Abstract: Goodwill is an indefinite-lived intangible asset. It comes into play in various business valuation assignments. This article discusses what goodwill is and the role it plays in divorce and financial reporting. A sidebar highlights the differences between personal and business goodwill.
Valuing “blue sky”
Why goodwill matters and how it’s measured
Goodwill is an indefinite-lived intangible asset. Some businesses have no goodwill. For others, goodwill is a significant part of their value. It comes into play in various business valuation assignments, from divorce and shareholder litigation to business combinations and financial reporting. Not surprisingly, the purpose of a valuation assignment can affect how it’s measured.
In a nutshell
Goodwill can be hard to define. Examples of the way goodwill can be viewed include:
- Going concern value. This comes from business assets that are producing income. The assemblage of capital (financial resources and equipment), labor and management creates intangible value.
- Excess business income. This is the amount of business income that exceeds the amount necessary to provide a fair rate of return on tangible assets (for example, buildings and equipment) and identifiable intangible assets (for example, patents, trademarks, copyrights, trade secrets, franchises and licenses). The theory is that such excess income is due to goodwill.
- Expectation of future economic benefits. The third component arises from expected economic benefits that aren’t directly related to current assets or operations. The value is the net present value of income that will come from expectations of attracting new customers, developing new goods or services and participating in M&As.
How much is goodwill worth? Parties — and experts — seldom agree on the value of this intangible or the appropriate valuation technique to apply.
Under U.S. Generally Accepted Accounting Principles (GAAP), goodwill normally goes unreported on the balance sheet unless it’s purchased, as in the sale of a business. The term “goodwill” refers to the residual asset recognized in a business combination after all other identifiable tangible and intangible assets acquired and liabilities assumed have been recognized. GAAP requires goodwill to be carried on the books at its initial fair value less any impairment. It generally isn’t subject to amortization.
Goodwill is impaired if the implied fair value of goodwill of a reporting unit (basically, an operating unit with its own discrete financial information, separate from the overall company) drops to an amount less than its carrying amount, or book value, including any deferred income taxes. Most companies are required to test for impairment at least annually, and more frequently under certain conditions.
Private companies can elect out of impairment testing, and, instead, amortize goodwill over a period not to exceed 10 years. But they’re still required to test for impairment if a “triggering event” — such as the loss of a major customer or the enactment of an adverse government regulation — occurs.
In divorce cases
How goodwill is handled in a divorce context varies depending on state laws and the facts of the case. When the marital estate includes a private business interest, most states include some or all goodwill when divvying up the couple’s assets. In a few states, all goodwill is specifically excluded from the marital estate.
Often, the treatment of goodwill in divorce cases hinges on whether a spouse who doesn’t participate in the business (the noncontrolling spouse) will receive alimony based on the earning capacity of the spouse that will retain the business (the controlling spouse). The logic here is known as “double dipping.” That is, the noncontrolling spouse shouldn’t benefit twice from the same asset by receiving 1) alimony based on the controlling spouse’s salary, and 2) half of the fair value of goodwill or, in some states, personal goodwill. (See “What’s the difference between personal and business goodwill?”)
A critical factor in valuing goodwill is whether the controlling spouse’s salary is reasonable compared to what other people receive for performing comparable work elsewhere. If the controlling spouse is under- or overpaid, adjustments to the amount of alimony awarded and income stream that’s used to value the business may be warranted.
Different circumstances call for different approaches to valuing goodwill. Whether you’re valuing goodwill for financial reporting or litigation purposes, retaining a qualified professional will ensure you get a value you can count on.
Sidebar: What’s the difference between personal and business goodwill?
In divorce cases in most states, it’s not enough to value goodwill as a whole. Your valuation expert also might need to break it down between personal and business goodwill. Why? Because some states specifically exclude personal goodwill from the marital estate.
Personal (or professional) goodwill is linked to individual business owners and their abilities to generate future income. It often attaches to a professional person because of confidence in that person’s skills and credentials, but the courts in some jurisdictions have rules that owners of manufacturing and retail businesses can also generate personal goodwill. Personal goodwill typically can’t be transferred to a third party unless the seller enters into a postclosing consulting or employment agreement with the buyer.
Conversely, business (or enterprise) goodwill arises from factors that separate it from the skills or attributes of an individual owner of the business. Examples of these factors include the company’s location, assembled workforce, brands, patents and name. Business goodwill is generally easier to transfer to a third party buyer than personal goodwill.
To ensure proper treatment of goodwill, it’s imperative to review the statutes and case law in the applicable jurisdiction of the divorce action.