What is goodwill?

Goodwill: The difference between the fair value of a business as a whole and the aggregate of the fair values of the separable and identifiable assets and liabilities. This implies that it is not possible to identify goodwill separately from the business, and this is largely because it is an intangible asset.

The definition above explains that goodwill is the value placed upon a business in excess of the sum of its individual assets; thus goodwill represents the value of the business continuing as a going concern, as compared with its assets being sold individually. However, it could be said to be more than that. All established businesses have some goodwill. Goodwill comprises business contacts, good staff relations, the right to occupy certain pieces of land, and so on. All of these have a value – the difficulty lies in placing a value on them.

Purchased and non-purchased goodwill

When a business first starts, it is either created by its owners or it is purchased from an existing business. In the latter case there will have been a certain amount of negotiation over the purchase price. The vendors will obviously seek to obtain the highest price possible, whereas the purchaser will seek to minimise the price. It is likely, however, that the final price will be greater than the purchaser’s valuation of the tangible assets taken over. This is accepted because the price includes the rights to the existing business’s customer base, possibly its name, its staff, and their experience and expertise, etc. This difference is the goodwill and, more precisely, is said to be purchased goodwill.

However, whether the business is created as a new start-up business or is the result of the acquisition of another business, new goodwill is earned or created by the new owners over a period of time. This is known as non-purchased goodwill.

Accounting treatment

The accounting treatment of purchased goodwill is for the purchaser to place a fair value on the net tangible assets (i.e. assets-liabilities) of the business acquired and to consider the difference between the sum of these values and the total purchase price to be goodwill.

This amount is debited to the goodwill ledger account. The purchaser will hope that the value of the goodwill will at least be maintained and that, if he were to sell the business, he would be paid for its goodwill.

However, it is important to note, when applying the concept of prudence, that assets should not be overstated. It could be that the factors which caused goodwill to exist in the past, for example location and customer base, no longer apply and that the value of the goodwill is now less than the price paid for it.

It is therefore necessary to estimate, on an annual basis, the value of the goodwill. If the current estimated value is less than the amount in the balance sheet, then the goodwill is said to be ‘impaired’. Impairment occurs when the value of a non-current asset is less than its carrying amount in the balance sheet. In this situation, the goodwill is reduced to its new lower value and the difference (the ‘impairment’) is charged to the income statement as an expense. It may be noted that impairment can also apply to tangible and other non-tangible noncurrent assets and will occur at any time that the carrying amount of an asset in a balance sheet is overstated.

Example

X Ltd has recently acquired the assets and liabilities of A Ltd for $1,500,000. The assets and liabilities acquired were valued by X Ltd as follows:

                                           $

Land and buildings      750_000

Plant and equipment   240_000

Inventories                     65_000

Receivables                  38_000

Payables                       (41,000)

-------------------------

                                1_052_000

The difference between the sum of the individual net assets and the purchase price is goodwill. In this example the value of goodwill is $448,000. If in the future X Ltd values the goodwill at only $400,000, then the impairment of $48,000 will be charged to the income statement and the goodwill in the balance sheet will be reduced to $400,000.

Non-purchased (or ‘internal’) goodwill is not recognised in the balance sheet. The reason for this is that it is not possible to obtain a reliable measurement of its value. In the case of purchased goodwill, the fact that someone has paid for goodwill does mean that it has a value and that this can be measured by the price paid. In the case of internal goodwill, there has been no such external transaction and there is no basis on which the internal goodwill can be valued.

What is a business organisation?

A business is an organisation that regularly enters into transactions that are expected to provide a reward measurable in monetary terms. It is thus obvious from everyday life that many business organisations exist; what is less obvious is that their organisational (legal) structure and therefore their accounting requirements may differ.

There are two main reasons for the different organisational structures that exist – the nature of their activities and their size.

1.7.1 Profit-making organisations

Some organisations are formed with the intent of making profits from their activities for their owners:

(a) Sole traders (sole proprietors). These are organisations that are owned by one person. They tend to be small because they are constrained by the limited financial resources of their owner.

