Goodwill: Nature and Valuation — Notes

Goodwill is the value of the reputation, customer connections and other advantages that enable a business to earn more than a normal profit. A buyer pays for it because he expects that extra profit to continue.

Features:

• Intangible: valuable, but without physical existence.
• Not fictitious: it has a real value that can be realised on a sale of the business.
• Inseparable: it cannot be sold apart from the business.
• Based on expected future profits, so it can change quickly.
• Subjective: different methods give different values; partners agree the method.

Purchased goodwill arises when a business is bought for more than the fair value of its net assets; the excess paid is goodwill.

Self-generated (internally generated) goodwill is built by the firm itself.

Accounting Standard 26 (Intangible Assets): only goodwill acquired for a consideration in money or money's worth is recorded. Self-generated goodwill is not recorded, because its cost cannot be measured reliably.

In a partnership, goodwill is usually valued (not recorded) on reconstitution; how the value is adjusted among partners is covered in Chapters 3 and 4.

Goodwill rises or falls with the profits a business can expect. The main factors:

• Nature of business: steady demand, stable products.
• Location: a site customers reach easily.
• Efficiency of management: low costs, reliable service.
• Market situation: little or no competition.
• Special advantages: patents, trademarks, licences, import quotas, long-term contracts, cheap power or raw material.
• Age and reputation: an old, trusted name.
• Key people: skilled owners or staff who stay.

Rule of thumb: ask whether a change will raise or lower future profits.

Goodwill is valued whenever partners' rights in future profits change:

1. change in the profit-sharing ratio of existing partners;
2. admission of a new partner;
3. retirement of a partner;
4. death of a partner;
5. amalgamation of firms, or sale of the business.

On each occasion a partner who gains a share of future profits compensates the partner who sacrifices it. The accounting treatment belongs to Chapters 3 (admission) and 4 (retirement and death).

Goodwill = average profit × number of years' purchase.

Normalising (future maintainable profit):

• abnormal losses (uninsured fire, theft, flood): add back;
• non-recurring gains (profit on sale of a fixed asset, an old insurance claim): deduct;
• income from non-trade investments: deduct each year;
• capital expenditure charged to revenue: add back in that year; deduct depreciation for that and later years;
• closing stock overvalued: deduct from that year, add to the next (undervalued: the reverse);
• fair remuneration of a partner who works without salary, and known future expenses (e.g. a new insurance premium): deduct from the average.

An ordinary trading loss stays in the average: deduct it and divide by all the years.

Used when profits show a clear trend. Recent years receive larger weights (usually 1, 2, 3 … from the oldest).

Weighted average profit = Σ (normal profit × weight) ÷ Σ weights

Goodwill = weighted average profit × number of years' purchase.

Rising profits: weighted average > simple average. Falling profits: weighted average < simple average. Steady profits: nearly equal.

Capital employed (net assets) = total assets − goodwill already in the books − non-trade investments − fictitious assets − outside liabilities.

Check from the capital side: partners' capitals + reserves + credit balance of Profit and Loss − goodwill − non-trade investments − fictitious assets.

Normal profit = capital employed × normal rate of return ÷ 100.

Super profit = average profit − normal profit.

Goodwill = super profit × number of years' purchase. If super profit is nil or negative, there is no goodwill.

When non-trade investments are left out of capital employed, their income is removed from profit as well.

Capitalisation of average profit:

• capitalised value = average profit × 100 ÷ normal rate of return;
• goodwill = capitalised value − capital employed.

Capitalisation of super profit: goodwill = super profit × 100 ÷ normal rate of return.

With the same figures and rate the two always agree: super profit × 100 ÷ rate = average profit × 100 ÷ rate − capital employed.

Comparing methods: the average profit method pays for all profit for a few years; the super profit method pays for the excess for a few years; the capitalisation methods value the excess earning power without a time limit. Partners agree the method in the deed or at the time of valuation.