Measuring Enterprise and Personal Goodwill     

By: George D. Abraham

CEO & Chief Appraiser

Business Evaluation Systems

In the state of Texas and several other states, appraisals for divorce, requires the appraiser to consider and analyze personal and enterprise goodwill in the dissolution of marital assets. Personal goodwill is not considered part of the marital assets to be divided.

The American Journal of Family Law states that Goodwill is "that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.[1]  It can be separated into two parts, defined as follows:

• Personal goodwill is the value of earnings or cash flow directly attributable to the individual's characteristics or attributes.  Personal goodwill, sometimes referred to as professional goodwill, is a function of the earnings form repeat business (customers) that will patronize the individual practitioner as opposed to the business, new consumers who seek out the individual, and new referrals who will be made to the individual. 

• Enterprise goodwill is the value of earnings or cash flow directly attributable to the enterprise's characteristics or attributes.  Enterprise goodwill, sometimes referred to as practice goodwill is a function of earnings from repeat business (customers) that will seek out the business (as opposed to the individual), new consumers who will seek out the business, and new referrals who will be made to the business.

Most appraisers approach the allocation by simply dividing the attributes into personal and enterprise, but you can take it one step further which offers a reasonable position if challenged and provides a consistent method and a defensible bases for your opinion.  

Once the appraiser has a solid goodwill value, the analysis of personal and enterprise goodwill can begin by analyzing the attributes that make up goodwill. The appraiser must keep in mind that the process requires several key factors:

• The attributes that impact personal goodwill are a percentage within a range.
• Enterprise goodwill is the reciprocal percentage.
• Does the presence of this attribute add to the earnings of the business? The greater the impact on earnings, the greater is the presence of the attribute.
• The difference between total goodwill and personal goodwill is the enterprise goodwill.

Goodwill Attributes

Personal Attributes

These are attributes that relate directly to the 'goodwill subject". This is the person for whom the goodwill allocation is being performed (physician, architect, accountant, etc). Personal attributes reflect the efforts by the goodwill subject and are inherent in the individual.  These personal attributes indicate personal goodwill, including: 

• Ability, Skills, and Judgment. These attributes focuses on the "doing" by the goodwill subject; e.g., the ability to perform at a level to generate sufficient earnings to establish goodwill.  The goodwill subject's education, training and demonstrated ability will almost always be important personal attributes.

• Age and health. These are significant as they help determine the longevity of the subject's impact on earnings. Underlying all value is the time frame for cash flow or earnings.  Older and less healthy subjects could mean a shorter and more uncertain stream of future earnings, and thus, a lesser personal goodwill allocation. 

• Personal Reputation. This is the customer's perception about the person's ability, skills and judgment. 

Business Attributes

These are the result of decisions that affect the business organization, operations, finances, and image.  If the goodwill subject makes decisions that improve enterprise attributes, this increases enterprise and not personal goodwill. Examples of business attributes to the enterprise include:

• Location, location, location.  There is a multiple location attribute and the business location attribute. Keep in mind that multiple locations do not mean a strong indication of enterprise goodwill. The appraiser must understand how the locations are being used. 

• Systems and organization. This encompasses the management decisions that determine how the business performs. These are well defined and maintained systems that make the business strong are a good indication of enterprise goodwill, even if the goodwill subject created the systems.

• Business reputation. If the customer's perception about the product or service, including price, customer support, quality and satisfaction are on the business, the characteristic is enterprise. In some cases the customers commonly associate a business with an individual, but it is the business reputation they are counting on.  Keep in mind that some businesses have both personal and enterprise attributes that the appraiser must separate and analyze. 

• Staffing. Staffing encompasses all the employees of the business, other than the goodwill subject. Usually employees are associated with enterprise goodwill, but there are times when employees may seek a position because of the personal reputation of the goodwill subjects training that would add value to their own resume. 

• Personalized business name.  This is the most misunderstood attribute as it is automatically assumed that if the business carries the subject's name, all is personal goodwill. However, many businesses are sold and carry on with the personalized name and others change the name sometime after the purchase. The question to address is:  "Would the customers abandon the business solely because it changed its name?" 

• Closeness of contact. Sometimes the goodwill subject's work habit includes more contact with the customer, and the more direct contact, the more likely the subject will have personal goodwill. (Dentists have close contact, while radiologists do not.) However, it is not so much the closeness of the contact as it is the personal nature of the contact. 

• Referrals. Referrals to a goodwill subject often indicate a high level of respect for one's abilities and are personal in nature and increase the individual's personal goodwill. However, referrals can certainly be made to a business and those referrals would support a greater enterprise allocation. 

• Repeating revenue stream.  This attribute deals with the specific nature of the revenue stream and is the heart of goodwill. Repeating business can be due to either enterprise or personal goodwill.  However, some businesses are more likely to enjoy repeat business by the nature of their industry and are not concerned with the reason for the repeating business, such as a great location. 

