Accounting Theory and Practice - Volume II

The final place among the assets of the balance sheet is given to the intangible items. Because this class of assets has so frequently been used for doubtful or illegitimate purposes, whatever the value given to them they should be shown boldly in a group by themselves and not merged with the values of tangible assets. Their real value, if any, should be open to verification. To list them with tangible items on the balance sheet is apt to raise a suspicion as to their validity much more than if they are shown in a group by themselves.

Because the assets of this group are intangible is no reason in itself for the hasty judgment frequently made that therefore they are worthless. It is true, as above stated, that the doubtful uses to which they may be put have caused them to be viewed with suspicion. Yet they have an entirely legitimate use and oftentimes constitute the most valuable portion of the assets. Therefore, the values at which these intangible assets are carried on the books should always be open to investigation and capable of verification.

It is purposed here to lay down the principles of the legitimate use of intangible assets, and to point out some of the wrong uses to which they easily lend themselves. The group comprises patents, copyrights, trade-marks, formulas, receipts, franchises, organization expense, going concern value, and good-will.

A patent is “a grant made by the government to an inventor conveying and securing to him the exclusive right to make and sell his invention for a term of years.” The purpose of the government in making such grants is to encourage and stimulate individual ingenuity along lines that will ultimately redound to public welfare. Letters of patent are in the nature of a monopoly grant but, although extreme care is taken in their issuance to see that they cover really new devices, no governmental guarantee implies that the patentee shall have free and uncontested use of his invention. If encroachment is made upon his rights under the patent, the courts are open to him for protection and similar privileges are extended to all alike. Oftentimes, until infringement proceedings have established a clear and uncontested right and property in an invention, little commercial value attaches to it. Patents therefore tend to create a monopoly in the marketable product protected by them and accordingly have value so long as the right to monopoly continues.

The valuation of patents owned and made use of by a business should always be on the basis of cost. If owned by purchase from the inventor, the consideration paid for the patent constitutes cost. When the consideration is cash, there is no question as to the valuation at cost. When payment is made in the capital stock of the purchasing concern the problem is the same here as in the proper valuation of other fixed assets purchased in the same way, referred to in Chapter XVII. The federal income tax law takes cognizance of this different basis for valuation and attempts to establish a true cash basis by allowing depreciation on patents, when purchased by means of stock, only on the basis of the cash value of the stock. Prevailing practice sponsors the bringing of patents onto the books at cost, as shown either by the cash paid for them or by the par value of the stock issued for them. Except where deceit and fraud are the points at issue, no serious objection can be raised to the practice, for any overvaluation thus occasioned is absorbed in the product by means of the depreciation charge spread over the life of the patent. Any additional costs necessary to secure the full enjoyment of the rights granted under the patent are considered proper charges against the patent, as giving it additional value.

When the patent is not purchased from outside but is developed within the plant itself, only the costs of development and of securing the patent are proper charges to the asset as constituting its value. In some concerns an experimental laboratory is maintained for the purpose of working out improved methods and devices. Much of the work of such a laboratory is often fruitless so far as patentable devices are concerned, but if the entire effort is directed towards the development of patents, then the entire cost becomes a proper charge to whatever patents result from the effort. More often some portion of the laboratory organization is also used for other purposes. However developed, whether in the formal laboratory or in any other way, the full cost of development and of securing letters patent is the figure for the original valuation of the patent. This cost includes the labor and material used in the process, drawings, models—including discarded models—attorney’s fees, government fees, etc.

As in the case of purchase, all the costs, whenever incurred, of defending the right to the patent or of prosecuting for infringements constitute additional elements of value, as only by such means can the real holder be made secure in the exclusive enjoyment of his right. It is hardly necessary to point out that if such proceedings and prosecution establish the right of the other party to a device which practically destroys or greatly diminishes the worth of the contested patents, not only must such costs usually be charged against revenue but also the whole or major portion of the value at which the patent is being carried. However, where the development of patents is one branch of a concern’s organization, costs of this nature may usually be absorbed by those patents which are successful. Because inflation of values is easy at this point, a careful investigation to establish the legitimacy of all such charges is always desirable. Each case must be judged on its merits.

