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whether certain payments such as partners' salaries should
be included in cost of goods or treated as part of the gen-
eral expenses of the business. Attempts have even been
made to include a certain percentage, representing normal
profits, in the cost price, a procedure which not only
opposes accounting practice but which has been prohibited
by the courts. 1

Goods in the process of manufacture for the general
market should not be inventoried at more than the cost
price; but when they are manufactured on a specific con-

1 Providence Rubber Co. v. Goodyear. 9 Wall. 788.

tract it is correct to take into account the selling price,
making due allowance for the unfinished work still to be
done, the risks intervening and interest charges involved.
Where the contract period extends beyond the current fiscal
period such inventorying is not only permissible but is the
only correct method. Otherwise the profits on the contract
work would all appear in the year when goods are deliv-
ered, although the labor involved belonged almost en-
tirely to a preceding year.


.NEYMARCK, A. Du meiileur mode & indiquer AU point de vue
statistique international pour la confection des bilans des
societes anonymes. Bulletin de VInstitut international de
statistique. Tome XIV, livraison 2, pp. 143-199. [Contains
answers to a series of questions propounded to various mem-
bers of the Institute.]

PIXLEY, F. W. Auditors, their Duties and Responsibilities.
Vol. I, Chapter XI. Ninth edition. London, 1906.

SIMON, H. V. Die Bilanzen der Aktiengesellschaften, pp. 326-444.
3te Aufl. Berlin, 1899.

On the Valuation of Real Estate.
HURD, R. M. Principles of City Land Values. New York, 1903.

On the Valuation of Machinery, etc.

ARNOLD, H. L. The Complete Cost Keeper, pp. 353-362. New
York, 1900.

MATHESON, E. The Depreciation of Factories, Mines, and Indus-
trial Undertakings and their Valuation. Chapter VI-XIII.
Second edition. London, 1903. [A standard authority.]

NORRIS, H. M. Machine Tool Depreciation as an Element of
Manufacturing Cost. Engineering Magazine, XVI, p. 957.
[Discusses views of Smith.]

SMITH, O. Inventory Valuation of Machinery Plant. Trans-
actions American Society of Mechanical Engineers, VII, p. 433.


On the Valuation of Investments.
MAY, G. O. The Proper Treatment of Premiums and Discounts on

Bonds. Journal of Accountancy, II, p. 174.
SPRAGUE, C. E. The Accountancy of Investment. Fourth edition.

New York, 1907. [A valuable treatise giving mathematical

Problems and Studies in the Accountancy of Investment.

New York, 1906. [A supplement to the above.]
> Premiums and Discounts. Journal of Accountancy, II,

p. 294. [A criticism of the article by May.]

See also the references to Chapters VII and XII.



GOODWILL, which may be taken as the typical form of
Immaterial Assets, represents the value of business con-
nections, the value of the probability that present custom-
ers will continue to buy in spite of the allurements of com-
peting dealers.

While the inclusion of intangible assets in the inventory
of corporations is not infrequently the object of popular
criticism the legitimacy of Goodwill has long been recog-
nized both by the .courts and by accountants. A clear
statement of the principle is given in the case of "Washburn
v. National Wall Paper Company, where the court said:
" AVhen an individual or a firm or a corporation has gone
on for an unbroken series of years conducting a particular
business, and has been so scrupulous in fulfilling every obli-
gation, so careful in maintaining the standard of the goods
dealt in, so absolutely fair and honest in all business deal-
ings that customers of the concern have become convinced
that their experience in the future will be as satisfactory
as it has been in the past, while such customers ' good report
of their own experience tends continually to bring new
customers to the concern there has been produced an ele-
ment of value quite as important in some cases, perhaps,
far more important than the plant or machinery with
which .the business is carried on. That it is property is
abundantly settled by authority, and, indeed, is not dis-
puted. That in some cases it may be very valuable prop-



erty is manifest. The individual who has created it by
years of hard work and fair business dealing usually ex-
periences no difficulty in finding men willing to pay him
for it if he be willing to sell it to them. ' ' x

