Accounting Principles – Goodwill

In discussing goodwill, it will be necessary to say something about the meaning of the term, the origin of goodwill, its valuation, its duration and its disposition.

By goodwill is meant, that intangible possession or qualification which is capable of producing recurring income or by virtue of which recurring sales may be made. It is the influence which the proprietor or his organization has upon the purchasing public through which he is enabled to attract and retain patronage. In some cases it may be the power of controlling certain patronage. It is that peculiar power of attraction whereby the proprietor causes the buyer to seek him or his place of business when in the market for the kind of goods which the proprietor has for sale.

Goodwill may be due to one or more of several causes. Possibly the manner of the proprietor or his sales force may be pleasing. Politeness, patience and general efficiency on the part of employees are important factors in the establishment. The uniform quality of goods, variety from which to select, and the privilege of returning goods which are unsatisfactory are all things which appeal to many customers and make them feel kindly towards the merchant. Honest goods and honest prices have built up many a business. Among other contributing causes may be mentioned, easy terms, attractive display of goods, attractive advertising, a level of prices slightly under the average, good location, facility with which goods may be found, permanent location for goods and lastly, general reputation. One of the oldest and largest department stores in New York City is probably not only losing goodwill but gaining ill-will through a recently introduced policy of frequently shifting goods from one part of the store to another. On the other hand, in a city like New York, general reputation has a great deal to do with the promotion of goodwill. A stranger coming to New York to live is undoubtedly influenced by a friend or acquaintance in favor of stores which have reputations for certain things. Most housekeepers in New York will tell you that for general trading a certain Fifth Avenue store is unsurpassed, while for muslins a Fourteenth Street establishment stands at the head.

Measuring goodwill, or placing a value upon it, is a much more difficult task than either defining it, or discussing the causes underlying its creation. The occasions for valuing it are practically three: to reduce the rate of return on capital investment; to dispose of it by sale or consolidation; to give a proper value to an established business before the admission of a new partner.

In connection with the first, a proprietor with a small capital investment might by means of goodwill be enjoying profits out of proportion to his nominal investment. The ratio of return to nominal capital might be abnormally high. For business reasons it might be to his advantage to increase his capital in accordance with the goodwill acquired and thus decrease the ratio of return to investment.

In the same manner, a corporation might find it advantageous to reduce the apparent return on its capital stock by setting up goodwill and distributing the surplus arising therefrom through a stock dividend.
In the second case, a concern about to sell out, to consolidate with another concern or to incorporate may very justly and reasonably wish to capitalize its goodwill.

In a similar manner a concern into which a partner is about to enter will undoubtedly value its goodwill before coming to an agreement with the new partner if he purposes buying an interest in the business.

As to the methods of placing a value upon the goodwill in any case, it must of course be admitted that in many instances the figures representing it show price instead of value. Such price may be fixed at what it is expected the prospective purchaser will be willing to pay. This is not placing a value upon it. There are two scientific methods of valuation generally in use. They are widely divergent and the application of the two methods to the same figures produces surprisingly different results. Both have as their basis of calculation what is known as the excess income.

It is conceded that every proprietor receives a certain normal share of trade in the line in which he is engaged. The normal share is assumed to be that which will yield him the average return on his investment. The average return for the line of

business in question is perhaps six per cent. Any excess above that, which 6% on the capital, or capital stock and surplus, will produce is attributed to goodwill.

To illustrate the first method, take as an example The Jones Manufacturing Company, engaged in the retail cloak business with a capital of $1,ooo,ooo. Such a concern might be imagined as having profits of $78,000 for the year. By net profits is meant the sum available for distribution as dividends, or the amount to be credited to surplus after every known charge except d1vidends has been deducted from the income. Ordinarily perhaps, the capital would be expected to yield but $60,000. The excess of $18,000 is attributable to goodwill and the capitalization of this amount at the average rate of interest determines the value of the goodwill. More specifically dividing $18,000 by six (6) per cent gives as a result $300,000. It would not be advisable to use the excess income of one year for this purpose since the income might have fluctuated considerably. The average excess income of periods extending from three to five years would seem to be a more conservative basis, although periods less than a year have at times been used.