Patented devices are sometimes purchased with no intent to use them. This may be for the purpose of eliminating competition, of forestalling obsolescence or supersession, and so of postponing the necessity of making expensive alterations that would be required to meet threatened competition, even to the point of scrapping a valuable organization. The ethics of such practice is not under review here. Correct accounting practice justifies the addition of the purchase price of such devices to the value of the asset, patents, and its periodic depreciation in regular course.

Patents are subject to depreciation. At the time of their purchase or acquisition, they should be valued at full cost, as stated above. At any subsequent time, value should be calculated on the basis of full cost less depreciation. The elements of depreciation as applied to patents are (1) time lapse, (2) supersession, and (3) obsolescence.

1. Time Lapse. There is no such thing as wear and tear on a patent itself, but since the grant by the government is for a definitely prescribed term of years, as each of those years goes by there passes with it some portion of the value attaching to the exclusive enjoyment of the right for the prescribed period. In this country a mechanical patent is granted for a term of seventeen years, after which the patented device or process becomes common or public property. The period allowed for patents covering designs is three and one-half, seven, or fourteen years, depending on the application. Thus, simply through the lapse of time the value of the right diminishes.

2. Supersession. If no other causes than time lapse were operative, the problem of depreciation would be a simple one, consisting of spreading the value of the patent over its life. In addition to lapse of time and operating simultaneously with it is the possibility of supersession. Supersession as an element of depreciation is the attempt to measure the probability of the patent’s being superseded before the expiration of its term by a better machine, device, or method. The measure of this element of depreciation is always speculative but should be attempted with the best judgment possible.

3. Obsolescence. Akin to the element of supersession is that of obsolescence. Obsolescence is particularly operative in cases where the patent covers a product the life of which depends on the whims of fashion. Obviously, when the market for the product ceases, the value of the patent is gone.

From the above it is seen that the three elements of depreciation are usually operative concurrently and the rate of depreciation must take cognizance of them all.

While the vast majority of patents become valueless before their expiration, some few may have a value beyond their protected term. It may happen that the concern using the patent has built up such an organization that competitors cannot with profit enter the field after the patent has expired; or it may have acquired the good-will of the purchasing public to such a degree that buyers come to it rather than to a competitor. In these and other ways the value of the patent may extend beyond its life. This is exceptional, however, and cannot with conservatism form the basis for estimating the service life of the average patent.

The prevailing practice authorizes writing off the value of a patent quite rapidly during the early years of its life when its earning capacity should be at a maximum, leaving only a small part of the value to be spread over its later years. This policy applies to the possession of single or separate patents. An effective method used for extending the life of a patent is the securing of auxiliary patents every few years. Thus an improvement of some part may be patented, without which the use of the original or basic patent would not be worth while. The basic patent may thus have its effective life—though not its legal life—extended almost indefinitely.

Where an additional cost, such as infringement costs, is incurred some time after the grant is made, strict accuracy would demand that these costs be spread over the remaining life of the patent. Where, however, the above policy of securing periodic improvements is in force, sufficiently accurate results are secured by wanting off at the end of each year—in the case of mechanical patents—one-seventeenth of the total values to date. In this way, by the end of the original 17-year term, there will be values left in the account which may be looked upon as applicable to the patented improvements. There is in these cases a constant overlapping of the grant periods and no serious inequity results as between fiscal periods by writing off each year one-seventeenth of the total value in the Patents account. In the case of the one original patent or an occasional improvement, the more accurate method is desirable because here the life of the patent is rather definitely limited.

If the estimated life on which the depreciation estimate is based, should prove longer than the real life, the value remaining in the asset at the end of its real life must be absorbed by the profits; i.e., charged against surplus. The Federal Income Tax Law allows this remaining value to be charged against the profits of the period in which it is written off.