In summary, the appraiser will analyze and separate each of the attributes into personal and enterprise goodwill by establishing a range with each attribute weighted according to its importance (impact on earnings).  Each attribute is then given a weighting as to its degree of existence.  The value of an attribute established by multiplying the degree of existence by the degree of importance represents a percentage of 100%.  As personal goodwill increases, enterprise goodwill decreases by the same amount.

The Allowance for Doubtful Accounts

What Does Allowance For Doubtful Accounts Mean?

The allowance of doubtful accounts is an estimation made by a company and documented on its balance sheet for receivables that might go uncollected. It is standard practice for a company to have funds set aside for money that cannot be collected.

The allowance for doubtful accounts is a reduction of the total amount of accounts receivable appearing on a company's balance sheet, and is listed as a deduction immediately below the accounts receivable line item. The allowance for doubtful accounts represents management's best estimate of the amount of accounts receivable that will not be paid by customers.

Estimation Methods for the Allowance for Doubtful Accounts.

There are several possible ways to estimate the allowance for doubtful accounts, which are:

• Risk classification. Assign a risk score to each customer, and assume a higher risk of default for those having a higher risk score.
• Historical percentage. If a certain percentage of accounts receivable became bad debts in the past, then use the same percentage in the future. This method works best for large numbers of small account balances.
• Pareto analysis. Review the largest accounts receivable that make up 80% of the total receivable balance, and estimate which specific customers are most likely to default. Then use the preceding historical percentage method for the remaining smaller accounts. This method works best if there are a small number of large account balances.

You can also evaluate the reasonableness of an allowance for doubtful accounts by comparing it to the total amount of seriously overdue accounts receivable, which are presumably not going to be collected. If the allowance is less than the amount of these overdue receivables, the allowance is probably insufficient.

You should review the balance in the allowance for doubtful accounts as part of the month-end closing process, to ensure that the balance is reasonable in comparison to your latest bad debt forecast. For companies having minimal bad debt activity, a quarterly update may be sufficient.

Allowance for Doubtful Accounts Affect on the Income Statement and Balance Sheet

The only real affect to the income statement is the initial transaction of setting up the allowance at the beginning of the year. The amount posted as bad debt expense will decrease net profit as it's recorded on the income statement. No other transactions affect the income statement.

Likewise, the only affect to the balance sheet is the initial transaction of setting up the allowance at the beginning of the year. The initial transaction decreases the asset accounts as it is recorded on the balance sheet. Examining the other above transactions, there are no effects to the balance sheet totals (debits and credits balance).

Normally assets have a debit balance. Even though the allowance for doubtful accounts is listed on the balance sheet as an asset, it normally has a credit balance. This is known as a contra asset. Contra asset account means that it's in contrast to what's normal. Assets normally have a debit balance, contra asset accounts have credit balances.

Accounting for the Allowance for Doubtful Accounts

If a company is using the accrual basis of accounting, it should record an allowance for doubtful accounts, since it provides an estimate of future bad debts that improves the accuracy of the company's financial statements. By recording the allowance for doubtful accounts at the same time it records a sale, a company is properly matching the projected bad debt expense against the related sale in the same period, which provides an accurate view of the true profitability of a sale.

For example, a company records $10,000,000 of sales to several hundred customers, and projects (based on historical experience) that it will incur 1% of this amount as bad debts, though it does not know exactly which customers will default. It records the 1% of projected bad debts as a $100,000 debit to the Bad Debt Expense account and a $100,000 credit to the Allowance for Doubtful Accounts. The Bad Debt Expense is charged to expense right away, and the Allowance for Doubtful Accounts becomes a reserve account that offsets the account receivable of $10,000,000 (for a net receivable outstanding of $9,900,000). Later, several customers default on payments totaling $40,000. The company then credits the accounts receivable account by $40,000 to reduce the amount of outstanding accounts receivable, and debits the Allowance for Doubtful Accounts by $40,000. This entry reduces the balance in the allowance account to $60,000. The entry does not impact earnings in the current period. A few months later, a collection agency succeeds in collecting $15,000 of the funds that the company had already written off. The company can now reverse part of the previous entry, thereby increasing the balances of both accounts receivable and the allowance for doubtful accounts.

The allowance for doubtful accounts is a balance sheet account that reduces the reported amount of accounts receivable. (A change to the balance in the allowance for doubtful accounts also affects bad debt expense on the income statement.) Providing an allowance for doubtful accounts presents a more realistic picture of how much of the accounts receivable will be turning to cash. 

After all, a company selling products (or services) on credit to thousands of customers will likely have a few customers who will not be able to pay the full amount they owe to the company. By recording an amount in the allowance for doubtful accounts it will also mean that the bad debt expense will be reported closer to the time of the sales-instead of waiting until the account is determined to be uncollectible. Hence, the matching principle is carried out more effectively.

The allowance account and the related bad debt expense is encouraged for financial reporting; however, it is not acceptable for income tax reporting. The Internal Revenue Service prefers that any expense for bad debts be deducted later-when an account is actually written off as uncollectible.