10 Goodwill and other intangibles

Need to know

A company’s own (i.e. inherent) goodwill is never recorded in its accounts due to the uncertainty and volatility in valuing inherent goodwill.

Consider, for example, a business that has been established for 20 years, with a recognised brand and a loyal customer base. Its workforce is experienced and has unique skills developed over many years. These attributes, taken together, reflect inherent goodwill in the business. Arriving at a reliable value for these attributes, however, would be highly subjective and therefore uncertain.

To understand volatility, consider the business a few months later. The company’s prospects have taken a dramatic turn for the worse. The business has had to make significant numbers of its staff redundant due to the devastating effects of an unforeseen pandemic. Customers’ orders have not been met due to challenges with staff restrictions on working safely at the premises. This in turn has impacted demand and loyalty, which has led to some tarnishing of the brand. Competitors, especially overseas suppliers, have been able to supply customers at a lower cost and with more reliability. It can be seen that, had inherent goodwill been recorded in the accounts in an earlier year, its value would have significantly changed over a very short period.

The above example reflects a broader concern that goodwill is tied very closely to brand and reputation. In today’s social-media-based environment, the reputation of a business can be damaged quickly as demonstrated by recent examples including TSB (IT failure), Facebook (data privacy) and Boeing (737 Max safety).

It is because of the difficulties in arriving at a value for goodwill together with the risk of volatility that inherent goodwill is never accounted, i.e. goodwill remains ‘invisible’.

When and why is it important?

Goodwill becomes an issue when trying to value a business. Valuing a business can be a complex task because the balance sheet does not identify or recognise the true value of all assets owned by a business (see Chapter 28 Business valuation).

Both the buyer and seller of a business will want to assess the value the assets recorded in the balance sheet as well as the worth of inherent goodwill. It is these assets, taken together, which enable a business to generate its profits. Sellers, in particular, will naturally expect a payment for the goodwill inherent in a business.

Once the purchase price is agreed and the acquisition is complete, an accurate figure can be recorded in the financial statements for goodwill. ‘Purchased’ goodwill is the excess sum paid for a business and this amount is recorded as an intangible fixed asset in the group accounts of the buyer (see Chapter 16 Group accounting). However, while the value of goodwill is calculated on acquisition, goodwill is by its very nature subject to volatility as explained above. Purchased goodwill must therefore be subjected to annual impairment testing to ensure that this asset continues to be worth of the sum paid for it (see Nice to know).

Example – purchased goodwill

A clothing retailer purchases another retailer in a nearby town. The separable (i.e. identifiable) net assets of the shop are valued at £200,000.

The acquirer agrees to pay £300,000 to buy the entire business. This represents a premium of £100,000 to the net asset value. In the buyer’s eyes this excess represents the payment to reflect inherent goodwill in the business. The goodwill may reflect the advantageous location, loyal customer base or brand that the buyer believes will help to sustain profits into the future.

From an accounting perspective, the identifiable net assets of £200,000 have been acquired for £300,000. The difference of £100,000 (£300,000 − £200,000) represents purchased goodwill and this sum will be recognised as an intangible asset in the group accounts of the buyer.

In practice

The ‘value’ of goodwill is arrived at typically through negotiation between a buyer and a seller. In deciding whether to pay any premium the acquirer will consider not only factors such as brand, customer base, competition but also strategic factors such as ‘synergies’ (e.g. cost savings from combining the businesses such as improved supplier volume discounts) or market power.

For listed companies (companies whose shares are traded on a recognised stock exchange), the share price arguably makes it easier to arrive at a business valuation, and therefore a value for goodwill.

It is not always the case that paying a premium to acquire a business is justified. Corporate history is littered with examples of the (over) exuberance of chief executives paying to acquire goodwill only to find that their expectations were misplaced.

For example, Microsoft acquired Nokia in 2014 in what at the time was described by the acquirer as a ‘signature event’. Little over a year later, Microsoft was forced to write off $7.6bn in goodwill, as the company accepted its mistake in trying to compete with already dominant players in an intensely cut-throat competitive market. In 2018, Kraft Heinz wrote down its goodwill by over $15bn resulting in an overall loss. This effectively confirmed that Heinz had overpaid for Kraft when acquiring it three years earlier.

Cynics often argue that goodwill simply serves as a number on the balance sheet to reflect the extravagance of the buyer!

Nice to know

Fair value

Goodwill is calculated as the difference between the fair value of what is paid for the purchase and the fair value of net assets acquired. Fair value should not be confused with book value.

The fair value of assets bears little relationship to the book value because businesses typically adopt an accounting policy to record their fixed assets at their original purchase (historic) cost rather than at current valuation (see Chapter 17 Revaluation). However, certain fixed assets, in particular land and buildings, are likely to increase in value over time and this will lead to a growing divide between fair (market) values and the book values recorded in the financial statements. Therefore, when goodwill is calculated on acquisition, a business must first revalue all of its assets (to their fair value) to reflect the market worth of the separable net assets at the point of sale.

