Accounting theory and practice, Volume 2 (of 3) : a textbook for colleges and…

securing the consent of affected property owners or of the whole community where such cost is to be borne by the petitioning company. All of these are costs which from the standpoint of good business practice may be capitalized under the caption “Franchises.” Depreciation on Franchises For periodic revaluations, depreciation should be in accordance with the terms of the grant. If the grant is perpetual, no depreciation need be taken account of; if it is for a limited term, the cost of the franchise should be prorated over that term; if the grant is indeterminate, as defined above, not only should a very liberal depreciation policy be pursued with regard to the franchise but, in the case of the type of franchise granted by Massachusetts, a liberal provision for writing off all the assets should be made, unless in the execution of the law a policy of non-revocability of franchises has become fairly well fixed. In contrast with the above, note the ruling of the Public Service Commission for the First District of the State of New York. “To this account—Franchises (Gas)—shall be charged ‘the amount (exclusive of any tax or annual charge) actually paid to the state or to a political subdivision thereof as the consideration for the grant of such franchise or right’ (Section 69 of the Public Service Commissions Law) as is necessary to the conduct of the corporation’s gas operations. If any such franchise is acquired by means of assignment, the charge to this account in respect thereof must not exceed the amount actually paid therefor by the corporation to its assignor, nor shall it exceed the amount specified in the statute above quoted. Any excess of the amount actually paid by the corporation over the amount specified in the statute shall be charged to the account ‘Other Intangible Gas Capital.’ If any such franchise has a life of _not more than one year after the date when it is placed in service_, it shall not be charged to this account but to the appropriate accounts in ‘Operating Expenses,’ and in ‘Prepayments’ if extending beyond the fiscal year.” To a depreciation account called “General Amortization” is to be charged, besides depreciation of tangible fixed capital, “such portion of the life of intangible fixed capital as has expired or been consumed during the month.” Such careful regulations as to the content of intangible asset accounts are not always nor everywhere imposed at the present time. It is not putting the case too strongly to say that the reader of a balance sheet containing items about which practice is not standardized should always be on his guard to assure himself as to the content of such items in order to establish the legitimacy of their use and value. Organization Expenses Organization expenses are those costs necessarily incurred for the purpose of getting an enterprise under way, i.e., of putting it in readiness to do business and produce income. These expenses usually comprise such costs as state incorporation fees, attorney’s fees for drawing up the application and other papers, the cost of prospectuses, soliciting costs for stock subscriptions, fees paid promoters and organizers, cost of printing and issuing certificates of stock, cost of capital stock records, and similar items. These are necessary and unavoidable expenses without which the company cannot come into being. A company organized and ready to commence business is in a better position than one whose elements have not been brought into harmonious working. In the same way that the costs of installing machinery in position and ready for use are capitalized by being added to the value of the equipment, so may the organization expenses of a corporation be legitimately capitalized as being the measure of the amount of the greater value which these organized business elements have over the same elements unorganized. Capital has been brought together and set to work, management and plan of operation have been secured, and business is ready to begin. Organization expenses are therefore, from the standpoint of classification, best treated as an intangible asset rather than as a deferred or prepaid expense. In strict theory the value of these costs will last as long as the corporate existence. In Italy where corporate life is limited to fifty years, it is prescribed that organization costs be prorated over the full life of the corporation. The best practice in this country requires a much more rapid writing off of these items; R. H. Montgomery[46] advocating writing them off as they occur or at most over the first two years’ operation. To one not cognizant of the many abuses which have crept in—and even frauds perpetrated—through this channel, the treatment advocated may seem harsh and severe. Perhaps no harm is done in pursuing a more liberal policy, if such expenses are carried under a proper title, if they are not used to inflate the value of the tangible assets, and if the caution stated above is observed as to the need for investigating the values of all intangible asset items. Certainly organization expense should never be used as a cloak for discount on stocks or other securities marketed. Good-Will—Definition and Nature The last of the intangible assets to be treated is good-will. Lord Justice Lindley, in an English case, says: “Good-will regarded as property has no meaning except in connection with some trade, business, or calling. In that connection I understand the word to include whatever adds value to a business by reason of situation, name and reputation, connection, introduction to old customers, and agreed absence from competition, or any of these things, and there may be others which do not occur to me.” The definition by George Lisle[47] is to the same general effect: “Good-will is the monetary value placed upon the connection and reputation of a mercantile or manufacturing concern, and discounts the value of the turnover of a business in consequence of the probabilities of the old customers continuing.” Good-will therefore includes every advantage connected with location, premises, reputation, personality, name, etc. That all these are elements of good-will cannot be gainsaid, but unless an earning power larger than that of a newly established competing concern goes along with these elements, no one would be willing to pay anything for the good-will of the old concern. [46] In “Auditing, Theory