Professional Documents
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Section overiew
Not all assets held for the long term can be touched; some are intangible.
7.1 Goodwill
If a business has goodwill it means that the market value of the business as a going
concern is greater than the book value of its assets less its liabilities.
Goodwill is created by good relationships between a business and its customers, for
example.
By building up a reputation (by word of mounth perhaps) for hight quality product or
high standards or service
By responding promptly and helpfully to queries and complaints from customers
Through the personality of the staff, their attitudes to customers and their skills
For example, the welcoming smiles of shop staff may contribute more to a supermarket’s
profits than the fact that a new electronic cash register has recently been acquired; even
so, whereasthe cash register will be recorder in the ledger accounts as a non-current asset,
the value of staff would be ignored for accounting purposes.
Goodwill is inherent in the business but it has not been directly paid for, so valuation
is difficult.
Goodwill changes from day to day. One act of bad customer relations might damage
goodwill and one act of good relations might improve it. Staff with a favourable
personality might retire or leave, to be replace by staff who need time to become
established. Since goodwill is continually changing in value, it cannot reliably be
recorded in the accounts.
The exception to the general rule that goodwill has no objective valuation arises when an
existing business is purchased. The buyer has to pay for not only its non-current assets
and inventoris (and perhaps take over its pyables and receivables too) but also for its
goodwill. This is why the purchase consideration for most business is more than the
value of their net assets.
Tony Tycoon purchases Clive Dunwell’s business for 30,000. Clive’s business has total
assets less liabilities of £25,000, all of which are taken over by Tony. Tony will be
paying (£30,000-£25,000)=£5,000 more for the business than its net assets are worth,
because he is purchasing the goodwill of the business too. The statement of financial
position of Tony’s business when it begins operations (assuming that he does not change
the value of what he has acquired) will be as follows:
TONY TYCOON
Capital 30,000
Purchased goodwill is shown in this statement of financial position because it has been
directly paid for. It has no tangible substance, and so it is an intangible non-current
asset.
Definition
Purchased goodwill: The excess of the purchase consideration paid for a business over
the fir value of the individual assets and liabilities acquired.
Goodwill continually changes. A business cannot last forever on its past reputation; it
must create new goodwill as time goes on.
If the goodwill loses some or all of its value, it is deemed to have become ‘impaired’.
Its value in the statement of financial position is then written down bye the amount of the
impairment and the impairment loss is charged against the profit of the period.
The value of the goodwill is a matter for the purchaser and seller to agree upon in
fixing the purchase consideration. However, two methods of valution are worth
mentioning here.
(a) The seller and buyer agree on a price without specifically quantifying the goodwill.
The purchased goodwill will then be the difference between the price agreed and the
value of the net assets in the books of the new business.
(b) The calcultion of goodwill may precede fixing the purchase consideration and may
become a central element of negotiation. There are many ways of arriving at a value
for goodwill and most of them are related to the profit record of the business in
question. For instance, they may agree to value goodwill as 2 x profit of the previous
reporting period, or a similiar calculation.
Goodwill shown by the purchaser in their account will be the difference between the
purchase cosideration and their own valuation of the tangible net assets acquired. If
values his tangible net assets at £40,000 and goodwill is agreed at £21,000 then B
agrees to pay £61,000 for the business. When setting up accounts for the asset acquired,
B may value the tangible net assets at only £38,000, so the goodwill in B’s books will
be £61,000 - £38,000 = £23,000.