Other intangibles

Intangible assets are fixed assets that have no physical form. Examples of intangible assets include development costs (costs associated with developing new products or services), patents (time-limited licences that give the holder the exclusive right to an invention), trademarks and software.

Intangibles are described as ‘assets’ because they are purchased or developed by a business to help generate revenue and profits for that business. Consider the example of a drug patent. The patent grants the owner the right to generate revenues through exclusive sale of the patented drug for a defined period. Patents therefore represent an asset because they support the generation of future revenues. Indeed, it is the opportunity to register a patent (as an asset) that is used by pharma companies to justify the significant up-front expenditure and risk needed to discover new drugs and treatments.

Intangibles are recognised in the accounts of the company that holds or owns the assets.

Amortisation

In contrast to all other fixed assets which have a limited or finite useful life (see Chapter 9 Tangible fixed assets and depreciation), there is a presumption that goodwill has an indefinite life. A company that pays a premium to acquire goodwill is expected to protect that asset into the future, for example by taking measures to ensure that customer loyalty and other factors that contribute to the goodwill are continuously preserved. For a business that does this successfully, purchased goodwill will remain as an asset on the balance sheet, indefinitely. The value of goodwill will never diminish and there will be no requirement to amortise goodwill, i.e. spread the cost over future accounting periods.

All other intangible assets need to be amortised over their expected useful life in the business because they have a finite life.

Impairment

Because of the indefinite life presumption, goodwill must be subjected to an annual impairment test to validate that its carrying value continues to be justified. Essentially this involves comparing the original assumptions that justified paying for the goodwill with the reality of how the business has performed in the years after it was acquired. Provided a business continues to meet its expectations post acquisition then there will be no impairment to goodwill.

Other intangibles (i.e. those with a finite life) are amortised and are not subject to impairment testing unless there is some evidence or indication that the assets have been impaired (see Chapter 18 Impairment).

Optional detail

Negative goodwill

Goodwill can be negative as well as positive.

Intuitively, negative goodwill implies that the buyer has paid less for a business than the worth of the separable assets acquired. It is possible that the buyer may have secured a bargain, for example, as a result of a distress sale on the part of the seller. Unlike goodwill, which is held on the balance sheet as an asset, negative goodwill is accounted for as profit (gain on acquisition) in the books of the buying company (rather than as a negative asset).

Reflect and embed your understanding

• 1For an example organisation, identify what factors exist that uniquely contribute to inherent goodwill of that business.
• 2Coca-Cola, the soft drinks company, had a net asset worth of $21bn according to its 2020 financial statements. The market value was, however, $221bn (based on the closing share price on 18 March 2021).
  • aApply the definition of goodwill to estimate its value for Coca-Cola (assume no fair value adjustments are required for net assets).
  • bConsider the factors that contribute to Coca-Cola’s goodwill.
• 3Choose an example listed company.
  • aWhat examples of intangible fixed assets is the organisation likely to own?
  • bReview the company’s financial statements to identify the accounting treatment of these intangibles.
  • cDoes the company include purchased goodwill in its group balance sheet? If so, identify whether goodwill has been impaired and the reasons for this (review the goodwill note within the financial statements).
• 4In 2021, the Financial Times reported according to Bloomberg data, that in 341 non-financial US listed companies with market values over $100m, goodwill alone made up at least a third of total assets. What issues, if any, arise if goodwill constitutes a large proportion of a company’s balance sheet?

For the authors’ reflections on these questions, please go to financebook.co.uk

Where to spot in company accounts

Goodwill is shown under non-current assets in the group accounts of the buying company.

Intangible fixed assets are shown on the face of the balance sheet under fixed (or non-current) assets.

The fixed asset note shows separately the carrying amount and accumulated amortisation. Movements for the year are shown by category of asset.

Inherent goodwill never appears in a company’s own accounts.

Extract from Greggs plc 2020 financial statements Appendix p. 465

Assets under development relate to software projects arising from the investment in new systems platforms.

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 391.

Watch out for in practice

• →Goodwill included in group accounts.
• →Increases /decreases in goodwill and the reasons for changes (acquisitions, disposals, impairments).
• →Indicators of possible goodwill impairment, e.g. revenues/profit of the acquired business failing to meet original forecasts
• →For quoted companies, share price declines during or post-acquisition, perhaps suggesting the ‘market’ is not convinced by the logic of the deal.
• →Negative goodwill in the accounts, which suggest a ‘bargain’ purchase. These transactions may attract greater attention because they will result in goodwill being recognised as profit.
• →Whether the company has adopted IFRS or UK GAAP. In contrast to IFRS, UK GAAP accounting treatment of goodwill requires annual amortisation.