What would you pay for a company that has a net worth of £5 million, but is generating £1 million profit a year? The answer would undoubtedly be more than £5 million, as you would not just be buying the assets, you would also be gaining access to £1 million profit every year.
The difference between the purchase price and the value of the business shown in the accounts is called goodwill. Goodwill is simply the difference between the purchase price of a company and the value of the net assets acquired – the premium paid to acquire the com- pany.
We will illustrate goodwill by using a simple example, but it is discussed in more detail in Chapter 19 – Groups.
7 Goodwill
Brands may be shown as intangible assets on the balance sheet, and where they are shown, they are often a significant proportion of the net assets. They are initially shown at cost or valuation. Valuing brands is not an exact science. Brands are not normally amortised, as they are believed to have an indefinite life. This will have to be proven in an annual impair- ment review from 23 December 1998, with the implementation of FRS 10.
SUMMARY
INTANGIBLE ASSETS
Significant owned brands, acquired since 1st January 1985, the value of which is not expected to diminish in the fore- seeable future, are recorded at cost, less appropriate provisions, as intangible fixed assets. No annual amortisation is provided on these assets but their value is reviewed annually by the directors and the cost written down as an excep- tional item where permanent diminution in value has occurred.
INTANGIBLE ASSETS (GRAND METROPOLITAN) Extract 7.1
Imagine that the net assets of my business are currently £20 million, and I agree to buy the com- pany we discussed above for £7 million in cash. I have to consolidate my newly acquired sub- sidiary in my accounts. My summarised balance sheet, before the acquisition, was as follows:
£ million
Fixed assets 22
Cash 8
Other current assets 15
Current liabilities (15)
Long-term loans ...(10)
...20 ...
Capital and reserves
Share capital 5
Profit and loss account ...15
...20
Following the acquisition, my cash was reduced by the £7 million that I have paid to acquire the business. In exchange, I will receive £5 million net assets. This will give me a major problem when I come to consolidate the two balance sheets:
My business Acquisition cost Acquisition Consolidated balance sheet
£ million £ million £ million
Fixed assets 22 3 25
Cash 8 (7) 0 1
Other current assets 15 5 20
Current liabilities (15) (2) (17)
Long-term loans (10) (1) (11)
20 5 18
Capital and reserves
Share capital 5
Profit and loss account 15 20
The consolidated balance sheet’s net assets does not balance with my capital and reserves of 20! Balance sheets are supposed to balance! However, it does not balance in this case because I have paid more for the business than it was worth on its balance sheet. The difference is the £2 million goodwill. I can make it balance in one of two ways:
● I can reduce the capital and reserves, by reducing the profit and loss account; or
● I can increase the net assets, by creating an intangible asset.
EXAMPLE
The first option writes goodwill off against pastprofits, the second option increases the assets and opens the debate about whether the goodwill should be amortised. Both the interna- tional accounting standards and FRS 10 suggest that goodwill should be amortised. (From 23 December 1998 it must be amortised unless the company can prove that the value has not fallen.) This has the effect of charging goodwill against futureprofits.
Historically companies in the UK wrote off goodwill through reserves (the first option).
Most companies overseas use the second option. However, FRS 10 requires them to follow the second option and show goodwill as an intangible asset. This will bring the UK in line with international accounting practice.
In the past the accounting treatment, shown in Option 1, overstated the returns on the investment and made it harder to spot those companies who had overpaid for their acquisi- tions. It actually reduces the capital and reserves, which may make some of the accounting ratios improve – as the denominator reduces the percentage increases! The new accounting treatment will ensure that the management will be held accountable for all aspects of the acquisition, and should identify whether the acquisition had added value for the share- holders. However, the transitional requirements allow companies to leave the goodwill writ- ten off against reserves before the implementation of FRS 10 to remain eliminated against reserves. This will mean that there will still be differences between companies in the value of the reserves that are shown in the accounts.