In booking the depreciation of patents, the periodic charge is to the expense account, Depreciation—or Depletion—and the credit is made either direct to the asset account or to the corresponding Depreciation Reserve account. It is sometimes argued that since the life of the patent is for a definite term, its depreciation is equally definite and the value of the asset should be written down rather than carry the estimated amount of the periodic depreciation in a reserve account. Because of the elements of supersession and obsolescence on which in the majority of cases the service life of the patent depends more than on its time grant, it is evident that determination of the amount of periodic depreciation is just as much a speculative estimate as is the case with any other asset. Either method of showing the periodic value of the patent may be used with equal propriety. If an easy determination of “total value to date” is sought, as under the policy referred to above, the information is better secured by carrying the offsetting estimate of depreciation in a reserve account. When no such purpose is to be served, it is a needless multiplication of accounts to use the reserve account.

A problem closely related to the valuation of patents has to do with the classification or incidence of the periodic depreciation of the patent. According to some theorists it is stated that if the patent applies to the process of manufacture—i.e., to any part of the manufacturing equipment used—the periodic depreciation is a cost of manufacturing and should be allocated to the product at that point. But if the patent covers the article itself, its periodic depreciation expense should be treated as a selling expense. Perhaps the point is well taken but the distinction is rather finely drawn. Another view requires the showing of depreciation on patents among the general administrative items, on the several grounds that there is no logical basis or method for distributing it directly to the product; that there is no direct connection between the product and this expense; and that it is a general overhead item which must be cared for out of gross earnings but cannot be applied definitely to manufacturing or selling. Failure to establish a suitable basis on which to apply the cost in practice cannot, of course, be allowed to militate against the determination of its theoretical incidence.

An analogous problem arises in the treatment of royalties where such cover the cost of renting the patented devices of others for the purpose of manufacture. Although the general practice is to treat this expense as a cost of manufacture, it is sometimes handled as a general management expense on the ground that it represents a policy of management which has adopted the royalty method of production in preference to the outright purchase or development of the patents. The point seems not well taken, however. The value of a patent may be looked upon as a prepaid expense item which is the equivalent of royalties expense and should therefore usually be treated as a manufacturing cost. There may be instances, however, where such treatment would not be advisable on practical and perhaps theoretical grounds.

Related to this problem of patent costs is the effect on manufacturing costs of the rate of depreciation of the patent. It is evident that a too rapid depreciation will result in an inequitable loading of the product made during the early years of the life of the patent as compared with that of its later life. A product made under a patent still valuable after all value has been written off the books, bears none of the burden though enjoying the benefit accruing from its being a patented article. On the other hand, if the rate of depreciation is not rapid enough, the product is then underburdened. It should constantly be borne in mind that depreciation is always an estimate. It should be the best estimate possible and subject to periodic revision where accurate results are desired. Slight inaccuracies and inequities are bound to occur and must be absorbed by the future product; the record of the past is a closed book and cannot usually be reopened.

The sale price of a patent, as distinguished from the value at which the owner may carry it in his accounts, frequently is based on the estimated savings in royalties which could be made by a purchaser. When a new concern is organized and patents are owned by some of the incorporators, and purchased from them, the value at which they are carried is almost always speculative and arbitrary. A valuation based on the saving in royalties has no place on the books of a concern unless that price were paid in purchase. Similarly, licenses to use patents should not be carried as an asset unless purchased by a lump sum payment even though they grant a virtual monopoly in the product.

Copyrights are similar to patents in that they secure to the author or publisher the exclusive right for a term of years to make and sell copies of literary or artistic productions. They are thus in nature a monopoly grant. The term for a copyright is 28 years, with a renewal privilege of 28 years if application is made within one year prior to expiration of original copyright.

A more rigid application of the principles of valuation enunciated for patents must be made for copyrights. On the books of the original grantee they should be carried at full cost which may be only the fees required in securing the copyright. For a subsequent purchaser they should be set up at full cost to him. A much smaller proportion of copyrights than of patents continue valuable for their granted term. Periodic valuations, then, require a very liberal and rapid depreciation from original value. In the accounts of publishers who make outright purchases of copyrights, extreme care is needed in keeping track of and valuing this asset, else a too optimistic outlook will result in carrying false and misleading values. Oftentimes the only satisfactory and reliable method of valuation will require an examination of each copyright owned and an independent appraisal of its worth.