The second method while based on the excess net income, proceeds in a manner quite different from the former method. It should be pointed out that the results obtained by the second method would theoretically be of value only where the sale or similar disposal of goodwill was involved and would not serve as a basis for adjusting the rate of return on investment . The factors are, an estimated excess income, recurring annually for an estimated number of years. For example, in the case of The Jones Manufacturing Company, the excess income was $18,000. If it might be estimated that the goodwill could be sold and conserved for a period of ten years, the value would appear to be, ten times eighteen thousand dollars (10 x $18,000) or $180,000. This conclusion is based on the assumption that the goodwill would continue to yield annually for a period of ten years an excess income of $18,000. This is capitalizing, without regard to interest by what is known as the years’ purchase method.

As a means of valuing goodwill this method seems fundamentally wrong. It looks too much like valuing the estimated productivity of the “hen which lays the golden eggs” without giving any attention to the hen. Who would think of saying that the value of a twenty year gold bond of $1,000 paying interest at 6% per annum was $1,200, because there were twenty interest payments of $60 each? On the other hand, who would say that the value of a piece of property estimated to produce $600 per year for the next five years was $3,000? Would it not be more logical to consider such a piece of property worth $6,000 since real estate ordinarily nets 10% on the investment?

If the method were allowed to pass without attack from this standpoint it should be criticized unless scientifically applied. Such application would consist in finding the present worth at x% of an annuity of $18,000 for ten periods. It will thus be seen that at 6% the computation would give as the value of the goodwill an amount of approximately $132,481.

The duration of goodwill is a variable quantity. To fix the time during which it will continue to produce excess income is a difficult task. Without a change of ownership even it may continue or it may dwindle depending upon the attention which is given to the basic factors upon which it was built. Under new ownership and changed conditions it may be conserved and increase in value or it may be lost in a short time. The chances that its value will not diminish are greater if it is not sold.

In case of sale it may be of interest to note its treatment from the accounting standpoint of both the vendor and vendee and ultimately its disposition by both. The valuation of goodwill having been placed upon it previous to the sale, when the deal has been consummated it loses its identity so far as the vendor is concerned and becomes merely an item in the group of assets upon which the selling price was based. That portion of the amount realized on the sale which corresponds to the goodwill would, in the failure to raise an account on the books of the vendor for goodwill, appear as so much profit arising in connection with the sale. It would probably more nearly represent the facts, in the case of a corporation if two accounts were to be created on the books of the vendor prior to sale, one for goodwill, which would be debited, another for capital surplus, which would be credited. Subsequently the capital surplus would be apportioned to stockholders, whose holdings would then represent the amount which each should receive upon distribution of the proceeds of sale.

The vendee is now in possession of an asset in exchange for which he has parted with value no matter what the moral right to carry accumulated or created goodwill prior to sale may be, obviously he is entitled to show same on his books and in his balance sheet. In doing so, however, he is morally bound to show it at its cost to him; that is to say, at the value fixed upon it by the terms of the sale. A corporation is not warranted in setting up an account for goodwill which represents the difference in value between the net assets and the capital stock. For example, in a case where physical assets at an appraised value of $90,000, were taken over subject to liabilities of $10,000 and capital stock in the amount of $100,000 was issued for same, the corporation is not justified in charging the difference of $20,000 to an account called goodwill merely for convenience. That this is frequently done may be seen by reference to the balance sheet of almost any large industrial merger where such accounts as “patents, goodwill and franchises” or “trademarks and goodwill” are usually to be found. Such practice has given rise to a distinction being made as between real and nominal goodwill, or “fictitious” goodwill, as the latter is more commonly called. Nominal goodwill constitutes one of the elements in corporate organization, which is known as “water.”

As to the disposition of goodwill authorities differ. Most Americans consider it as an asset of diminishing value. English authorities are divided in their opinions; some of them favor writing it off over a period of years; others advocate its continuance at the cost price irrespective of fluctuations in its value. It is to be borne in mind that it may appreciate in value and the question arises as to whether or not it should be revalued annually. The tendency in the value is to decline and the safest policy to adopt would probably be to make provision for a reserve to offset the item of goodwill, the annual amount of the provision depending upon the number of years which the most conservative estimate would fix as its life.

Access the contact form and send us your feedback, questions, etc. We are always welcome to help someone out. You can also contact us if you wish to submit your writing, cartoons, jokes, etc. and we will consider posting them to share with the world! The Facebook and LinkedIn groups are also good areas to find people interested in accounting like yourself, don’t hesitate to join as everyone of all levels are welcome to become part of the community.

Are You Ready to Take Your Accounting Skills to the Next Level on the Information Highway?

How Can We Help?