Goodwill must be reviewed at the end of the first full financial year to ensure that the pre- mium that has been paid to acquire the company will be covered by the acquisition’s future cash flows. The review is carried out in two stages. Initially, the company compares the first year performance of the acquired company with the pre-acquisition forecasts for the first year. A full impairment review is then undertaken if there is evidence that the post-acquisi- tion performance does not meet the pre-acquisition expectations. The impairment review compares the value of the acquisition with the present value of its future cash flows. This impairment review ensures that if there has been an overpayment the loss is recognised immediately.
INTERNATIONAL DIFFERENCES
International differences in accounting for goodwill are discussed in Chapter 19.
Extract 7.2 is from the French retailing and distribution company, Pinault Printemps- Redoute illustrates the information that is disclosed about intangible assets in the notes to the accounts. (French companies analyse goodwill in detail.)
7 Goodwill
9 – GOODWILL
1996 1995
(in FF millions) Gross Amorti- Net Net
zation Retail Division
Printemps 245 (33) 212 219
Prisunic 147 (16) 131 115
Conforama 1,099 (130) 960 988
La Redoute 1,023 (160) 863 897
Fnac 2,736 (127) 2,609 2,340
Financial Services
Division 162 (22) 140 144
Wholesale Division
Rexel 1,781 (152) 1,629 846
Pinault Distribution 282 (72) 210 216
International Trade 608 (104) 504 282
Total 8,083 (825) 7,258 6,047
The main changes in goodwill during the year were (in FF millions):
Net book value at December 31, 1995 6,047 Add:
Rexel: acquisitions 833
PPR: IENA 218
Fnac: acquisition of Sodal 121
CFAO: acquisitions 192
Other 23
Less:
Other
Exchange differences and changes in Group
structure 52
Amortization charge (228)
(excluding write-backs of negative goodwill)
Net book value as at December 31, 1996 7,258
10 – OTHER INTANGIBLE ASSETS
1996 1995
(in FF millions) Gross Amorti- Net Net
zation, provisions Trading names and
market share 10,158 (117) 10,041 9,795
Goodwill and
leasehold interests 1,302 (65) 1,237 1,264
Other 413 (247) 166 98
Total 11,873 (429) 11,444 11,157
The heading Trading names and market share breaks down as follows:
1996 1995
(in FF millions) Gross Amorti- Net Net
zation, provisions Retail Division: Trading names
Printemps 1,100 (55) 1,045 1,045
Prisunic 400 – 400 400
Conforama 2,363 (1) 2,362 2,362
La Redoute 3,600 – 3,600 3,600
Other
(less than FF 100 million) 4 4 6
Wholesale Division: Market share
Rexel 810 – 810 810
Rexel Inc.
(Formerly Willcox
& Gibbs) 604 – 604 480
Grouplec 292 – 292 292
S.E.W. 223 – 223 188
C.E.I.M. 110 – 110 109
Other
(less than FF 100 million) 625 (35) 590 499 Other (less than FF
100 million) 27 (26) 1 4
Total 10,158 (117) 10,041 9,795
GOODWILL AND OTHER INTANGIBLE ASSETS (PINAULT PRINTEMPS-REDOUTE) Extract 7.2
Goodwill is the premium paid to acquire a company, and represents the difference between the purchase price and the net assets acquired. Most UK companies have histori- cally written goodwill off through reserves, and do not show it as an intangible asset. How- ever, from December 1998 goodwill will be capitalised and amortised over its useful life.
SUMMARY
Amortisation A charge made to reflect the reduction in value of intangible fixed assets.
Development costs The costs associated with developing a new product, or process. Development costs may be shown as intangible fixed assets under certain circumstances.
Goodwill The difference between the cost of an acquisition and its net asset value.
Licence An agreement with a third party to carry out certain actions.
Patent A government grant to an investor giving him the sole right to use and sell his invention for a limited period.
Research costs The costs associated with gaining new scientific or technical knowledge. It may or may not be directed towards a specific objective. Only the costs of fixed assets used for research may be capitalised (and shown as fixed assets in the normal way). All other costs should always be charged to the profit and loss account.
Trade mark A name or other symbol that differentiates one company’s products from those of its competitors.
7 The balance sheet: intangible fixed assets
JARGON