Similarly accountants have recognized that the pur-
chase of Goodwill of an established firm may be a most
valuable transaction, for it may save, as Guthrie has
neatly put it, " the period of perilous probation." Indeed
even the Goodwill of a bankrupt house is at times legiti-
mately sold at a high price, and where so purchased it is
as true an asset as factory, machine, or stock of mer-

But in valuing Goodwill for the inventory the limita-
tion of its value to its cost must be most rigorously ob-
served. It has been seen that the restriction of inventory
value to cost price is of rather general application, but its
force is much greater when the Goods to be valued are
immaterial. No one would object to the inclusion in the
inventory of treasure trove even though it cost the finder
nothing. But Goodwill is rigorously excluded unless it
has been secured at a cost. Hence it is recognized as
legitimate for the purchaser of Goodwill to include it
among his assets, but accounting practice prudently,
though perhaps illogically, forbids the firm which created
the Goodwill to place in the Balance Sheet any value on
the clientele which it has built up and which it could at
any moment sell for a large sum.

This conservative restriction is doubtless necessary to
prevent a harmful exaggeration. Human nature is so in-
curably optimistic, especially when it comes to estimating
one's own possessions. The boy's jackknife, the citizen's
fatherland, the man's children, are in normal cases a little
better than similar possessions of anyone else. The same
phenomenon appears in the valuation of one's business

81 Federal Rep. 20.


assets, where the natural instinct to overvalue one's own
possessions is augmented by the fact that such overvalua-
tion may be the means of overreaching some one else in a
business deal. In proportion as it is difficult to verify
values it is therefore customary to limit the value at which
they are appraised. Cash being of definite value may be
listed though it cost nothing; quoted securities or com-
modities may, according to some authorities, be listed at
the market value even though that exceed the cost; but
Goodwill, because of its vague nature and the difficulty of
verifying its appraisal is to be excluded unless it has been
purchased. 1

But it is not always easy to determine whether there
has been an actual -purchase of Goodwill, or what price,
if any, has been paid. Most frequently where a corpora-
tion buys out the business of a partnership or of another
corporation the purchase is made with stock, not with
cash. When, as is generally the case, the par value of the
stock given is in excess of the value of the tangible assets
it is at times difficult to determine whether the difference in
these values represents Goodwill purchased or a mere dis-
count of the stock issued. In ordinary American practice
the accountants have assumed the existence of Goodwill
wherever the tangible property purchased is less than the
par value of the stock issued therefor. Thus in the recent
capitalization of a large catalogue house, whose total assets
were less than $20,000,000, there was added at the time
of reorganization the item of Goodwill valued at $30,000,-
000. The exaggeration in this figure is clearly established
by the quoted prices of the stock issued for its purchase.

1 For a possible exception to this see the decision in the English case
In re Barrow Haematite Steel Co. ([1900] 2 Ch. 855) where it was held
that a decline in the value of part of the assets should be offset by the
introduction of Goodwill before it could be claimed that capital had
been impaired.


In general the recent organization of the so-called trusts
included a high valuation for Goodwill, ordinarily roughly
corresponding to the amount of common stock issued. In
most cases this was grossly overstated, and openly and
notoriously incorrect. This is shown for instance by the
experience of the Asphalt Company whose earnings esti-
mated at ten per cent, of the capitalization proved to be
less than one per cent. ; or by that of the American Malt-
ing Company where the $2,100,000 earnings estimated in
the prospectus dwindled to a negative quantity in the first
year of operation. It is, therefore, necessary to examine
the conditions in which Goodwill exists, and to consider
the principles governing its valuation.

