Calculating Business Goodwill

Acquiring another business by way of buying its assets at a premium creates goodwill, which becomes an intangible asset in the balance sheet.

Caveat

Where tax relief is concerned this article deals with goodwill created or acquired before 8th. July 2015. Beyond that date corporation tax relief is no longer allowable against its amortisation.

Definition

Goodwill arises when one business acquires another business by way of buying its assets for more than their perceived “fair” (open market) value. It is calculated by deducting the fair value of net assets from the purchase price.

Goodwill does not arise however in the case of a company that is being acquired by the purchase of its shares.

The first step towards assessing the value of any goodwill is to establish the fair (market value) of net assets and compare that with their values as shown in the balance sheet. For example consider a company that is for sale with balance sheet values for its assets and liabilities as follows:

Accounts Receivable    £20,000
Stock £10,000
Plant & Machinery      £12,000
less: Debt Payable    £16,000
Net Assets £26,000

Fair Value of Assets

Now assume that £2,000 of accounts receivable have been outstanding for more than 90 days and are therefore doubtful, that £1,000 of the stock is considered to be “past its sell-by date” and that a realistic open market value of plant and machinery at £7,000 is £5,000 lower than its balance sheet value. The fair value of net assets now becomes:

  Balance Sheet Value Less Impairment: Fair Market Value
Accounts Receivable    £20,000 £2,000 £18,000
Stock £10,000 £1,000 £9,000
Plant & Machinery      £12,000 £5,000 £7,000
less: Debt Payable    £16,000 - £16,000
Net Assets £26,000 £8,000 £18,000

How Goodwill is Calculated

If £30,000 is then paid to buy this company’s assets in order to acquire it, goodwill of £12,000 will then be created – i.e. the purchase price of £30,000 less the fair value of net assets at £18,000.

When buying the assets of a business out of administration or receivership, only the assets will feature in the purchase price as these are sold without debt.

Goodwill in the Balance Sheet, Impairment and Tax

Once the target company has been taken over, the balance sheet will show the assets at their fair value, which total £18,000 in the example above. The £12,000 of goodwill will then be shown in the balance sheet, as an "intangible asset".

Unlike most other assets goodwill is not depreciated or amortised yearly. Instead the market values of the assets acquired have to be reassessed at the end of each financial year. For example if the fair market value of plant and machinery at the time of acquisition has fallen by another £5,000 a year later, the value of goodwill will be reduced by that amount. This is known as “impairment” which qualifies as an allowable deduction against the taxable profit.

Testing the Value of Goodwill

Goodwill therefore represents a premium that is paid because the opportunities of enhanced profits and cash flows from the company being acquired are seen as being much greater than the fair value of its net assets.

The value of that goodwill premium should never be taken for granted though. Before agreeing to pay it any prospective new owner of the business should first test its true worth by running accurate profit and loss; balance sheet; liquidity and cash flow forecasts - ideally using conservative assumptions for sales revenues and profit margins.

Rapidly and easily producing such forecasts including calculating and applying all VAT transactions and corporation tax is what Figurewizard specialises in. To view working examples of the forecasts select the link titled "Take a Look" above the menu bar to the left.

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