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