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Goodwill: Myths and facts

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16th Apr 2012
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Steve Collings tackles one of the topics that causes the most trouble for practitioners: when and how to measure and recognise goodwill in a client’s financial statements.

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 said:

“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. 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 (ie 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:

Cost to acquire a 75% stake

£30,000

Net assets acquired:

Share capital

£5,000

Share premium

£1,500

Reserves

£10,000

£16,500

x 75%

(£12,375)

Goodwill on acquisition

£17,625

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 assessed the useful economic life of this goodwill to be 25 years and will amortise 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 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 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 among 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?

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:

(a)        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

(b)       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 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 “superprofits”), 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

While 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.

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘The Interpretation and Application of International Standards on Auditing’ and ‘The AccountingWEB Guide to IFRS’). He is also the author of ‘IFRS For Dummies’ and was named Accounting Technician of the Year at the 2011 British Accountancy Awards.

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Replies (15)

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By carnmores
16th Apr 2012 13:26

why cant we print these

if only to pdf s

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Replying to Norma Stitz:
collings
By Steven Collings
16th Apr 2012 13:48

Printing the article

carnmores wrote:

if only to pdf s

Hi Carnmores

There is a print button at the top of the article (near to where the comment notification icon is). 

All the best

Steve

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By carnmores
16th Apr 2012 13:58

it wasnt showing earlier

thats why i asked but it is now ;-)

 

perhaps it only kicks in after a comment has been added....

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By Ayesha Bham
16th Apr 2012 14:09

To amortise or not
It's alarming that some newly qualified accountants are saying it is wrong to amortise goodwill at all. It begs the question why? I know you do not have to amortise but then you impair review but surely amortising is easier.

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collings
By Steven Collings
16th Apr 2012 14:19

@Ayesha

Hi

The majority of students studying for professional examinations are examined under international accounting standards and IFRS 3 'Business Combinations' prohibits the amortisation of purchased goodwill - instead entities reporting under the IFRS regime have to test goodwill for impairment annually, which is where some students/newly-qualified's who work in general practice might get slightly muddled up between IFRS 3 rules and FRS 10/the FRSSE rules.

The new (proposed) UK GAAP which is based on the IFRS regime, reduces the 20 year period mentioned in the article above, to 5 years.  This is particularly the case when management may not be able to make a reliable estimate of the UEL of goodwill.

Regards

Steve

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By carnmores
16th Apr 2012 16:28

i have been qualified for 30 years

and i am still confusd , shocking i know...

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By Tim Charles
17th Apr 2012 11:23

Goodwill on incorporation

Thank you for the article, however the majority of accountants using this website will only encounter goodwill on incorporation, which is not mentioned in the article.

Any comments and guidance on how to value goodwill on incorporation.

Thanks

Tim Charles

www.charlesaccountancy.com

 

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By robbieb666
17th Apr 2012 12:36

Print issues

Slightly off topic - Whenever I use the print facility at the top of the article I only seem to print the first page out - anyone else suffer with this strange affliction?

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By carnmores
17th Apr 2012 14:14

that's true
The comments don't print and that's a problem

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By KH
17th Apr 2012 14:54

Valuing Goodwill on Incorporation

Now there's a dark and arcane art for you! To get this right you have to be a fully paid up weirdo. However, a simple rule of thumb seems to work OK with HMRC ... if the business is totally tied up with the owners, such as with some restaurants, some health professionals, all sports people, etc, then there is no transferable goodwill, so goodwill is zero on incorporation.

But, if the business could be sold, then take a simple percentage of last year's net profits ... if business is run from home then about 50% to 25% or even less, whereas if the business is run from high-street premises, then maybe 100% to 300%, depending on you and your client's estimate of the value of his own personality and skills ... the more the business is dependent on the client's own personality and skills, the less the value of the goodwill.

And I fully accept that this way of valuing goodwill is nothing more than hocus pokus, but I've successfully argued this method with HMRC "special branch" in the past, sometimes me agreeing a reduction in goodwill, sometimes HMRC agreeing my guesstimate as being roughly fair.

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By squirmy
17th Apr 2012 22:16

Further info on incorporation
I would also welcome further thought on goodwill on incorporation. The article is pretty definitive in not introducing personal goodwill into a personal business and I understand HMRC opinion on not allowing amortisation of personal goodwill post incorporation but how about the impact of enabling CGT taxation as opposed to Income taxation via crediting a sizeable amount to the DLA ASSUMING that the goodwill calculation is based on realistic figures rather than tax motivated numbers? What experience of this have others had?

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By Ayesha Bham
18th Apr 2012 09:05

HMRc
To be honest when we have incorporated clients recently am investigation has been opened each time and there has been a restriction of all or part of the goodwill. I know of at least 6 other accountants that have been unsuccessful in their goodwill claims. In my case it was literally because HMRC said that goodwill cannot be transferred or sold if the business changes ownership. When we challenged it HMRC commissioners said that goodwill which we had valued properly by using calculations like p/e ratios etc could not be separated from the business and therefore couldn't be recognised. It seems like the tax treatment of goodwill may follow the accounting treatment. We tend to use multipliers and cash flow approach to value goodwill but I think HMRC tend to restrict any personal goodwill being transferred on incorporation at the very least. Well that's my experience of it when we have incorporated clients.

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By KH
18th Apr 2012 10:55

Update on my post of yesterday

I should add, in the light of Ayesha's comment, that I haven't incorporated any client with goodwill issues in the last three years, so my experience on this is all prior to 2009 ... but I had several clients with complementary medical practices who were incorporating business which they had been running as sole traders prior to 2002, and, in only one case, where the goodwill was mooted at £30k, was any one of these queried by HMRC's complex-tax-return branch in Solihull ... and in the end a goodwill of £18k was agreed for that individual, which was c.50% of one year's net profits. All of these practitioners were working from high-street clinics, and could have sold their patient lists to other practitioners, so there were genuine sale opportunities open to these clients.

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By Jonathan Mann
20th Apr 2012 15:33

Goodwill and IFRS3 .. don't forget intangibles !

Steve's comment regarding goodwill under IFRS3 omits reference to intangibles.  Unlike UK GAAP,  IFRS will usually require the separate identification and recognition of the various intangible assets (customer lists, contracts, etc) that are being acquired ... which must then be amortised, usually very quickly.  The result is that under IFRS you may well end up recognising a smaller amount of goodwill which is not being amortised (smaller because you have recognised a higher value of assets), but at the expense of higher amortisation of of intangible assets.  I have seen situations where annual amortisation of newly recognised intangibles under IFRS is greater than the equivalent amortisation of goodwill under UK GAAP.

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By Spanish
14th Jan 2015 12:38

I understand according to IFRS internally generated goodwill is not allowed but if a new shareholder buys stake in a company(that has no goodwill on it's books) , say 10% for 50k. Can goodwill be generated OF (50000*100/10=500000) and would it be acceptable to HMRC?

.

 

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