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Accounting Goodwill Treatment

Introduction

Arnold, J., Egginton, D., Kirkham, L., Macve, R. and Peasnell, K., ‘Theoretical Considerations’, in Goodwill and Other Intangibles, The Research Board, London, pp3-18.

According to the authors, financial reporting of goodwill has assumed importance just recently. In its earlier definition goodwill just meant customer loyalty. They attribute two main reasons for the increase in goodwill’s importance.

First is the increase in merger and acquisition (M&A) activities in the market and second is the rising stock market. This has created a wide gap between the book value and market value and also between the fair value and paid value of assets of a firm. As a result, the increasing importance of recognition, valuing and accounting of goodwill was widely felt.

Definition

Catlett, G. and Olson, N. 1968, ‘Accounting Research Study no 10’, Accounting for Goodwill, American Institute of Certified Public Accountants, New York, pp.1-21.

The authors have taken Accounting Research Study no.5 by the Accounting Principles Board as a base for their study on Accounting for Goodwill. In their study, they say that the definition of goodwill has evolved and changed over time to reflect the true picture of its nature. Goodwill is difficult to measure and its accounting treatment is also very controversial.

They have included the definition of goodwill from the Webster’s Third New International Dictionary. It defines goodwill as ‘the capitalized value of the excess of estimated future profits of a business over the rate of return on capital considered normal in the related industry’.

In general, goodwill is a result of good reputation of the firm in the market. Superior quality goods and customer service, integrity and efficiency of management, good employee relations and many other factors helps a company earn goodwill. Nowadays, technological advantages, efficient manufacturing process, ability to raise finance also assume great importance. The earning power of goodwill is the most relevant concept as of today.

Different Concepts

Gynther, R. 1969, [Abstract of ‘Some “Conceptualizing” on Goodwill’, The Accounting Review, vol. 44, no. 2, pp.247-255], [Electronic], Available: JSTOR [2007, Nov 11].

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Gynther has cited two main concepts of goodwill, the ‘residuum concept’ and the ‘future excess profits concept’. Under the residuum concept, goodwill is measured as a difference between purchase price and book value of a company’s assets. Goodwill is the residual value after taking into account all the tangible and identifiable intangible assets.

According to future excess profits concept, goodwill is the present value of all the excess profits expected in the future, over and above the normal/average profits in the industry. It is difficult to measure goodwill using this concept as there is no certainty of the future profits.

Nature and Characteristics

Arnold, J., Egginton D., Kirkham, L., Macve, R. and Peasnell, K., ‘Theoretical Considerations’, in Goodwill and Other Intangibles, The Research Board, London, pp.18.

Goodwill can be of two types. Goodwill can either be internally generated or purchased. Goodwill is said to be internally generated when a firm earns super profits. On the other hand, purchased goodwill is a result of merger and acquisition activities. However, goodwill is accounted only when a business is purchased or sold. Internally generated goodwill cannot be accounted otherwise.

Catlett, G. and Olson, N. 1968, ‘Accounting Research Study no 10’, Accounting for Goodwill, American Institute of Certified Public Accountants, New York, pp.20-21.

The value of goodwill cannot be directly attributed to a particular cost. Goodwill is sometimes created due to favorable conditions and certain other factors, and sometimes even without any efforts by a company. The value of goodwill is directly attached to a business. It cannot be separated and sold differently. Several factors can affect the value of goodwill. As such, the value of goodwill may rise or fall due to changes in those factors. The investors’ perception reflected in the stock prices forms the base for calculating goodwill.

Treatments of goodwill

Non-purchased goodwill

Walker, G. T. 1938, [Abstract of ‘Non-purchased Goodwill’, The Accounting Review, Vol. 13, No. 3. pp. 253-259], [Electronic], Available: JSTOR Arts and Sciences 4 [2007, Nov 11].

In this paper Walker argued that almost all the accountants agree that non-purchased goodwill should not be recognized in account. “They are fully aware that goodwill created by a concern is just as valuable - and in most instances, more valuable- to that concern than to the firm which might make a specific purchase of that goodwill”.

Montgomery has pointed out this view in his Financial Handbook that goodwill may have economic value even without being purchased by another entity. But it was considered to be bad practice to record goodwill on the books since many frauds happened in the early days, when the term goodwill was freely used.

Seetharaman, A., Balachandra, M. and Saravanan, A.S. 2004, [Abstract of ‘Accounting treatment of goodwill: yesterday, today and tomorrow: Problems and prospects in the international perspective’, Journal of Intellectual Capital, Vol. 5, Iss. 1, pp. 131-153], [Electronic], Available: Proquest ABI/INFORM [2007, Nov 11].

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Seetharaman also argued in the article that only purchased goodwill is acknowledged for accounting purpose. Although, in reality, with the development of the relationship with suppliers, customers and the work force, all the business generate internal goodwill as they grow. But it seems that no attempt was made to account for non-purchased goodwill. Lee (2004) gave the reasons why there is no accounting for non-purchase goodwill:

(1) The accountants adopt conservative view, together with the fear that internally generated goodwill may turn out to be a fictitious asset in order to make the balance sheet look better.