and Practice.” [47] In “Accounting in Theory and Practice.” It sometimes happens in the case of a merger, that because of the dormant or latent good-will of the various units—or some of them—to be merged, a promoter may be willing to pay something more than the value of the tangible assets in order to acquire the various properties. Dormant or latent good-will signifies the excess earning power that would exist if it were not for poor management, an inharmonious working together of the various parts of the organization, and other similar handicaps which the new management will remove. It may be objected that until such handicaps have been removed there is no good-will; that any good-will brought into evidence through the removal of these handicaps is the good-will built up by the new concern and not the old. It cannot be denied, however, that all the other elements of good-will may have been acquired and built up by the old company and that without them the new concern would be unable to bring good-will into evidence simply by a change of management. It is true that the merger may be able to build up quickly a good-will of its own through the elimination of competition, and through the full utilization of all the advantages of the different units—such as access to supplies of raw material, favorable trade agreements of various sorts, and the like. While there is a sense in which expected future performance as indicated above, may be an element in the determination of good-will and may be legitimately paid for as such, as a usual thing the essence of good-will lies in the ability to make a profit in excess of the normal. Past performance must be reviewed by which to judge the normality of the present profits and the probability of their continuance in the future. Local and Personal Character of Good-Will It should be pointed out, as a corollary to the above statement that only those elements which are transferable and are transferred can be disposed of for a price. Thus, when a business goes to the new owner, if there is apt to be a very appreciable shrinking in profits—as is the case in the transfer of some professional businesses—or if the favorable location on which in some cases depends the ability to earn excess profits cannot be turned over to the purchaser because of the expiration of the lease or other reason, good-will may not be worth much to a prospective purchaser. There is thus a local and personal character to good-will which cannot be ignored. Difficulty of Valuing Good-Will The valuation of good-will presents at times many complexities. The general principle of valuation at cost—and not market—may be said to apply here, too. What constitutes cost is sometimes difficult to determine. A corporation which buys out an existing business, paying an agreed sum for the good-will, should set up on the books that sum as the value of good-will. The vendor concern during the years of the establishment of its good-will, unless specific expenditures were made for that purpose, should not show any value for it on its books. In an English case, Stewart v. Gladstone, 1879, the court said: “Is it reasonable ... that a changing thing like good-will, the value of which would vary year by year according to the state of the trade ... and to the reputation which the house had acquired or had lost for integrity, punctuality, solvency, and mercantile prudence, was to be valued from year to year,” and the increase or decrease was to be treated as profit or loss for the year and distributed? The impropriety of bringing good-will on the books unless paid for by purchase or otherwise, is established and rests on principles of sound business. Creation of Good-Will by Advertising There is perhaps only one case in which a concern which has not acquired good-will by purchase but has built it up for itself may with propriety set up its value on the books. Creating a demand for a product by means of extensive advertising is one of the quickest ways of building up good-will. The difference between the cost of the advertising necessary to retain a given volume of trade—which we may call the normal advertising expenditure—and the cost of the publicity required to secure that trade may be treated, in theory at least, as an expenditure on account of good-will and be so shown on the books. This is usually a difficult matter to determine at the close of the publicity campaign and before the cost of normal advertising is known, and the valuation at best is somewhat speculative. But where handled carefully and with conservatism there seems no serious objection to bringing good-will on the books at a value calculated in this way. Unless it is possible to treat some expenditures of this sort as the direct cause of good-will, the evidence of the possession of good-will must be sought in the profit and loss record rather than in the balance sheet, as its existence would be indicated only by above-normal profits. Valuation of Good-Will Based on Normal Profits Valuing good-will for a purchaser is not so difficult. Two standard methods are in use, the one based on profits, the other on excess profits. According to the first, the value of the good-will is estimated as so many years’ purchase price of the net profits of the last year; or, better, the average of the last three or five years. This simply means multiplying the profits by the number of years’ purchase. The number of years to be used as a multiplier varies from one to fifteen, or twenty in some instances. Thus, if the agreement is to pay three years’ purchase of the average profit for the past five years and this average is $50,000, the price paid will be $150,000 and at that value good-will should be shown on the purchaser’s books. Valuation of Good-Will Based on Excess Profits The other method determines first the excess profits, i.e., the amount by which the profits of a particular business exceed the normal or average figures for that line of business. Thus, if the profits are $75,000 and normal profits are $50,000, the excess earning capacity per period is $25,000. This amount is then capitalized on some arbitrary basis, ranging in practice from the prevailing interest rate, say 5%, to 20% or even 50%. The effect of such capitalization is to apply a multiplier, as in the first method, ranging from 20 to 5 or less. Thus, if 20% is the agreed rate, the excess, $25,000 multiplied by 5 gives $125,000 as the value. It is, of course, apparent