The rights and wrongs of goodwill
Steve Collings examines some of the common problems accountants experience in respect of goodwill and clarifies some of the points they need to consider.
Goodwill is probably one of the most subjective issues in financial reporting and generates a lot of debate and questions in accountancy update courses when it is being discussed.
Problems inherent with goodwill go back as far as 1901 when the issue surrounding goodwill was tested in the case of Commissioners of Inland Revenue v Muller & Co Margarine  AC 217. In this case, Lord MacNaghten said: “What is goodwill? 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. Goodwill is composed as a variety of elements. It differs in its composition in different trades and in different businesses in the same trade.”
Nowadays, FRS 102, the financial reporting standard applicable in the UK and Republic of Ireland defines goodwill as “Future economic benefits arising from assets that are not capable of being individually identified and separately recognised.”
Internally generated goodwill
FRS 102, para 18.8C(f) specifically prohibits internally generated goodwill from being recognised on the balance sheet. In order for an intangible asset to be recognised on the balance sheet it must meet the definition of an intangible asset which is:
“An identifiable non-monetary asset without physical substance. Such an asset is identifiable when:
(a) it is separable, ie capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or
(b) it arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.”
An asset is separable if the entity can either dispose of the asset separately without having to dispose the underlying business or it can be leased to a third party.
Internally generated goodwill fails to meet the definition of an intangible asset because it is not separable and does not arise from contractual or other legal rights which are controlled by the entity which are reliably measurable.
In a recent conference, a delegate asked whether a client would be able to capitalise a large amount of goodwill on the balance sheet following a professional valuation obtained by a mid-sized firm of accountants on the basis that this had been professionally valued so was not just a figure made up by the directors – there was a supporting valuation available.
Even though the valuation had been obtained professionally, it is still not possible to recognise this goodwill on the balance sheet because the goodwill had been internally generated. This issue is also covered by company law.
The Small Companies and Groups (Accounts and Directors’ Report) Regulations 2008 (SI 2008/409) states at Note 2 to the balance sheet formats that goodwill must only be included to the extent that the goodwill was acquired for valuable consideration. The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410) contains similar wording in Note 3 to the balance sheet formats.
In other words, only purchased goodwill can be recognised on the balance sheet. Therefore, whenever a client asks to include internally generated goodwill on the balance sheet because they believe it should be recognised, refer them in the direction of FRS 102, para 18.8C(f) and SI 2008/409 or SI 2008/410 as appropriate.
FRS 102 deals with goodwill in Section 19 Business Combinations and Goodwill. However, Section 19 states that an entity must follow the principles in paragraphs 18.19 to 18.24 in respect of amortisation so there is an element of overlap with Section 18 Intangible Assets other than Goodwill but only in respect of amortisation because the requirements for goodwill amortisation are consistent with those for other intangible assets.
Goodwill arising in a business combination, ie when a parent acquires a subsidiary, will be recognised in the consolidated financial statements (group accounts) where these are prepared. The way in which goodwill is calculated is no different than previous UK GAAP and it still represents the excess of consideration over the net assets acquired in the combination. Small groups continue to be exempt from the requirement to prepare group accounts (s399, CA 06).
As noted above, FRS 102, para 19.23(a) refers preparers to paragraphs 18.19 to 18.24 in respect of amortisation. Under FRS 102 it is not possible to assign an indefinite useful life to goodwill, hence all goodwill must be amortised on a systematic basis over its useful life.
FRS 102, para 19.23(a) states that if, in exceptional cases, the entity is unable to make a reliable estimate of the useful life of goodwill, the life must not exceed 10 years. It must be emphasised that FRS 102 refers to these situations being ‘exceptional cases’ and therefore the standard does not expect that such cases will be common.
The reference to 10 years as a ‘cap’ on amortisation when management are unable to make a reliable estimate of the useful life of goodwill is not a minimum period – it is a maximum. Therefore, management may decide that a period shorter than 10 years is appropriate in such circumstances.
Companies and groups will have to carefully consider the useful economic life of goodwill. There will have to be good justifications to support a relatively long period of amortisation (eg 20 years) and where the entity is audited, the auditor must ensure they obtain sufficient appropriate audit evidence to support the client’s amortisation period.
Also, do not forget that FRS 102 para 19.25(g) requires the entity to disclose the useful life of goodwill, and if this cannot be estimated reliably, supporting reasons for the period chosen must also be disclosed.
There may be situations when an entity decides it is appropriate to change the useful life of goodwill for whatever reason. Where this is the case, it should be noted that a change in useful life is a change in an accounting estimate and not a change in accounting policy.
Changes in accounting estimates are dealt with in FRS 102, Section 10 Accounting Policies, Estimates and Errors and are accounted for prospectively from the date of the change. Hence, retrospective restatement is not carried out.
There are specific (additional) goodwill impairment requirements in FRS 102, Section 27 Impairment of Assets at paragraphs 27.24 to 27.27. In respect of impairment, the first thing to assess is whether the goodwill is showing indicators of impairment; if not, there is no need to carry out an impairment test.
If there are indicators of impairment, an impairment test will have to be carried out which involves calculating recoverable amount. A future article on impairment of assets will be published later in the year.
However, it should be noted that where a subsidiary is not wholly-owned (ie there are non-controlling interests), then for the purposes of impairment testing the goodwill has to be notionally adjusted to gross up the carrying amount of goodwill to include the non-controlling interest. The notionally adjusted carrying amount is then compared with recoverable amount to determine whether the subsidiary (cash-generating unit) is impaired.
The Bradshaw Group owns an 80% stake in Matthews Ltd. The year-end financial statements of Matthews Ltd recognise a large loss in the year due to the loss of a number of key customers. The finance director has concluded that the subsidiary is impaired. Goodwill arising on the acquisition of the subsidiary amounts to £250,000.
For the purposes of impairment testing, goodwill is notionally adjusted as follows:
£250,000 x 100 / 80 = £312,500
The £312,500 is then aggregated with the other net assets to determine the value of the impairment loss.
It must also be noted that impairment losses recognised on goodwill cannot be subsequently reversed as they can for other types of assets (FRS 102, para 27.28).
This article has considered a couple of the more subjective areas relating to goodwill. Do keep in mind that internally generated goodwill can never be capitalised on the balance sheet (either in the individual financial statements or in the group accounts). Also be careful with the amortisation cap of 10 years because this only relates to those exceptional circumstances when management are unable to reliably estimate a useful economic life.