(b) Partnerships. These are organisations owned by two or more persons working in common with a view to making a profit. The greater number of owners compared with a sole trader increases the availability of finance and this is often the reason for forming such a structure.

(c) Limited companies. These are organisations recognised in law as ‘persons’ in their own right. Thus a company may own assets and incur liabilities in its own name.

The accounting of these organisations must meet certain minimum obligations imposed by legislation, for example, via company law and other regulations. Some of these requirements constitute recommended accounting practice for other types of organisation. Two types of limited companies can be identified: private limited companies; and public limited companies.

Public limited companies can be further divided according to their size, and whether they are ‘listed’ on a stock exchange. These distinctions can be important when considering the accounting requirements. A common feature of private limited companies is that their owners are actively involved in running the business. In this way they are similar to sole traders and partnerships. This is rarely true of public companies, where the owners may not become involved in the day-to-day activities of the business. Listed companies may have many thousands of owners (shareholders) who are even further removed from the running of the business.

1.7.2 Non-profit-making organisations

Other organisations are formed with the intent of providing services, without intending to be profitable in the long term:

(a) Clubs and societies. These organisations exist to provide facilities and entertainments for their members. They are often sports and/or social clubs and most of their revenue is derived from the members who benefit from the club’s facilities. They may carry out some activities that are regarded as ‘trading’ activities, in which profits are made, but these are not seen as the main purpose of the organisation.

(b) Charities. These exist to provide services to particular groups, for example people with special needs and to protect the environment. Although they are regarded as non-profit-making, they too often carry out trading activities, such as running shops.

(c) Local and central government. Government departments are financed by members of society (including limited companies). Their finances are used to provide the infrastructure in which we live, and to redistribute wealth to other members of society. You will not look at the accounts of government bodies in this Learning System.

Who uses financial statements?

Accounting information is used by many people, both as individuals and in organisations. To get a feel for the purpose of accounts it is useful to classify these users into groups, and to look at the reasons why they use accounts and what they hope to get from them.

Any classification of this sort is somewhat arbitrary, and many users fall into more than one classification. However, the following groups are commonly recognised as having particular needs for accounting information:

(a) The investor group. This group includes both existing and potential owners of shares in companies. They require information concerning the performance of the company measured in terms of its profitability and the extent to which those profits are to be distributed to shareholders. They are also interested in the social/economic policies of the company so that they may decide if they wish to be associated with such an organisation.

(b) The lender group. This group includes both existing and potential providers of secured or unsecured, long- or short-term loan finance. They require information concerning the ability of the organisation to repay the interest on such loans as they fall due; and the longer-term growth and stability of the organisation to ensure that it is capable of repaying the loan at the agreed time. In addition, if the loan is secured, the value of the appropriate secured assets is important as a means of recovering the amount due.

(c) The employee group. This group includes existing, potential and past employees. They require information concerning the ability of the organisation to pay wages and pensions today. In addition, they are interested in the future of the organisation because this will affect their job security and future prospects within the organisation.

(d) The analyst/adviser group. This group includes a range of advisers to investors, employees and the general public. The needs of these users will be similar to those of their clients. The difference is, perhaps, that in some instances, the members of this group will be more technically qualified to understand accounting reports.

(e) The business contact group. This group includes customers and suppliers of the organisation. Customers will be concerned to ensure that the organisation has the ability to provide the goods/services requested and to continue to provide similar services in the future. Suppliers will wish to ensure that the organisation will be capable of paying for the goods/services supplied when payment becomes due.

(f) The government. This group includes taxation authorities, and other government agencies and departments. The taxation authorities will calculate the organisation’s taxation liability based upon the accounting reports it submits to them. Other departments require statistical information to measure the state of the economy.

(g) The public. This group includes taxpayers, consumers and other community and special interest groups. They require information concerning the policies of the organization and how those policies affect the community. The public is increasingly interested in environmental issues.

