Goodwill for all seasons

It’s trickier than you might imagine valuing the goodwill of a business on the balance sheet and P&L, warns NEIL MORRISON

I have regular discussions and ‘catchup’ meetings with my banking contacts and there’s always a business slant to part of the discussions.

Before and after Christmas, for example, a regular topic related to goodwill. What does it mean? How is it valued? How should it be dealt with in a set of accounts? How can we assess the reasonableness of a price being paid (and loan finance provided) for ‘goodwill’?

The dictionary definition of goodwill is “an intangible asset valued according to the advantage or reputation a business has acquired (over and above its tangible assets)”. Essentially, this relates to the quality of the client base the business has grown and how that business is perceived in the marketplace. The valuation of goodwill is not a precise science: valuers will come up with different valuations – particularly if the goodwill is being valued for a seller rather than a buyer.

You’ll often hear certain industries valuing goodwill as a proportion of turnover. This, is too crude, in my view, and can only be a starting point. Of greater importance is the level of profitability in the business and thus the potential return on investment to the purchaser. Adjustments need to be made to the reported trading account(s) to arrive at an ‘adjusted profits’ figure and then a multiple (usually between 3 and 4 for small owner managed businesses) applied to that ‘adjusted profits’ figure to arrive at a goodwill value.

A key question assessing and financing goodwill is “how likely are profits to continue to be earned at the same (or a higher) level?” For a dental business which is predominantly NHS-based, for example, there’s a high level of certainty given the fixed nature of monthly income and cash flows arising on an established, stable patient list. So, even these days when it’s more difficult to find available finance, dentists can still obtain 100 per cent funding for the purchase of goodwill. Most business sectors are not in this fortunate position.

Another factor, often ignored by business owners until they are looking to sell their business, is “can the business run independently of the owner?” For many owner managed businesses, the owner is still a key component of the day-to-day dealings. The problem is that, if the owner’s involvement is essential to the smooth day-to- day running of the business, then it can be argued that the goodwill is worth nothing.

So it’s essential systems and business processes are put in place so that a business can run independently of any one key individual. That not only protects goodwill value, but also frees up the time of key individuals to manage the business properly and effectively.

Watch out for the accounting treatment, though – it’s often wrongly assumed that goodwill is treated in the same manner by businesses. Accounting standards require purchased goodwill to be capitalised and amortised systematically through the profit and loss account (usually over 20 years or less). Furthermore, impairment reviews should be undertaken, particularly if goodwill is regarded as having an infinite life and is thus not being amortised.

For those businesses you look after with purchased goodwill, do you know if they amortise the goodwill or not? If they’re assuming an infinite life, is this correct? What would be the impact on the trading account and balance sheet if goodwill was amortised?

We are now past the ‘season of goodwill’ and heading towards spring but I suspect that the questions regarding goodwill in terms of valuation and accounting treatment will be with us for a while yet!

Campbell Dallas LLP is a leading independent firm of Chartered Accountants in Scotland. The firm is the Scottish associate of UHY International. For more information or advice please contact Neil Morrison on 01738 441 888 or email neil.morrison@campbelldallas.co.uk.

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