Goodwill: Myths and Facts

The issue surrounding the recognition of goodwill on a company’s balance sheet seems to crop up quite a lot in practice, with many practitioners unsure when, and how, goodwill should be both recognised and measured within a client’s financial statements.  This article aims to clarify some of the ambiguities connected with goodwill and the way it should be recognised and subsequently measured within a client’s financial statements.

Defining goodwill

The accounting standard which governs the recognition and measurement of goodwill is that of FRS 10 Goodwill and intangible assets.  FRS 10 recognises two particular types of goodwill: that of purchased goodwill and that of internally generated goodwill.  FRS 10 defines purchased goodwill as:

The difference between the cost of an acquired entity and the aggregate of the fair value of that entity’s identifiable assets and liabilities. 

In the case of Re Commissioners of the Inland Revenue vs Muller & Co Margarine (1901), Lord MacNaghten asked ‘what is goodwill?’ and then went onto to say that:

‘it is a thing very easy to describe, very difficult to define.  It is the benefit and advantage of the good name, reputation and connection of the business.  It is the attractive force which brings in custom.  It is the one thing which distinguishes an old established business from a new business at its first start.’

Valuing goodwill

The concept of goodwill brings with it a host of complexities and ambiguities.  If we look to the provisions in FRS 10, paragraph 7 says that ‘positive’ ‘purchased’ goodwill should be capitalised and classified as an asset on the balance sheet.  Paragraph 7 is referring to instances when a business combination takes place (i.e. a parent company acquires a subsidiary).  In these cases the valuation of goodwill is fairly easy to calculate as demonstrated as follows:

Figure 1

On 1 January 2012, Company A Ltd acquired a 75% stake in the net assets of Company B Ltd.  Extracts from Company B’s financial statements at that date are as follows:

Share capital               £5,000

Share premium           £1,500

Reserves                      £10,000

Company A Ltd paid £30,000 for a 75% stake.  Goodwill is calculated as follows:

The goodwill of £17,625 will be amortised over its expected useful economic life. FRS 10 does contain a rebuttable presumption that the useful economic life of purchased goodwill (as well as other intangible assets) is limited to 20 years or less. FRS 10 recognises two instances where the 20-year presumption can be rebutted:

(a)        the durability of the acquired business or intangible asset can be demonstrated and justifies estimating the useful economic life to exceed 20 years; and

(b)        the goodwill or intangible asset is capable of continued measurement (so that annual impairment reviews will be feasible).

FRS 10 acknowledges that in many cases, the useful economic life of goodwill will normally be uncertain, but also acknowledges that such uncertainty does not form grounds for using a default period of 20 years, or assuming that the goodwill’s useful life is indefinite.  Management must make an estimate of the goodwill’s useful economic life where it is expected to be less than 20 years.  Management must also be able to justify useful economic lives when these are deemed to be in excess of 20 years.

Figure 2

A parent company has goodwill in the consolidated financial statements amounting to £100,000 which relates to a single acquisition of a subsidiary in which the parent owns 100% of the net assets.  Management have assessed the useful economic life of this goodwill to be 25 years and are amortising over this lifespan.

FRS 10 at paragraph 37 says that when the useful economic life is deemed to exceed 20 years from the date of acquisition, the goodwill should be reviewed for impairment at the end of each reporting period (note, paragraph 37 also applies to goodwill and intangible assets which are not being amortised).

Figure 3

A parent company has goodwill in the consolidated financial statements amounting to £120,000 which also related to a single acquisition of a subsidiary in which the parent owns 100% of the net assets.  On 1 January 2011 (the date of acquisition), management deemed this useful economic life to be 15 years.  On 1 January 2012, management revised its estimate of the useful economic life of goodwill to 30 years.

