Goodwill - features of calculating its amount and accounting
25.02.2021Recently, more and more questions have arisen from our readers about the concept of goodwill (goodwill – English). What is it, how to calculate its value in theory and using a numerical example, how to depreciate it and what happens if it is sold without taking into account the cost, etc. About all this in our article today
What is goodwill?
Goodwill (goodwill – English) is business reputation, that is, the added value of your company, in addition to the value of assets and liabilities. Let's look at the situation using an example.
You have a pastry shop known throughout the region for its delicious pastries and beautiful wedding cakes. Three hundred meters down the street, there is a second bakery that sells nothing but eclairs and apple pies. When sold, your pastry shop will undoubtedly have a higher added value due to a better reputation.
How is goodwill calculated?
There are several factors that can be relevant when calculating goodwill, for example:
Field of activity
A consumer electronics company, due to the higher pressure on profitability, may receive a lower level of goodwill;
Owner
If the reputation of a restaurant is based entirely on that of a renowned chef, goodwill at the time of sale will be determined based on whether the chef is still associated with the restaurant;
Location
A store in a less sales-friendly area will have lower goodwill;
Market development
It is possible that a company will need significant investments to defend its position in the market;
Future prospects
A company with its own know-how, which is of high value, will receive more goodwill. An example is biotech companies, which, despite the fact that they are not yet profitable, change hands for a lot of money.
Theoretical method for calculating goodwill
Goodwill is often determined using a theoretical calculation method. The profitability of the company is made up of the profit indicators of previous years.
Profit for the last three fiscal years is taken as the starting point for determining goodwill. Profits for these years are adjusted for unforeseen expenses and income from business activities. Then the profit is reduced by the remuneration that the entrepreneur pays himself for his work.
Finally, interest on equity is deducted from profits. The final amount is excess profit. Excess profit multiplied by a factor from two to six gives an idea of business reputation. The final multiplier is determined by the earnings forecast, the outcome of negotiations and the above factors.
Example of calculating goodwill
Patrick has a car painting shop. In the first year he made a profit of €45, in the second year he made a loss of €378, and in the third year he made a profit of €11.
In the first year, he completely renovated his paint shop and adapted it to the most stringent environmental and industry requirements - at a cost of €68. Excluding contingencies for renovations, the average annual profit over three years was €067.
Patrick pays himself an annual salary of € 36 for his work. The company's equity capital is 302 euros.
The excess profit will be:
gross profit € 56 – wages € 722 – equity compensation (36%) € 302 € = € 10.
It is possible that the forecast for the profit of the car paint shop has increased due to investments in the first year. In this case, goodwill can be valued quite high. But if paint technology is already obsolete due to new environmental regulations, or the location of a car paint shop no longer meets government zoning plans, the amount of goodwill will decrease significantly.
Amortization of goodwill
If you bought a company, you probably want to write off the value of the goodwill you paid as soon as possible. Good business reputation should be amortized over its expected useful life. This service life is assumed to be finite, but in the range of 10 to 20 years.
The recognition of negative goodwill that arises when the purchase price is below the fair value of the assets and liabilities acquired depends on the reason for that assessment.
If negative goodwill is related to expected future losses and expenses, goodwill should be added to the bottom line as the estimated losses and expenses arise. In other cases, negative goodwill should be included in the revaluation reserve, followed by a progressive write-off or write-off of a lump sum.
Selling goodwill without cost is a gift
The Dutch tax authority pays special attention to determining the amount of goodwill in transactions between affiliated parties.
In particular, in the case of a family business transfer, goodwill is sometimes disregarded or measured at the lowest possible value. The tax authorities themselves can calculate goodwill in suspicious cases. To do this, the tax authority independently determines the excess profit and multiplies it by 2,5-3 times.
In the example of painting a car, the excess profit was € 18. In a "bad" scenario, when buying a company, you will have to pay tax on the gift on the amount of 151 euros.
To sell your company without unpleasant consequences, it is advisable to seek help from a specialist. It is important not only to determine the real selling price, but also the final amount that you have to pay to the tax authorities. The Nalog.nl team will help you both with calculating the value of goodwill and with all the organizational aspects of selling a company in the Netherlands.
The information posted in the article is current at the time of its publication.
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