The value of Goodwill, or the other similar categories,
" Franchise," "Patent Rights," " Trade Marks," " Trade
Names," depends on the existence of some legal right or
trade custom which will bring to the owner of the business
profits in excess of that to be obtained in other ordinary
channels of trade. If the firm's name and its past repu-
tation for good dealing will bring to its doors a flow of
customers without the expense of profuse advertising or
despite the lower prices of less favorably known rivals,
there is a source of profits in excess of what could be
obtained by establishing a new house. If the right to use-
a particular location to the exclusion of others, whether
that location be of a newspaper stand on a crowded cor-
ner, or a street railway with an exclusive franchise to
the streets, there is at least a possibility that ft opens the
doors to the receipt of profits which could not be gained in
any line of business not thus specially favored. If any
business is protected by a monopoly, whether the legal
monopoly of a patent right or a partial business monopoly
resting on the combination of all present competitors in
a " trust," there is a possibility of maintaining prices at
a level which will yield profits in excess of the current


normal rate, and hence a legitimate basis for the valuation
of Goodwill.

The one justification of a valuation of Goodwill is the
existence of some transferable right which will secure to
the purchaser profits in addition to the normal returns on
the amount of capital invested in the business. Such a
surplus over the normal income to be derived from invest-
ment is practically an uncertain annuity and ' its value
depends (1) on the annual amount, (2) on the degree to
which it can be transferred, and (3) on the length of time
during which it will continue. The determination of the
amount of excess profits is generally based on the records
of past experience and relies upon the accounts of the
firm or corporation selling its Goodwill. How long a
period should be taken into survey is a delicate problem.
A single year is not a sufficient period, for the high profits
of that year may be altogether due to exceptional tempo-
rary conditions. Nor should too long a period be consid-
ered lest the conditions of the remoter years be so dif-
ferent from those prevailing at the time of valuation as
to make an average of little significance. Especially if
the business is declining, the inclusion of the operations
of the earlier years in the estimate is objectionable, as
tending to exaggerate the showing of profits. Yet in
recent capitalizations the National ^all Paper Company
based the estimate of the valuation of Goodwill on the
earnings of only eleven months. The Rubber Goods Manu-
facturing Company took the earnings of a single year;
the National Salt Company averaged the earnings of two
years, and the National Cordage Company those of three
to five years. In English corporation finance the latter
figures seem to be most generally used.

In determining the amount of surplus profits to be capi-
talized two distinct methods are used. One is to capitalize
the entire net profits, of course being sure that the profits


stated are really net profits and that due allowance has
been made for depreciation and other charges, and from
this capitalization is deduced the value of the tangible
assets. This was done by the National Wall Paper Com-
pany. Another way is to deduct from the net profits the
assumed normal rate of profits on the capital actually
Invested and then capitalize the remaining surplus earn-
ings. This method is more commonly used in floating
English companies. Of course the results will be the same
provided the rate at which the earnings are capitalized is
the same as the assumed rate to be derived from invested

2. The transferability of the excess income is a point
which varies greatly. When a lawyer, physician or other
professional man sells his Goodwill it is always a question
as to how far the clientele which he has had is a purely
personal matter. On the other hand the surplus derived
from an exclusive franchise of a street railway is clearly
transferable. Between these two limits there is room for
variation, depending largely on the degree to which the
personal element of the proprietor has been a determining
factor in creating the profits. It is not uncommon where
Goodwill is bought by a corporation to specify that the
former proprietors, managers or officers shall agree to con-
tinue their services for a given time after the purchase,
as was done, for instance, in the case of the Cordage

3. The duration of the annual excess depends on two
factors: those having to do with competition, and those
relating to general trade conditions. Error has been com-
mitted in the calculations of many of the large combina-
tions both in this country and in England in assuming
the continuance of large profits, where that is conditioned
on the absence of competition. A notable instance was in
the case of the Columbia Straw Paper Company, where


large profits were perhaps honestly estimated on the basis
of the high prices to be obtained by a practical monopoly.
But as soon as prices were raised old mills were reopened,
new mills were immediately constructed, and, in addition,
new competition arose through the introduction of wood-
pulp as the basic material of wrapping paper such as was
previously manufactured exclusively from straw. As a
result the company was insolvent in less than two years.

