ACCOUNTING

What is goodwill in business?

As sales activity and consolidation continues across the self storage sector, have you thought about the value of goodwill in your business? By Juston Jirwander, Director Bishop Collins

Goodwill is the value in a business created over time from of its name, reputation, brand strength, and/or the grand ideas it has developed. Goodwill is intangible. If you wanted a storage facility with a good reputation, a well-known brand-named storage facility would often have a leg up over an unknown storage facility. That powerful recognition is a priceless quality. If you were to purchase the storage facility business, a substantial amount of the purchase price would be represented by that intangible asset. This extra amount paid is goodwill. The stronger the goodwill, the greater its effects on the business by way of direct revenue increase or influence on associated assets. Specifically, goodwill is the part of the purchase price that is higher than the sum of the net market value of all assets purchased in the acquisition, less the fair market value of the liabilities included in the purchase.

Let’s get technical – how is goodwill recorded?

Goodwill is recorded as an intangible asset classified as non-current assets on the balance sheet of the acquiring business. Under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), it is a requirement that a company evaluates the value of goodwill on their financial statements at least once a year and records any impairments.

Complexities in calculating goodwill

The process for calculating goodwill is straightforward in principle but can be quite complex in practice. Remember goodwill is the purchase price less the difference between the Juston Jirwander.

The value of a business’ brand/s is not the only influence on the determination of goodwill. The following additional areas will influence why goodwill exists in a business and the value placed on it: l The customer base – think

Facebook l Customer interaction and engagement – think Amazon l Staff/employee expertise – think Space X, a highly technical field l Location, location, location. – think high traffic roads for storage facilities l Proprietary technology – think Intel Chips l Reputation – think Harvard

University l Operating procedures/ protocols – think McDonald’s

Goodwill is essential to accountants to recognise the value assigned to the future earning capacity of the business. This must be recognised in the accounts of the storage facility to reflect the true value. fair market value of assets and the fair market value of liabilities. Fair market value for liabilities is pretty straight forward excluding provisions or contingent liabilities. There are, however, competing approaches among accountants to calculate Goodwill because of the many ways to determine the fair market value of assets. This is especially true in an entity that is not a publicly-traded company. If seven registered business valuers performed a valuation on a business asset involved in an acquisition, there could be seven different results, though they should not be wildly different from each other. Goodwill is a workaround for accountants and is necessary because acquisitions often involve estimates of future earnings of a facility and other unknown considerations at the time of the acquisition. The complexity comes with determining the fair market value of assets in the storage facility being acquired and any previous businesses that the facility group acquired, along with the goodwill calculations made previously. For example, is the goodwill of that previously purchased business still worth the value reflected in the company’s balance sheet, or has the value increased/decreased?

Impairments

When the market value of an asset drops below its historical cost, this is called an impairment. This can

occur due to an adverse event in the self storage industry, such as increased competition or change in market forces/consumer habits/ technology. Companies usually perform an impairment test on intangible assets to assess whether an impairment is needed. The two methods for testing impairments are the market comparison and the income approach. Using the market comparison, the assets of similar self storage businesses’ operating in the same industry are analysed. With the income approach, estimated future cash flow is discounted to the present value. If a self storage business’ acquired net assets fall below the historical value, the company has overstated the amount of goodwill. Therefore, it must correct the balance sheet by doing a write-down on the asset’s value to record the impairment. The impairment expense is calculated as the difference between the current market value and the asset’s purchase price. The impairment results in a decrease in the goodwill account on the balance sheet. The expense is then recognised as a loss on the income statement, which reduces the net income for the year. In turn, EPS (earnings per share) and the company’s stock price are also negatively affected. The FASB (Financial Accounting Standards Board), which sets standards for GAAP rules, is considering a change to how goodwill impairment is calculated. Due to the subjectivity of goodwill impairment and the cost of testing impairment, FASB is considering reverting to an older method called “goodwill amortisation“. As a result, the value of goodwill is slowly reduced annually, like the depreciation of a car. The problem with this approach is that goodwill can appreciate over time. Accountants like things to be black or white in business as it gives certainty; however, sometimes, we must be flexible and consider the shades of grey.

Goodwill vs other intangibles

Goodwill and other intangible assets are not the same. For example, goodwill is a premium paid over fair value during a transaction and cannot be bought or sold independently. Goodwill arguably has an indefinite life, while other intangibles have a finite useful life.

Are there limitations to using goodwill?

Goodwill is difficult to value , and we can observe negative goodwill when an acquirer purchases a company for less than its current market value. This usually happens when the facility is under stress to sell. This transaction will result in a gain from the acquiring entity, entered into the profit and loss for the transaction year. There is also the risk that a previously successful facility could face insolvency. When this happens, investors deduct goodwill from their determinations of residual equity. This is because, at the point of insolvency, the goodwill the company previously enjoyed may not have a resale value – but not always.

Key takeaways

Goodwill is an intangible asset. However, not all intangibles are goodwill.

Goodwill is different from most other intangible assets, with an indefinite life, while most other intangible assets have a finite useful life, such as licences. Goodwill is calculated by taking the purchase price of a company and subtracting the difference between the market value of the assets and liabilities. Public companies are required to review the value of goodwill on their financial statements at least once a year and record any impairments. l

If you have any questions please call Bishop Collins on 02 4353 2333.