that the valuation of good-will for prospective purchase is largely dependent upon the individual judgment of the buyer and that seldom will any two men arrive at the same valuation. As a matter of prudence, under either method the average profits for the past few years should be used rather than those of the last year. The latter may be sporadic and under conditions such as not to warrant their continuance. An average figure gives a better indication of what the business may be expected to do under normal conditions. Inasmuch as the value of good-will depends on excess earning capacity, the second method of valuation rests on better theoretical grounds than the first. Practically there is no preference, since valuation is largely a matter of personal judgment under either method. Valuation of Good-Will Based on Capitalization of Profits A slight variation of the second method is sometimes used. Under it the average net profits are capitalized at some agreed rate, giving the amount of money on which the average profits could be earned at the rate used. The difference between this amount and the amount of capital actually invested gives the value of the good-will. Thus, if on an investment of $250,000 net average profits are $60,000 and the normal rate for this business is 15%, $60,000 would represent a 15% income on $400,000. Good-will must therefore represent the difference between $400,000 and $250,000, or $150,000. This must evidently work out in exactly the same way as the second method if the rate used is the same. Therefore it constitutes not a distinct method, but only a variation. In the one case the difference between the average and normal profits is capitalized; in the other both are capitalized and the difference of their capitalizations is taken. False Good-Will to Cover Capital Deficiency A method of valuing good-will which makes it represent the difference between the value of tangible assets contributed or purchased and the par value of the stock issued cannot be countenanced at all. This use of good-will to cover up a capital deficiency is not only improper and misleading but often fraudulent. It is the favorite means by which “water” is injected into corporations. Thus, a concern desiring to capitalize at $500,000 and unable to sell its stock for more than $300,000, might carry an asset, good-will, to take care of the $200,000 discount on stock. A partnership desiring to incorporate might issue for the partnership assets stock with a par value much more than the assets taken over, and either inflate the asset values or set up a good-will account to care for the difference. This practice cannot be too severely criticized. In connection with this it should always be kept in mind that a newly organized company can never include good-will among its assets except by purchase. Somewhat analogous to the above practice is that of increasing the capitalization of a company and issuing new shares in exchange for the old. Thus a company capitalized at $1,000,000 might increase its capital to $2,000,000, issuing two shares of the new for each share of the old. This will necessitate bringing onto the books an intangible asset, usually good-will, to cover the additional $1,000,000 of stock issued. Sometimes a real good-will may be existent as shown by the abnormal profits. In such cases, the effect of an increase of capital stock will be to keep down the _rate_ of profit on the capital stock and so decrease the market value of each share, but not the real value of the total shares nor the _amount_ of profit distributable to each of the holders of shares of the original issue. The purpose in such an increase of capital stock is usually an ulterior one, such as the desire to cover up real earnings in order to prevent a reduction of rates, as in the case of a public utility company. The purpose may sometimes seemingly justify the practice. The problem is mainly an ethical one and it is not proposed to discuss it here further than to say that the practice is usually to be condemned. Periodic Revaluation of Good-Will Periodic revaluation of good-will must next be considered. This involves a determination as to whether it is subject to depreciation. From what has been established as the essence of good-will, viz., the ability to earn excess profits, it is apparent, as stated in the case Stewart v. Gladstone on page 333, that its value must fluctuate from time to time with the earnings of the business. Because of this changing and at times doubtful value, some authorities advocate its being written off the books periodically, and a good many concerns do so write it off. The effect of this, so long as there is any value remaining in good-will, is to create a secret reserve and this is justified on the ground of conservatism. The practice is not reprehensible, though usually to be discouraged. The weight of authority is to the effect that all purposes are best served by allowing it to remain always on the books at cost. There is no logical reason for writing it off. When profits are large, good-will is a very real asset. To write it off then is not logically consistent. When profits are small and good-will is accordingly of less value than before, it would hardly be logical to write off any amount less than its decreased value, yet the profits at such a time are rarely sufficient to stand so heroic a treatment. As was stated above on page 330, all intangible assets should be examined carefully by a prospective purchaser as to the values at which they are being carried. Good-will, because of the improper and misleading uses to which it has so often been put, is never above suspicion and its value should not be taken without close investigation. If it _really_ exists, the profit and loss record will show it. That should guide as to its valuation and not the value carried on the balance sheet. Accordingly, since the asset does not depreciate but only fluctuates in value, and since it is neither prudent nor consistently possible to take these changing values onto the books, the best course for all purposes seems to be to retain good-will in the accounts always at its cost figure. The above considerations as to the depreciation of good-will apply with almost equal weight to the depreciation of trade-marks. In closing this chapter attention should be called to the fact that the term “going value” is used in the case of public utility companies in much the same way as good-will.