Almost equal error has arisen from neglecting the pos-
sibility of change of general trade conditions. Thus in the
consolidation of English factories for making bicycles a
large valuation was placed on the Goodwill based on the
continuance of previous demand; but almost immediately
after the shares of the combination were floated the fad
for bicycle riding ceased, and with it the value of the
shares so eagerly purchased by the public. Similarly the
Goodwill of a distillery, or of a saloon, might cease be-
cause of the emergence of a sentiment in favor of absti-
nence or the enactment of a prohibition law.

With all the variables referred to, it is evidently impos-
sible to lay down a rate at which to capitalize Goodwill.
Dicksee gives a rough estimate that to determine the value
of the Goodwill of a trading company the average net
profits interest on capital and allowances for proprietors'
services having been deducted should be multiplied from
one to five times ; the multiplier to be used for a manufac-
turing concern being from one to four, for a professional
practice one to three, for newspapers and " other quasi-
monopolies ' ' $ much higher figure, ten not being unusual
In determining the value of Goodwill of the trusts already
referred to the profits were multiplied by 10 for the
Cordage Trust, by 10 for the Salt Trust, by 14| for the
Rubber Goods Manufacturing Company, and by 16 for
the National Wall Paper Company. But in these cases
the element of monopoly was perhaps erroneously sup-


posed to exist, and the profits were the total net profits,
not those profits less the normal rate of interest on in-
vested capital. Furthermore payment in these cases was
made generally in stock worth far less than its par value.

Mr. Charles S. Fairchild gives the following descrip-
tion of the method of estimating the value of Goodwill :

" In some cases the value of the Goodwill acquired
has been very carefully estimated. For example, the pro-
moters of one company made a special point of the con-
servative methods employed in arriving at the value of
the Goodwill of the companies which were consolidated.
According to their statement, the new company was vir-
tually buying the real estate, plants, stock, etc., on the
basis of appraised cash value. In addition an allowance
was made for Goodwill, calculated upon this basis; from
the net profits of each company deduct 7 per cent, upon
the capital actually employed, 1 per cent, upon sales,
which were about three times the capital, 2 per cent, for
depreciation on brick buildings, 4 per cent, on frame
buildings, and 8 per cent, on machinery. If the average
net earnings were in excess of all this, and in this case it
appeared from the promoter's statement that they usually
were, the excess was capitalized as " Goodwill " on the
basis of 20 per cent, per annum i. e., the value of the
Goodwill was estimated to be five times the amount of
such earnings in excess of 7 per cent, on capital and al-
lowance for depreciation. ' ' *

As has been shown by Francis More it is correct to
have a different rate for capitalizing different portions of
the surplus earnings. Thus, to use the illustration given
by him, if it is assumed that 8 per cent, is the normal rate
of profits, a concern having assets worth $100,000 and earn-
ing $8,000 affords no basis for Goodwill, . the earnings

1 Publications of the American Economic Association, 3rd Series, I.
p. 156


snowing no excess over the normal rate. If earning $13,-
000 the excess of $5,000 might be capitalized, say at seven
years' purchase making a valuation of $35,000. But if
the earnings were $18,000 it would be unwise again to add
$35,000, but the additional surplus of $5,000, might per-
haps be multiplied by five. And so each additional por-
tion of surplus should be taken at a lower rate of capital-
ization, or to express the idea more generally, the larger
surplus earnings are relatively to normal profits, the lower
should the rate of capitalization be. This is reasonable
since a small excess is more likely to continue than a large
one, affording a smaller field for competition, and probably
being less subject to other fluctuations.

"What has been said in support of the legitimacy of
including Goodwill and similar immaterial assets in the
inventory in no way justifies the practice, all too common,
of listing a nonexistent or a greatly overvalued Goodwill.
Such an item is not merely immaterial but also imaginary.
From the view point of accounting, there is no more justi-
fication for such a procedure than there is for placing in
the list of assets a brick building which has no existence,
or for stating in the Balance Sheet the money in bank at
twice the sum actually on deposit. As was said by the
United States Supreme Court, " Goodwill is a legitimate
asset where it is actually existent, but it must not be some-
thing unsubstantial and shadowy but capable of pecuniary
estimation. ' ' x

The question has arisen as to whether Goodwill having
once been properly entered in the books at its cost price
should continue at that figure, or whether it should be
subject to periodical revaluation or regularly written off,
as machinery is marked down to allow for depreciation.
In this, as in other questions of accounting theory, opinions
differ. In the discussion which has been carried on among

> Camden v. Stuart, 144 U. S. 104 (1892).