(2) Certain accounting rules such as historical cost, objectivity and verifiability are extremely difficult to apply in accounting for non-purchased goodwill in practice.

(3) It is difficult to revalue non-purchased goodwill annually. Some assumptions have been made to carry out the test, such as the estimation of future profits and of what should be a reasonable rate of return for a particular business.

(4) The business costs which attribute to the value of goodwill are difficult to measure. For instance, it is difficult to bifurcate which part of the cost of R&D or advertising expenditure contributed to the sales that in turn generated goodwill.

Purchased goodwill

1. Immediately write off

For:

Hughes, H, P. 1982, ‘Goodwill in Accounting: A History of the Issues and Problems’, United States of America.

Under this method, goodwill is immediately written off against an account in the equity part, generally retained earnings. Hughes presented in this book that the fundamental concern about immediately write off treatment is that goodwill was not an asset. Spacek expressed the view that the total expenditure of buying an entity or business over the fair value of the company is “a cost to the buyer of earning over and above the cost of the assets required to produce those earnings”. And Spacek points out that goodwill may generate future economic benefits, but those benefits are not secured (Cited in Hughes, 1982).

Massoud, F. 2003, [Abstract of ‘Accounting for goodwill: Are we better off?’] Review of Business,Vol.24, Iss.2, p.26], [Electronic],Available: Proquest ABI/INFORM [2007, Nov 11]

Spacek’s view is supported by the idea that goodwill is neither something that can be really used, nor it can produce earnings. But, it represented the investors’ appraisals of earnings or expectations of earnings. In such case, goodwill carried a risk of facing wide fluctuations which related to the investors’ decision. Therefore, the value of goodwill has no reliable or continuing relation to costs incurred in its creation, its purchase or its maintenance.

Seetharaman, A., Balachandra, M. and Saravanan, A.S. 2004, [Abstract of ‘Accounting treatment of goodwill: yesterday, today and tomorrow: Problems and prospects in the international perspective’, Journal of Intellectual Capital, Vol. 5, Iss. 1, pp. 131], [Electronic], Available: Proquest ABI/INFORM [2007, Nov 11].

Seetharaman et al, in this paper also gave some reasons why immediate write off is a better way. There are arbitrages existing in the way of capitalization and amortization and they will understate the net income, argued Spacek. Thus, writing off goodwill immediately to reserves is a preferable method.

Another rationale supporting this method is that goodwill, which is generated from the purchase activity of companies, will eventually disappear over time with reasonable expectation. Advocates of this method also argue that goodwill is not a normal issue like other assets. It has difficulty in measurement and cannot be sold separately in most cases. Therefore, carrying goodwill as an asset in the balance sheet does not add value to the users of the financial report.

Against:

Holgate, P, A. 1990, ‘Goodwill, Acquisitions & Mergers’, London.

A practical argument against immediate write-off method is that, this treatment may lead to negligible or negative amounts of shareholder’s equity as it reduces the balance sheet total of the acquirer. And this method ignores the fact that goodwill represents real value to shareholders and it has the opportunity to flourish and make profits in the future.

2. Amortization

Under this method, the acquisition cost of goodwill will not be immediately written off, but instead, it should be allocated to the periods over which it provides benefits through a process called ‘amortization’.

For:

Holgate, P, A. 1990, ‘Goodwill, Acquisitions & Mergers’, London.

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Holgate in his book presented that the amortization method benefited certain particular groups. First, those foreign-based companies whose policy is amortization are in favor of this goodwill treatment. Holgate explained this idea by pointing out that, by selecting this policy, these subsidiaries could reduce some consolidation adjustments.

Thus, they would save a lot of cost of adjustment and time. Next, Holgate also pointed out that supporters of amortization consider that goodwill does not have an indefinite life. So it should be amortized over its useful economic life. They are of the opinion that, ‘Goodwill is both unidentifiable and intangible and should be allocated to the periods which benefit from it by a regular charge because it will be difficult to tell when it has been completely fallen in value’.

Against:

Holgate in this book also discussed the opponents’ opinion about amortization of goodwill. He indicated that opponents argued that ‘goodwill should be recorded as an asset on the balance sheet and written down only when a permanent diminution in its value occurs’. Since, goodwill does not wear out no charge should be made as a measure of goodwill. Furthermore, they argue that goodwill may maintain or increase its value in a successful business.

In this situation, the residual value of goodwill may not fall over time. So it is not logical to record a loss in the value of goodwill. Finally, Holgate discussed the reason why amortization of goodwill may not be a suitable method. According to him, systematic amortization of purchased goodwill does not represent a real economic event. That is, the depreciation charge for any asset in any one period can only be an estimate, not an exact measure of the economic reality. Thus it does not provide useful information to users of accounts.

3. Impairment

Under this method, goodwill must be annually tested for impairment in order to determine whether it continues to maintain its value. When the market value of goodwill declines below its carrying value, an impairment loss must be recognized.

For:

Seetharaman, A., Sreenivasan, J., Sudha, R., Tey Ya Yee., 2006 [Abstract from ‘Managing impairment of goodwill’, Journal of Intellectual Capital , Vol. 7, Iss. 3, pg. 338] [Electronic], Available: Proquest ABI/INFORM [2007, Nov 12].

