Unit 2: Audit types and valuation
Corporate Accounting and Auditing notes · PTU syllabus (MCOP403-18)
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Unit summary
Audits come in many forms — financial, cost, management, internal and public sector — and auditors often value businesses and shares. This unit covers the concept and rationale of financial audit, cost audit, management audit, internal audit, proprietary audit, efficiency audit and C&AG audit, valuation of goodwill (super profit, annuity, capitalisation) and valuation of shares (book value and earnings approaches).
After this unit you can
- Explain the concept and rationale of financial audit
- Distinguish cost, management, internal, proprietary, efficiency and C&AG audits
- Value goodwill by super profit, annuity and capitalisation methods
- Value shares by book value and earnings approaches
PTU syllabus topics
- Concept and rationale of financial audit
- cost audit
- management audit
- internal audit
- proprietary audit
- efficiency audit and audit by the C&AG
- valuation of goodwill (super profit, annuity, capitalization approaches)
- valuation of shares (book value, earnings approach)
Super profit
Average profit − normal profit
Goodwill (super profit)
Super profit × number of years' purchase
Goodwill (capitalisation)
(Average profit / normal rate × 100) − net assets
Share value (net assets)
Net assets for equity / number of shares
Share value (yield)
(Expected rate / normal rate) × paid-up value
Topic 1
Financial audit: concept and rationale
Audit is an independent examination of financial information of an entity, with a view to expressing an opinion on whether the financial statements give a true and fair view (ICAI).
- Objectives: primary — express an opinion; secondary — detect and prevent errors and frauds.
- Rationale: separation of ownership and management, credibility for investors and lenders, statutory requirement, tax and regulatory reliance, deterrent to fraud.
- Standards on Auditing (SAs) issued by ICAI and notified/recognised; NFRA oversees audit quality of listed and large companies.
Topic 2
Types of audit
| Audit | Focus | By whom |
|---|---|---|
| Cost audit | Verification of cost records and cost accounting principles (Section 148) | Cost accountant |
| Management audit | Effectiveness of management functions and policies | Management auditors/consultants |
| Internal audit | Continuous review of internal controls, risk and operations (Section 138) | Internal auditor (employee or external firm) |
| Proprietary audit | Propriety of executive decisions — whether expenditure is wise, economical and in public interest | C&AG (government); boards |
| Efficiency (performance) audit | Whether resources are used efficiently to achieve objectives (value for money) | C&AG, internal auditors |
| C&AG audit | Audit of government departments and government companies (Article 148–151; CAG Act 1971) | Comptroller and Auditor General of India |
- C&AG in government companies: appoints statutory auditors, conducts supplementary/test audits, comments on accounts placed before Parliament or legislatures.
Topic 3
Valuation of goodwill
Goodwill is the value of a firm's reputation and the ability to earn more than normal profits.
Average profit method
Average profit × Number of years' purchase
Super profit method
Super profit × Number of years' purchase; super profit = Average profit − Normal profit
Normal profit
Capital employed × Normal rate of return
Capitalisation of average profit
(Average profit × 100 ÷ Normal rate) − Capital employed
Capitalisation of super profit
Super profit × 100 ÷ Normal rate
Annuity method
Super profit × Present value of annuity factor
Example
Capital employed ₹10,00,000; normal rate 10%; average profit ₹1,40,000. Normal profit = ₹1,00,000; super profit = ₹40,000. Goodwill at 3 years' purchase = ₹1,20,000; by capitalising super profit = 40,000 × 100 ÷ 10 = ₹4,00,000.
- Adjustments to profits: remove abnormal gains/losses and non-operating income; adjust for under/over-valuation of assets; deduct management remuneration if not charged; consider future tax.
Goodwill
Super profit × Present value of annuity of ₹1 for n years at the normal rate
Example
Super profit ₹40,000 for 5 years at 10% (annuity factor 3.791): goodwill = ₹1,51,640.
Topic 4
Valuation of shares
Net assets (intrinsic value) method
(Net assets available for equity shareholders) ÷ Number of equity shares
Yield method
(Expected rate of return ÷ Normal rate of return) × Paid-up value
Fair value method
(Intrinsic value + Yield value) ÷ 2
Earnings (capitalisation) method
EPS × P/E ratio or Profit ÷ Capitalisation rate
Example
Net assets ₹12,00,000 (including goodwill, after paying liabilities and preference capital); 1,00,000 equity shares of ₹10. Intrinsic value = ₹12. Expected dividend 15% vs normal 12%: yield value = 15 ÷ 12 × 10 = ₹12.50. Fair value = (12 + 12.50) ÷ 2 = ₹12.25.
- Need for valuation: amalgamation and takeovers, unquoted shares, wealth/gift tax (historical), loans against shares, ESOP pricing, dissenting shareholders.
- Book value per share = Net worth (equity share capital + reserves − fictitious assets) ÷ Number of equity shares.
- Earnings approach = EPS × appropriate P/E ratio, or (expected rate of earnings ÷ normal rate) × paid-up value.
Key terms
- Audit
- Independent examination to express an opinion on financial statements
- Internal audit
- Continuous review of internal controls and operations
- Proprietary audit
- Audit of the propriety of decisions and expenditure
- Efficiency audit
- Audit of economy and efficiency of resource use
- Annuity method
- Goodwill as present value of super profits
Quick revision
- Financial audit: true and fair view; SAs; NFRA.
- Cost, management, internal, proprietary, efficiency, C&AG audits.
- Goodwill: average profit, super profit, annuity, capitalisation.
- Shares: book value, earnings (yield), fair value.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.Define audit.
- Q2.Distinguish internal and statutory audit.
- Q3.What is a proprietary audit?
- Q4.What is the role of the C&AG in government companies?
- Q5.How is goodwill valued under the annuity method?
- Q6.What is book value per share?
Long-answer questions
- Q1.Explain the concept, objectives and rationale of financial audit.
- Q2.Explain the various types of audit.
- Q3.Explain the methods of valuation of goodwill.
- Q4.Explain the methods of valuation of shares.
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