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.
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.”
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:
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:
Company A Ltd paid £30,000 for a 75% stake. Goodwill is calculated as follows:
Cost acquire a 75% stake
Net assets acquired:
Goodwill on acquisition
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.
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.