ICB's Director of Learning, Peter Stewart, takes a look at 'goodwill'.
The general theme in my articles is to find a topic within the ICB syllabus and give you some insight into the ‘bigger picture’. So I’m not aiming to teach you how to do the techniques and calculations to help you answer questions but hope that I can help you to understand why you’re being asked to do them.
In this article, we’ll look into “Goodwill” and think about why we have to make all those adjustments in the M5 syllabus when a partnership structure changes and also why we don’t come across it elsewhere.
Business Valuation
The value of any business ultimately has nothing to do with what’s in the books of account: the profit and loss account or the balance sheet.
As you know, they record what the business has done (P&L) and where it’s ended up (Balance Sheet). They reflect past business only.
The value of the business is an amount that an owner is prepared to accept if selling the business or an investor is prepared to pay when making an investment in the business. In both cases, both sides of the deal will be considering what the business will do in the future.
The factors to consider when establishing those future cash flows are to do with the business’s prospects and ability to make sales, turn in profits and turn those profits into cash flow. They include:
- Brand reputation
- Quality of products and services
- Innovation
- Quality of customer service and support
- Skill, experience and motivation of employees
- Customer loyalty
- Supplier and partner relationships
- Management structure and processes
- Industry trends
- Regulatory environment, including taxes and tariffs
Not one of these factors is measured in the financial statements of the business. However, should someone be seeking to buy or sell a business, they will all feed into the amount at which a deal will be done.
In the case of a large, publicly listed company, you will see the share price which reflects a lot of the factors and you can see how quickly the perception of “value” can change when one or more of these factors changes – such as the recent fall in the Tesla share price when Elon Musk behaved oddly in public.
Selling a business or part thereof
If a sole trader were to sell their business to someone else, there would be a straightforward transaction of cash in return for the business (assets, liabilities, customer list, supplier contacts, etc.). Since this is the action of the business owner, rather than one of the business itself, there would be nothing to do in the books of account. The value of the transaction could be higher or lower than the net asset value in the balance sheet but there is no need to record the difference.
If we had to come up with a name for that difference, we could call it “goodwill”. The buyer of the business is paying for the net assets of the business and for the goodwill of the business, which is an intangible (and very subjective) value attached to the factors listed above.
Likewise, if a company or part of a company were to be sold to a new investor, the transaction takes place independently of the books of account. A shareholder and the new investor would agree on a value of the business, which is divided into shares.
Any difference between the value attached to the shares and the net asset value of the business could also be described as ‘goodwill’. The important point (in terms of bookkeeping) is that we do not record share transactions in the accounts, so do not need to work with goodwill in the M7 exam – or when working with the books of a limited company.
“Selling” part of a partnership
Which brings us to M5 and partnerships. When there’s a change in the structure of a partnership (retirement of a partner, introduction of a new partner or introduction of fresh capital and a change in the partnership share), we want to recognise the value of the partnership at that point so that the value generated up until the date of change can be acknowledged and allocated to the partners who have generated the value up until that point.
It is similar in many ways to the concept of selling shares. However, the different nature of ownership requires us to record the change of ownership and our best estimate of value in the books of account.
If a new partner is introduced to the business, they will be asked to pay for the share of the business they are taking over.
Let’s say that the new partner will have 20% of the business. If the business is valued at £250,000 (considering all those factors from the earlier list), the new partner will invest capital of £50,000.
If, at the time of the investment, the balance sheet shows net assets of £150,000, the value of the transaction tells us that there is £100,000 of goodwill.
The new partner has just invested £20,000 for that goodwill and our adjustments to the books will ensure that that value is added to the capital accounts of the existing partners.
Note that it is only the share of goodwill that has been paid for which is carried in the books; we would never include goodwill as an asset in the balance sheet.
It is similar when a partner retires. We acknowledge the value of the business by adding goodwill to the capital accounts of all partners, so that the retiring partner’s capital account now reflects their share of the full value of the business.
If, instead of our partnership introducing a new partner, we were to have a 40% partner retire. Our bookkeeping adjustments would be designed to ensure that the retiring partner “banked” 40% of the £100,000 goodwill at the time of retirement.
The result of our adjustments would, therefore, see the retiring partner’s capital account increase by £40,000, while the capital accounts of the remaining partners would decrease also by £40,000. The business remains valued at £250,000 but the retiring partner can now cash in on the share of that value to which he or she has contributed up to retirement.
Conclusion
All businesses have a degree of goodwill. You’d hope that goodwill has a positive value but it’s conceivable that it is negative (in which case, you might be better off selling all the assets piecemeal than trying to sell the business).
Very few businesses have to think about the value of goodwill as an intangible asset. The convoluted bookkeeping adjustments we make for partnerships are necessary due to there being no shares to be traded outside the business and it’s only when there is a change in the ownership share of a partnership that you’ll have to dust down your books to make those adjustments.
Remember that if you do have to do those adjustments, ICB will be here to help you with any workings!