(h) Internal users. The management of the company require information to assist them in the performance of their duties. Three different levels of management can be identified:

• Strategic. This is the level of management found at the top of organisations. In a commercial organisation it is referred to as the board of directors. These people require information to assist them in decisions affecting the long-term future of the organisation.

• Tactical. This is often referred to as middle management. These people require information to assist them in monitoring performance and making decisions to enable the organisation to achieve its short- to medium-term targets.

• Operational. This is the level of management responsible for decisions concerning the day-to-day activities of the organisation. It is common for the information provided to them to be quantified in non-monetary units, such as hours worked, number of components produced, etc.

EU economic governance

The EU and its Member States have taken a series of important decisions that will mean stronger economic and budgetary coordination for the EU as a whole and for the euro area in particular. As a result, the EU’s interdependent economies will be better placed to chart a path to growth and job creation.

Surveillance of economic and fiscal policies

The economic and financial crisis has revealed a number of weaknesses in the economicgovernance of the EU's economic and monetary union. The cornerstone of the EU response is the adoption by the European Parliament and the Council of six legislative proposals put forward by the Commission in September 2010. The legislative package has four main components:

·    Stronger preventive action through a reinforced Stability and Growth Pact (SGP) and deeper fiscal coordination: Member States are required to make significant progress towards medium-term budgetary objectives (MTO) for their budgetary balances. Expenditure benchmarks will now be used alongside the structural budget balance to assess adjustments towards the MTO. A non-interest bearing deposit of 0.2% of GDP will be imposed on non-compliant euro-area countries.  

·    Stronger corrective action through a reinforced SGP: The launch of an Excessive Deficit Procedure (EDP) can now result from government debt developments as well as from government deficit. Member States with debt in excess of 60% of GDP should reduce their debt in line with a numerical benchmark. Progressive financial sanctions kick in at an earlier stage of the EDP. A non-interest-bearing deposit of 0.2% of GDP may be requested from a euro-area country which is placed in EDP on the basis of its deficit or its debt. Failure of a euro-area country to comply with recommendations for corrective action will result in a fine.

·    Minimum requirements for national budgetary frameworks: Member States should ensure that their fiscal frameworks are in line with minimum quality standards and cover all administrative levels. National fiscal planning should adopt a multi-annual perspective, so as to attain the MTO. Numerical fiscal rules should also promote compliance with the Treaty reference values for deficit and debt.

·    Preventing and correcting macroeconomic and competitiveness imbalances: Over the past decade, Member States have made economic choices which have lead to competitiveness divergences and macroeconomic imbalances within the EU. A new surveillance mechanism will aim to prevent and correct such divergences. It will rely on an alert system that uses a scoreboard of indicators and in-depth country studies, strict rules in the form of a new Excessive Imbalance Procedure (EIP) and better enforcement in the form of financial sanctions for Member States which do not follow up on recommendations.

Enforcement is strengthened by the expanded use of 'reverse qualified majority' voting. Under this voting system, a Commission recommendation or proposal to the Council is considered adopted unless a qualified majority of Member States vote against it.

Forensic accounting

Forensic accounting is the specialty practice area of accountancy that describes engagements that result from actual or anticipated disputes or litigation. "Forensic" means "suitable for use in a court of law", and it is to that standard and potential outcome that forensic accountants generally have to work. Forensic accountants, also referred to as forensic auditors or investigative auditors, often have to give expert evidence at the eventual trial.^[1] All of the larger accounting firms, as well as many medium-sized and boutique firms, have specialist forensic accounting departments. Within these groups, there may be further sub-specializations: some forensic accountants may, for example, just specialize in insurance claims, personal injury claims, fraud, construction,^[2]or royalty audits.^[3]

Engagements relating to civil disputes may fall into several categories: calculating and quantifying losses and economic damages, whether suffered throughtort or breach of contract; disagreements relating to company acquisitions—perhaps earn outs or breaches of warranties; and business valuation. Forensic accountants often assist in professional negligence claims where they are assessing and commenting on the work of other professionals.

