Goodwill: Myths and facts

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 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.

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. 

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.

   
   
   
   
   
   
   
   

 

Continued...

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Comments
carnmores's picture

why cant we print these

carnmores | | Permalink

if only to pdf s

Steve Collings's picture

Printing the article

Steve Collings | | Permalink

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

carnmores's picture

it wasnt showing earlier

carnmores | | Permalink

thats why i asked but it is now ;-)

 

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

To amortise or not

Ayesha Bham | | Permalink

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.

Steve Collings's picture

@Ayesha

Steve Collings | | Permalink

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

carnmores's picture

i have been qualified for 30 years

carnmores | | Permalink

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

tim@charlesaccountancy.com's picture

Goodwill on incorporation    1 thanks

tim@charlesacco... | | Permalink

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

 

Print issues

robbieb666 | | Permalink

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?

carnmores's picture

that's true

carnmores | | Permalink

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

KH's picture

Valuing Goodwill on Incorporation

KH | | Permalink

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.

Further info on incorporation

squirmy | | Permalink

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?

HMRc    1 thanks

Ayesha Bham | | Permalink

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.

KH's picture

Update on my post of yesterday    1 thanks

KH | | Permalink

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.

Goodwill and IFRS3 .. don't forget intangibles !

Jonathan Mann | | Permalink

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.