English accountants, Child, Cooper, Guthrie and Pixley
are among those favoring a regular writing off of Goodwill,
while Dieksee, Caldicott, Garcke and Fells, and James
argue that it may be continued at its original figure re-
gardless of changes in its value. Some set a less absolute
rule but differ, and somewhat strangely. Thus Welton
in general opposes the writing off of Goodwill, but says
that it should be done when the company has not earned
the anticipated profits on which the valuation of Good-
will was based. But with Guthrie the writing down of
Goodwill is conditioned on the company having unusual
profits which can be appropriated for that purpose.

The English courts, have decided in Wilmer v. McNa-
mara ([1895], 2 Ch. 245) that even where the Goodwill
has actually declined in value it is not necessary to charge
the shrinkage against profits. The decision was based on
the conception that Goodwill is " fixed " capital, and the
application of a previous decision * that a decline in the
value of " Fixed Capital " (or permanent assets) need not
be taken into account in determining profits.

From one point of view it is true that Goodwill is the
most permanent of assets. Anything else, even the factory
site may conceivably be sold without necessarily terminat-
ing the business. But Goodwill cannot be disposed of
without selling the business itself. Furthermore the very
indefiniteness of Goodwill renders its overvaluation less
harmful than that of other assets. Every one knows that
the price paid for Goodwill gives no indication of its pres-
ent value, and that at any time a new valuation needs to
be taken. Hence there is little danger of deception by con-
tinuing it among the assets at the cost price. But this
doctrine of the permanence of Goodwill seems inconsist-
ent with the theory of valuing it as the purchase of a
temporary, terminating annuity. Strict logic requires, at

' See below, p. 208.


least where the price paid for Goodwill is definitely based
on a number of years' purchase of excess earnings, that
the valuation should be written off in the same number of
years. To require the writing off only when the expected
returns are not realized appears unnecessarily hard on the
stockholders for they are doubly burdened: first, by the
decline in expected earnings, and then by a further charge
against the diminished earnings to cover decline in Good-
will. To mark down Goodwill when profits are unusually
high is clearly illogical, though it is not thereby necessarily
discredited in accounting practice, for it reduces the valu-
ation of excess earnings at the ve^ry time and in direct
ratio to the increase of such earnings. Probably the most
satisfactory solution is ordinarily to write off Goodwill in
proportion to the number of years figured in its valuation,
for in any event it is an uncertain asset, and a depreciation
of even fixed assets" (in which class it is somewhat forced
to include Goodwill), w r hile it legally need not be made, is
justified on the plea of conservatism. And where it is
clear that the valuation of the Goodwill was erroneous,
that it is not worth its book value, the best method of
adjustment is that advocated by Dicksee, to offset the
decline in its value by a reduction of capital, not by a
charge against profits.

In American corporation finance Goodwill frequently
is not openly shown on the Balance Sheet. Oftentimes it
is included with the tangible property under the title
' ' Property, etc., " or it may be combined with other items
of an intangible nature under headings such as " Good-
will, Patents, Leases, Trade Marks, etc." (American Cot-
ton Oil Co.), " Patent Rights and Goodwill " (American
Glue Co.), " Franchises, Goodwill, etc." (American
Graphophone Co.), "Goodwill and Patents" (Sears
Roebuck Co.). While such property rights as patents,
trade marks, etc., are quite different in their legal naturo


from^ Goodwill yet economically they are very similar,
both representing a transferable right from which excep-
tional profits may be derived. Those which are distinctly
terminable, as patents, copyrights, etc., differ from Good-
will in that the value must some day disappear, and hence
the necessity of marking down their value is apparent.


, Another class of items appearing in the Balance Sheet
are called Deferred Assets or Deferred Charges. These
terms indicate that payment has been made of expenses

Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 9 of 27)