On the basis that management have got credible information to support the increase in the goodwill’s useful economic life, management will amortise the carrying value as at the date of the revision over the revised remaining useful economic life, but they must also comply with paragraph 37 to FRS 10 and undertake an impairment review at the end of each reporting period.  Had the situation been the reverse (i.e. that the goodwill was previously assessed as having a useful economic life of 30 years, but now management have revised down their estimate to 15 years), then this would not eliminate the need for an impairment review.  Paragraph 34 to FRS 10 requires that where goodwill is amortised over a finite period, not exceeding 20 years from the date of acquisition, management should review goodwill for impairment:

(a)        at the end of the first full financial year following the acquisition; and

(b)        in other periods if events or changes in circumstances indicate that the carrying values may not be recovered.

Figure 4

A parent has purchased goodwill in the consolidated financial statements.  On 31 December 2011 management had assessed the goodwill’s useful economic life to be indefinite and carried out an impairment review which revealed that the goodwill attributable to the purchase of the subsidiary was not impaired.  However, during the year to 31 December 2012, the subsidiary’s profitability declined to the extent that management have carried out a review of the goodwill’s useful economic life and have determined that the useful life is now only realistically 10 years.  The issue here is whether this would trigger a change in accounting policy, which would then result in a consequential prior year adjustment.

UITF Abstract 27 Revisions to estimates of the useful economic life of goodwill and intangible assets says that in such cases, a decision not to rebut the 20-year presumption is not a change in accounting policy, but instead is a change in the way in which the goodwill’s useful economic life is estimated.  This is because FRS 10 does not allow a choice of accounting policy – goodwill must be amortised unless the useful economic life of the goodwill is indefinite.  Instead, FRS 10 allows two choices in respect of estimating useful economic lives (one of estimating useful economic lives and another more prudent one), hence such a situation in Figure 4 would be a change in estimation, therefore no prior year adjustment would be required and the revised estimate of the goodwill’s useful economic life would be applied going forward.

Internally generated goodwill

The issue of ‘internally generated goodwill’ does cause confusion amongst accountants.  Many clients would view a successful business as containing an element of goodwill, as cited by Lord MacNaghten earlier in the article.  Where internally generated goodwill is concerned, FRS 10 is explicit on this point at paragraph 8 – such internally generated goodwill cannot be capitalised.  Why is this the case then?

It is very difficult to place a value on internally generated goodwill, primarily because no active market exists for such goodwill.  The Statement of Principles at Chapter 5 requires that an asset (and a liability also) can only be recognised in the financial statements if:

• sufficient evidence exists that the new asset or liability has been created or that there has been an addition to an existing asset or liability; and

• the new asset or liability or the addition to the existing asset or liability can be measured at a monetary amount with sufficient reliability.

Notwithstanding the fact that some clients may view internally generated goodwill as an asset, and have evidence that such internally generated goodwill exists (for example a client earning profits over and above the usual return on the money invested in a business – often coined ‘super profits’), clients will often fall foul of point (b) which requires a reliable monetary estimate being attributable to such goodwill in order to meet the recognition criteria.  For this reason, internally generated goodwill can never be recognised on the balance sheet.

Figure 5

Gabriella runs an English/Italian restaurant in a vibrant city centre location.  Over recent years the restaurant has received 5-star ratings because of the high quality food it serves to customers and always receives glowing reports in the local newspapers.  It is considered to be one of the most popular restaurants within the city centre and it is often fully-booked, with customers sometimes having to book months in advance for events such as Christmas parties and weddings.  Gabriella has asked her accountant to value the goodwill of the business because she feels that this can quite easily be included on the balance sheet.

The problem in this scenario is that the goodwill cannot be separated, in other words, it is simply not capable of being sold or transferred if the business were to change hands. When the business is sold, the chances are that the goodwill will die with the change of ownership.  There would also be no active market in which Gabriella could obtain a market value for such internally generated goodwill.

Conclusion

Whilst it is undeniable that many businesses will have an element of goodwill attached to them, in a lot of cases this goodwill is internally generated and therefore prohibited from being recognised on the balance sheet.  Purchased goodwill is permissible, but when the useful economic life of purchased goodwill is deemed to exceed 20 years, it is necessary to undertake an annual impairment review also.

Category: Accounting and standards, Audit