This article discusses goodwill, an intangible asset usually not reflected on a balance sheet.
One of the most basic questions for any business owner is “What is my business worth?” Because the balance sheet lists assets, liabilities, and equity, it should be useful in answering this question.
The balance sheet, despite sometimes being called the statement of net worth, does not always give a clear picture of the entire worth of a business. In fact, often the balance sheet gives a far better picture of the liquidating value of the business, as compared to its going concern value. The liquidating value is the amount that would be realized in cash if the assets were sold piece-meal, and the liabilities satisfied from the proceeds. Liquidating value is generally applied to a business that will cease operations.
In contrast, the going concern value of a business is the cash value of all the assets, purchased together, under the assumption that the new owners will continue to operate the business. Often, this going concern value is significantly greater than the liquidating value. The difference between the going concern value and the liquidating values is called goodwill. What creates goodwill.
Goodwill reflects a firm’s ability to retain customers based on prior performance. Essentially, if a business does a good job providing a product or service, its customers are likely to be repeat customers. The distinction between going concern and liquidating value can be illustrated by the following example.
Example. Carlo Castrato has run a successful ball bearing company for several years. If he decided to sever operations, close his doors, and sell his equipment and furnishings, he might realize $25,000. This is the liquidating value of the assets. On the other hand, his nephew Carmine is willing to pay him $225,000 for the same equipment if he can use the firm’s name and operate at the same location. The difference between the liquidating value and the going concern value is $200,000, reflecting the goodwill that Carlo has built over the years.
Why would Carmine be willing to pay $200,000 for equipment and furnishings that he could purchase for $25,000? Because, if he opens up a new ball bearing company at a different location under a different name, it may take several years to reach the level of profitability currently being realized by Castrato. The ability to step into his uncle’s shoes allows Carmine to make considerably more profit immediately.
Although this example may seem extreme, it is not. Most businesses that have operated successfully over several years are able to command going concern value. If goodwill is such a common and valuable asset, why doesn’t GAAP require it to be reflected on the balance sheet? Simply put, there is no one reliable and universally accepted method to measure the goodwill of a business.
While there are many theories and methods of valuing goodwill, until a business actually goes through the laborious negotiation process involved in selling its entire operation, the actual value of goodwill is not precisely determinable. The appraisal of goodwill is more art than science. For this reason, GAAP allows the recognition of goodwill on the balance sheet only after one business has actually acquired another business.
Absent an actual purchase, GAAP believes that allowing management to determine the value of its own internally generated goodwill would lead to wildly inflated valuations, with little ground in economic reality. However, because goodwill is not reflected on most small business balance sheets, these statements generally do not provide an accurate assessment of the worth of a firm as a whole.