Friday, October 28, 2011

What is goodwill?

Goodwill: The difference between the fair value of a business as a whole and the aggregate of the fair values of the separable and identifiable assets and liabilities. This implies that it is not possible to identify goodwill separately from the business, and this is largely because it is an intangible asset.
The definition above explains that goodwill is the value placed upon a business in excess of the sum of its individual assets; thus goodwill represents the value of the business continuing as a going concern, as compared with its assets being sold individually. However, it could be said to be more than that. All established businesses have some goodwill. Goodwill comprises business contacts, good staff relations, the right to occupy certain pieces of land, and so on. All of these have a value – the difficulty lies in placing a value on them.

Purchased and non-purchased goodwill
When a business first starts, it is either created by its owners or it is purchased from an existing business. In the latter case there will have been a certain amount of negotiation over the purchase price. The vendors will obviously seek to obtain the highest price possible, whereas the purchaser will seek to minimise the price. It is likely, however, that the final price will be greater than the purchaser’s valuation of the tangible assets taken over. This is accepted because the price includes the rights to the existing business’s customer base, possibly its name, its staff, and their experience and expertise, etc. This difference is the goodwill and, more precisely, is said to be purchased goodwill.

However, whether the business is created as a new start-up business or is the result of the acquisition of another business, new goodwill is earned or created by the new owners over a period of time. This is known as non-purchased goodwill.

Accounting treatment
The accounting treatment of purchased goodwill is for the purchaser to place a fair value on the net tangible assets (i.e. assets-liabilities) of the business acquired and to consider the difference between the sum of these values and the total purchase price to be goodwill.

This amount is debited to the goodwill ledger account. The purchaser will hope that the value of the goodwill will at least be maintained and that, if he were to sell the business, he would be paid for its goodwill.

However, it is important to note, when applying the concept of prudence, that assets should not be overstated. It could be that the factors which caused goodwill to exist in the past, for example location and customer base, no longer apply and that the value of the goodwill is now less than the price paid for it.

It is therefore necessary to estimate, on an annual basis, the value of the goodwill. If the current estimated value is less than the amount in the balance sheet, then the goodwill is said to be ‘impaired’. Impairment occurs when the value of a non-current asset is less than its carrying amount in the balance sheet. In this situation, the goodwill is reduced to its new lower value and the difference (the ‘impairment’) is charged to the income statement as an expense. It may be noted that impairment can also apply to tangible and other non-tangible noncurrent assets and will occur at any time that the carrying amount of an asset in a balance sheet is overstated.

Example
X Ltd has recently acquired the assets and liabilities of A Ltd for $1,500,000. The assets and liabilities acquired were valued by X Ltd as follows:
                                           $
Land and buildings      750_000
Plant and equipment   240_000
Inventories                     65_000
Receivables                  38_000
Payables                       (41,000)
-------------------------
                                1_052_000

The difference between the sum of the individual net assets and the purchase price is goodwill. In this example the value of goodwill is $448,000. If in the future X Ltd values the goodwill at only $400,000, then the impairment of $48,000 will be charged to the income statement and the goodwill in the balance sheet will be reduced to $400,000.

Non-purchased (or ‘internal’) goodwill is not recognised in the balance sheet. The reason for this is that it is not possible to obtain a reliable measurement of its value. In the case of purchased goodwill, the fact that someone has paid for goodwill does mean that it has a value and that this can be measured by the price paid. In the case of internal goodwill, there has been no such external transaction and there is no basis on which the internal goodwill can be valued.

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