced: the product (or output) method, the expenditure method, and the income method. The product method looks at the economy on an industry-by-industry basis. The total output of the economy is the sum of the outputs of every industry. However, since an output of one industry may be used by another industry and become part of the output of that second industry, to avoid counting the item twice we use, not the value output by each industry, but the value-added; that is, the difference between the value of what it puts out and what it takes in. The total value produced by the economy is the sum of the values-added by every industry.

The expenditure method is based on the idea that all products are bought by somebody or some organisation. Therefore we sum up the total amount of money people and organisations spend in buying things. This amount must equal the value of everything produced. Usually expenditures by private individuals, expenditures by businesses, and expenditures by government are calculated separately and then summed to give the total expenditure. Also, a correction term must be introduced to account for imports and exports outside the boundary.

The income method works by summing the incomes of all producers within the boundary. Since what they are paid is just the market value of their product, their total income must be the total value of the product. Wages, proprieter's incomes, and corporate profits are the major subdivisions of income.

The output approach The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces.

Because of the complication of the multiple stages in the production of a good or service, only the final value of a good or service is included in total output. This avoids an issue often called 'double counting', wherein the total value of a good is included several times in national output, by counting it repeatedly in several stages of production. In the example of meat production, the value of the good from the farm may be $10, then $30 from the butchers, and then $60 from the supermarket. The value that should be included in final national output should be $60, not the sum of all those numbers, $100. The values added at each stage of production over the previous stage are respectively $10, $20, and $30. Their sum gives an alternative way of calculating the value of final output.

Formulae:

GDP(gross domestic product) at market price = value of output in an economy in a particular year - intermediate consumption

NNP at factor cost = GDP at market price - depreciation + NFIA (net factor income from abroad) - net indirect taxes[3]

[edit] The income approach
The income approach focuses on finding the total output of a nation by finding the total income received by the factors of production owned by that nation.

The main types of income that are inclhose who provide the natural resources), interest (the money paid for the use of man-made resources, such as machines used in production), and profit (the money gained by the entrepreneur - the businessman who combines these resources to produce a good or service).

Formulae:

NDP at factor cost = compensation of employee + operating surplus + mixed income of self employee

National income = NDP at factor cost + NFIA (net factor income from abroad) - Depreciation

[edit] The expenditure approach
The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent. This is acceptable, because like income, the total value of all goods is equal to the total amount of money spent on goods. The basic formula for domestic output combines all the different areas in which money is spent within the region, and then combining them to find the total output.

GDP = C + I + G + (X - M)
Where:
C = household consumption expenditures / personal consumption expenditures
I = gross private domestic investment
G = government consumption and gross investment expenditures
X = gross exports of goods and services
M = gross imports of goods and services

Note: (X - M) is often written as XN, which stands for "net exports"




Names

The names of the measures consist of one of the words "Gross" or "Net", followed by one of the words "National" or "Domestic", followed by one of the words "Product", "Income", or "Expenditure". All of these terms can be explained separately.

"Gross" means total product, regardless of the use to which it is subsequently put.
"Net" means "Gross" minus the amount that must be used to offset depreciation – ie., wear-and-tear or obsolescence of the nation's fixed capital assets. "Net" gives an indication of how much product is actually available for consumption or new investment.
"Domestic" means the boundary is geographical: we are counting all goods and services produced within the country's borders, regardless of by whom.
"National" means the boundary is defined by citizenship (nationality). We count all goods and services produced by the nationals of the country (or businesses owned by them) regardless of where that production physically takes place.
The output of a French-owned cotton factory in Senegal counts as part of the Domestic figures for Senegal, but the National figures of France.
"Product", "Income", and "Expenditure" refer to the three counting methodologies explained earlier: the product, income, and expenditure approaches. However the terms are used loosely.
"Product" is the general term, often used when any of the three approaches was actually used. Sometimes the word "Product" is used and then some additional symbol or phrase to indicate the methodology; so, for instance, we get "Gross Domestic Product by income", "GDP (income)", "GDP(I)", and similar constructions.
"Income" specifically means that the income approach was used.
"Expenditure" specifically means that the expenditure approach was used.
Note that all three counting methods should in theory give the same final figure. However, in practice minor differences are obtained from the three methods for several reasons, including changes in inventory levels and errors in the statistics. One problem for instance is that goods in inventory have been produced (therefore included in Product), but not yet sold (therefore not yet included in Expenditure). Similar timing issues can also cause a slight discrepancy between the value of goods produced (Product) and the payments to the factors that produced the goods (Income), particularly if inputs are purchased on credit, and also because wages are collected often after a period of production.

GDP and GNP

Main articles: GDP and GNP
Gross domestic product (GDP) is defined as "the value of all final goods and services produced in a country in 1 year".[4]

Gross National Product (GNP) is defined as "the market value of all goods and services produced in one year by labour and property supplied by the residents of a country."[5]

As an example, the table below shows some GDP and GNP, and NNI data for the United States:[6]

National income and output (Billions of dollars) Period Ending 2003
Gross national product 11,063.3
Net U.S. income receipts from rest of the world 55.2
U.S. income receipts 329.1
U.S. income payments -273.9
Gross domestic product 11,008.1
Private consumption of fixed capital 1,135.9
Government consumption of fixed capital 218.1
Statistical discrepancy 25.6
National Income 9,679.7
NDP: Net domestic product is defined as "gross domestic product (GDP) minus depreciation of capital",[7] similar to NNP.
GDP per capita: Gross domestic product per capita is the mean value of the output produced per person, which is also the mean income.

National income and welfare

GDP per capita (per person) is often used as a measure of a person's welfare. Countries with higher GDP may be more likely to also score highly on other measures of welfare, such as life expectancy. However, there are serious limitations to the usefulness of GDP as a measure of welfare:

Measures of GDP typically exclude unpaid economic activity, most importantly domestic work such as childcare. This leads to distortions; for example, a paid nanny's income contributes to GDP, but an unpaid parent's time spent caring for children will not, even though they are both carrying out the same economic activity.
GDP takes no account of the inputs used to produce the output. For example, if everyone worked for twice the number of hours, then GDP might roughly double, but this does not necessarily mean that workers are better off as they would have less leisure time. Similarly, the impact of economic activity on the environment is not measured in calculating GDP.
Comparison of GDP from one country to another may be distorted by movements in exchange rates. Measuring national income at purchasing power parity may overcome this problem at the risk of overvaluing basic goods and services, for example subsistence farming.
GDP does not measure factors that affect quality of life, such as the quality of the environment (as distinct from the input value) and security from crime. This leads to distortions - for example, spending on cleaning up an oil spill is included in GDP, but the negative impact of the spill on well-being (e.g. loss of clean beaches) is not measured.
GDP is the mean (average) wealth rather than median (middle-point) wealth. Countries with a skewed income distribution may have a relatively high per-capita GDP while the majority of its citizens have a relatively low level of income, due to concentration of wealth in the hands of a small fraction of the population. See Gini coefficient.
Because of this, other measures of welfare such as the Human Development Index (HDI), Index of Sustainable Economic Welfare (ISEW), Genuine Progress Indicator (GPI), gross national happiness (GNH), and sustainable national income (SNI) are used.

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