Forensic accountants are also engaged in marital and family law of analyzing lifestyle for spousal support purposes, determining income available for child support and equitable distribution.

Engagements relating to criminal matters typically arise in the aftermath of fraud. They frequently involve the assessment of accounting systems and accounts presentation—in essence assessing if the numbers reflect reality.

Some forensic accountants specialize in forensic analytics which is the procurement and analysis of electronic data to reconstruct, detect, or otherwise support a claim of financial fraud. The main steps in forensic analytics are (a) data collection, (b) data preparation, (c) data analysis, and (d) reporting. For example, forensic analytics may be used to review an employee's purchasing card activity to assess whether any of the purchases were diverted or divertible for personal use.

Forensic accountants

Main article: Forensic accountant

Forensic accountants may be involved in recovering proceeds of crime and in relation to confiscation proceedings concerning actual or assumed proceeds of crime or money laundering. In the United Kingdom, relevant legislation is contained in the Proceeds of Crime Act 2002. In India there is a separate breed of forensic accountants called Certified Forensic Accounting Professionals. Some forensic accountants are also Certified Forensic Accounting Professionals,Certified Fraud Examiners, Certified Public Accountants, Chartered Accountants or ACCAs.

Forensic accountants utilize an understanding of business information and financial reporting systems, accounting and auditing standards and procedures,evidence gathering and investigative techniques, and litigation processes and procedures to perform their work. Forensic accountants are also increasingly playing more proactive risk reduction roles by designing and performing extended procedures as part of the statutory audit, acting as advisers to audit committees, fraud deterrence engagements, and assisting in investment analyst research.

"While Forensic Accountants ("FAs") usually do not provide opinions, the work performed and reports issued will often provide answers to the how, where, what, why and who. The FAs have and are continuing to evolve in terms of utilizing technology to assist in engagements to identify anomalies and inconsistencies. It is important to remember that it is not the Forensic Accountants that determine fraud, but instead the court." (David Malamed, Forensic Accountant, Toronto Ontario.)

Hollywood accounting

Hollywood accounting (also known as Hollywood bookkeeping)^[1] refers to the opaque accounting methods used by Hollywood to budget and record profits for film projects. Expenditures can be inflated to reduce or eliminate the profit of the project thereby reducing the amount which the corporation must pay in royalties or other profit-sharing agreements based on the net profit.

Creative accountants

Hollywood accounting gets its name from its prevalence in the entertainment industry — that is, in the movie studios of Hollywood. Those affected can range from the writers^[2] to the actors.^[3]

John D. MacDonald's novel Free Fall in Crimson (1981) references Hollywood accounting in its dialogue:

"Darling! This is the Industry! The really creative people are the accountants. A big studio got over half the profit, after setting breakeven at about three times the cost, taking twenty-five percent of income as an overhead charge, and taking thirty percent of income as a distribution charge, plus rental fees, and prime interest on what they advanced."

How it works

Hollywood accounting can take several forms. In one form, a subsidiary is formed to perform a given activity and the parent entity will extract money out of the subsidiary not in terms of profits but in the form of charges for certain "services". The specific schemes can range from the simple and obvious to the extremely complex.

Three main factors in Hollywood accounting reduce the reported profit of a movie, and all have to do with the calculation of overhead:

§  Production overhead – Studios, on average, calculate production overhead by using a figure around 15% of total production costs.

§  Distribution overhead – Film distributors typically keep 30% of what they receive from movie theaters ("gross rentals").

§  Marketing overhead – To determine this number, studios usually choose about 10% of all advertising costs.

All of the above means of calculating overhead are highly controversial, even within the accounting profession. Namely, these percentages are assigned without much regard to how, in reality, these estimates relate to actual overhead costs. In short, this method does not, by any rational standard, attempt to adequately trace overhead costs.

Due to Hollywood accounting, it has been estimated that only about 5% of movies officially show a net profit, and the "losers" include such blockbuster films as Rain Man, Forrest Gump, Who Framed Roger Rabbit, and Batman, which all took in huge amounts in box office and video sales.