Akin to copyrights are formulas for manufacture, receipts, and other trade secrets. These may constitute very valuable holdings, perhaps the most valuable of all the assets, but they are not usually carried on the books as assets under this title. A baker with a secret economical process of making yeast may have a marked advantage over competitors. An oil refiner with a process which secures a larger return of gasoline has a similar advantage over competitors without such means of refining. If costs are incurred in developing or acquiring these formulas or processes, the same reason exists for treating them as assets as in the case of patents or copyrights. If not protected in any way by the government, greater need of rapid depreciation is apparent as the discovery of the secret by others might greatly reduce its value.

A trade-mark is an earmark of ownership for advertising and selling purposes. Thus a firm may adopt a label for their products or a manner of marking or displaying them which wherever used is evidence of the make, brand, and quality of the goods. A concern enjoying a trade built up by educating the public to recognize its trade-marks and what they represent may possess therein a very valuable property. The courts of the country guarantee the rightful owner in the exclusive enjoyment of any benefits arising from the use of his trade-mark. Priority of continuous use is the factor determining rightful ownership. Such priority is most easily established through registration of the trade-mark with the government. Registration is not necessary but is offered by the government as a convenient and certain means of establishing rightful ownership. Continuous use is necessary to retain unquestioned ownership of the right.

Trade-marks must be valued at cost. Cost to develop, cost of purchase, cost to defend—all are legitimate charges to the asset. At times even some portion of the advertising expense may be capitalized under the caption “Trade-Marks.” This question and that of periodic revaluation follow so closely the principles of revaluation of good-will and the treatment of depreciation in relation thereto, that its consideration is deferred for combined treatment in later pages of this chapter.

A franchise is an intangible asset of considerable value in most cases. Its appearance on a balance sheet is usually limited to those of public, or quasi-public, utility companies. There it is included as an asset of value from the standpoint of rate-making rather than for ordinary commercial purposes. Such companies are usually under the close supervision and regulation of public service commissions. The latter prescribe the manner of showing the utility company’s accounts and the basis for the valuation of its assets, chiefly from the point of view of an adequate protection of the interests of the public. It is neither the purpose nor within the scope of the present volume to raise the question of the valuation of public utility companies, part of which problem would be concerned with the valuation of franchises. An attempt will be made, however, to lay down some principles of valuation from the commercial standpoint as distinguished from the rate-making standpoint, applicable to a very limited number of concerns which are not subject to state regulation, and to indicate briefly the tendency of the rulings of the best public service commissions with regard to franchises.

A franchise is defined by H. A. Foster[45] as “a privilege given by the community to a private person—or corporation—for use of the public property for the benefit of the public, and only incidentally is it the intention of the community in granting such a right, to allow the person accepting the same enough profit to insure his willingness to take advantage of it by investing in plant to make use of the grant.” To the same effect is the statement of the Federal Court in the case of the Consolidated Gas Co. of New York, 157 Fed. 373: “The franchise is but a part of the power or privilege of sovereignty allotted to a private person for the benefit of all, and only incidentally given for private emoluments.”

Franchises may be perpetual, where the grant is without time limit; limited, where the term is definitely stated; and indeterminate where the privilege granted is good “during good behavior and may be terminated by the authorities at any time by paying the fair value of the property exclusive of the franchise.” It may be noted that in Massachusetts no provision is made for buying the property of the utility company in case of revocation of the franchise. Manifestly the contract entered into with the state will influence very largely the manner of handling and the valuation of all the assets. Without regard to such contract and on the general principles of valuation as laid down for fixed assets, a franchise should be taken onto the books at full cost to acquire. Proper charges to the account would cover:

1. Lump sum payments to the state or some division thereof, applicable to the life of the franchise as distinguished from regular annual payments which are in the nature of a license or rental charge and are therefore an operating expense.

2. The full purchase price paid another company for the assignment of its rights and privileges under a franchise owned by it.

3. Legal and other fees in connection with securing the grant.

4. Any other legitimate expenses, such as the cost of 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.”

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 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.

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.

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.

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.

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.

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.

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.

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.

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.

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 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.

CHAPTER XVIII INTANGIBLE ASSETS—PATENTS, FRANCHISES, GOOD-WILL

CHAPTER XVIII
INTANGIBLE ASSETS—PATENTS,
FRANCHISES, GOOD-WILL