In this article, A. Seetharaman et al discussed the advantages of impairment treatment of goodwill by focusing on investors’ point of view. Harper (2001) suggested that impairment test offers a clear picture of goodwill to users of financial statements. He pointed out that when the fair value of goodwill is less than its carrying value, goodwill will be impaired and charged off. This practice not only forces companies to revalue their investment but also reflects the quality of management investment decision as well.

According to Hepburn (2004) who is a researcher, this method provides investors with better understanding of intangible assets and makes corporate financial statements more informative. Thus, investors are able to make better decisions of companies’ true current and future value. That is to say, impairment testing of goodwill helps build and improve the relationship between companies and investors.

Against:

A. Seetharaman et al presented in this article that, there were still some limitations of goodwill impairment. First, they stated that because goodwill cannot be separated by itself and does not produce its own cash flows, testing for impairment by determining the fair value of goodwill is a challenge. Furthermore, the method of goodwill impairment treatment leaves significant room for management interpretation, bias and judgment.

It may lead researchers raise doubts in carrying out the impairment test and its calculation, since the guidelines of this method are quite subjective. The final reason why impairment is not a perfect method of goodwill treatment based on the fact that more and more international companies encounter difficulties in selecting which accounting treatment to adopt.

A. Seetharaman et al explained this idea; by pointing out that one particular accounting standard may not be applicable to another country. And there may be no comparability across the so-called national boundaries.

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Goodwill in practice around the world: past and present

Steven, G.S. 2007 ‘Market Reaction to Accounting Regulatory Changes: Adoption of SFAS 142’, Journal of American Academy of Business, Cambridge, Vol. 10, Iss. 2, pp.7, 289.

As far as treatment of goodwill is concerned, countries around the world use different policies. There are even countries, which have changed their accounting treatment in order to surpass some problems, such as USA. The companies had been abided by Accounting Principles Board opinion 17 (APB 17) till 2001.

According to these principles goodwill was characterized as an asset. Hence, it had to be capitalized and amortized for the whole period which is used, but not exceeds forty years. After 2001, APB 17 was replaced by SFAS 142. The main characteristic of this policy is the impairment testing, which has to take place at least annually.

Wang, Victoria Shao-Pin (2003) ‘Empirical studies related to goodwill treatment accounting in the U.K.’, Unpublished doctoral dissertation, University of Lancaster.

On the other hand, U.K. companies could choose between great varieties of accounting treatments in the past. However, the vast majority of them were using the immediate write off method according to SSAP 22. But in 1997, when FRS 10 came into existence, they changed the treatment of goodwill. Mrs. Wang in her thesis has summarized the FRS 10 by mentioning the three characteristics of these standards.

Firstly, the main point of FRS 10 is that positive goodwill has to be capitalized and amortized. Secondly, the period of the amortization has to be related to the years that goodwill is used. Finally, in case the life span of goodwill either exceeds 20 years or is indefinite, an annual impairment test has to be implemented.

Frederick D. S. Choi and Changwoo Lee. 1999, ‘Merger premia and national differences in accounting for goodwill’, Journal of International Financial Management and Accounting, Vol. 3, Issue 3, pp.219-240.

What Mr. Choi and Mr. Lee underline is the fact that when USA was using amortization and UK immediate write-off of goodwill, UK companies had some advantages over USA companies. The main advantage of UK companies was that they were better bidders. In order to understand this, we have to consider that the immediate write-off method of goodwill leads the companies to report higher performance, such as earnings. Thus, UK companies were willing to purchase an asset at higher price than the fair value, and report the difference as goodwill. The disadvantage of this phenomenon was that this procedure was against the shareholders.

Wang, Victoria Shao-Pin (2003) ‘Empirical studies related to goodwill treatment accounting in the U.K.’, Unpublished doctoral dissertation, University of Lancaster.

The above mentioned differences have been reduced by the implementation of new accounting standards and by the contribution of International Accounting Standard Board (I.A.S.B.) and Financial Accounting Standard Board (F.A.S.B.). Efforts have been made in order to harmonize the treatment of goodwill around the world. However, Luxemburg insists on the 5-year write-off.

On the other hand, the countries which belong to the European Union follow the IASB’s policy; allowing capitalization and amortization for not longer than 20 years. Furthermore, Argentina and Japan capitalize and amortize goodwill. Last but not least, Australia, according to AASB 1013, uses the capitalization and amortization of the purchased goodwill. The period of the amortization has to be equal to the period that goodwill is used, but cannot exceed 20 years.

Conclusion

As discussed above goodwill is really a controversial area of accounting. The intangible nature, different types, difficulty to measure and hence account for clearly shows that. Many authors have written for and against different treatments of accounting for goodwill, clearly showing the benefits and disadvantages of each of them. But there is no concrete and ideal method suggested to be used for the purpose. Different countries have adopted different methods to value and account for goodwill. The future of accounting for goodwill is also going to be very controversial with the boom of cyberspace industry which has very limited physical assets.


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