Because of this, net points are sometimes referred to as "monkey points," a term attributed to Eddie Murphy, who is said to have also stated that only a fool would accept net points in his or her contract.^[5][6]

All of this shows why so many big-name actors insist on "gross points" (a percentage of some definition of gross revenue) rather than net profit participation. This practice reduces the likelihood of a project showing a profit, as a production company will claim a portion of the reported box-office revenue was diverted directly to gross point participants.

Examples

Winston Groom's price for the screenplay rights to his novel Forrest Gump included a share of the profits; however, due to Hollywood accounting, the film's commercial success was converted into a net loss, and Groom received nothing.^[7] That being so, he has refused to sell the screenplay rights to the novel's sequel, stating that he "cannot in good conscience allow money to be wasted on a failure".

Stan Lee filed and won a lawsuit after the producers of the movie Spider-Man did not give him a portion of the gross revenue.^[8]

The estate of Jim Garrison sued Warner Bros. for their share of the profits from the movie JFK, which was based on Garrison's book On the Trail of the Assassins.^[9]

Art Buchwald received a settlement after his lawsuit Buchwald v. Paramount over Paramount's use of Hollywood accounting. The court found Paramount's actions "unconscionable", noting that it was impossible to believe that a movie (1988's Eddie Murphy comedy Coming to America) which grossed US$350 million failed to make a profit, especially since the actual production costs were less than a tenth of that. Paramount settled for an undisclosed sum, rather than have its accounting methods closely scrutinized.

The film My Big Fat Greek Wedding was considered hugely successful for an independent film, yet according to the studio, the film lost money. Accordingly, the cast (with the exception of Nia Vardalos who had a separate deal) sued the studio for their part of the profits. The original producers of the film have sued Gold Circle Films due to Hollywood accounting practices because the studio has claimed the film lost $20 million.^[10]

Hollywood accounting is not limited to movies. An example is the Warner Bros. television series Babylon 5 created by J. Michael Straczynski. Straczynski, who wrote 90% of the episodes in addition to producing the show, would receive a generous cut of profits if not for Hollywood accounting.^{[citation needed]} The series, which was profitable in each of its five seasons from 1993–1998, has garnered more than US$1 billion for Warner Bros., most recently US$500 million in DVD sales alone. But in the last profit statement given to Straczynski, Warner Bros. claimed the property was $80 million in debt. "Basically", says Straczynski, "by the terms of my contract, if a set on a WB movie burns down in Botswana, they can charge it against B5's profits."^[11]

Peter Jackson, director of The Lord of the Rings, and his studio Wingnut Films, brought a lawsuit against New Line Cinema after "an audit... on part of the income of The Fellowship of the Ring." Jackson stated this is regarding "certain accounting practices," which may be a reference to Hollywood accounting. In response, New Line stated that their rights to a film of The Hobbit were time-limited, and since Jackson would not work with them again until the suit was settled, he would not be asked to direct The Hobbit, as had been anticipated.^[12] Fifteen actors are suing New Line Cinema, claiming that they have never received their 5% of revenue from merchandise sold in relation to the movie, which contains their likeness.^[13] Similarly, the Tolkien estate has sued New Line, claiming that while their contract entitled them to 7.5% of the gross receipts, the film studio has refused to pay them any share of the $6 billion hit.^[14]

A WB receipt was leaked online, showing that the hugely successful movie Harry Potter and the Order of the Phoenix ended up with a $167 million loss on paper.^[15]

Michael Moore is suing Bob and Harvey Weinstein for creative accounting to deprive him of his share of profits for the film Fahrenheit 9/11. 

Production accounting

Production accounting is a filmmaking term, used especially in Hollywood, referring to the project accounting of the cost of a film project. As with construction accounting, salient issues are the accurate allocation of workers' time to specific projects (usually requiring each worker to fill out a weekly timesheet), and the correct assessment of indirect costs such as employee benefits.

Specialized software to support production accounting has been developed.