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Goodwill is one of the intangibles which have always been a constant problem of accountants and accountancy ever since its existence was first acknowledged in the 1880s. Many authors have since then defined the concept of goodwill (Dicksee&Tillyard, 1906, Seed, 1937, Gynther, 1969, Fess and Niswonger, 1981). Other authors developed valuation theories for goodwill starting with P.D. Leake in his book "Commercial Goodwill. Its history, Value and Treatment in Accounts" (1921), to one of the latest original approaches given by M. Bloom in "Double Accounting for Goodwill. A problem redefined" (2008). The most controversial aspect in recent years has been the accounting treatment of goodwill, from recognition in the financial situations to amortization or evaluation of its impairment. It is interesting to observe that the divergent opinions with regard to the definition of goodwill are also true about the accounting treatment of goodwill once it has been introduced in the financial statements.
Many questions which researchers raised one hundred years ago are still being answered today, which represents a strong reason to study this topic, which is challenging, current, ambitious and also important both to stakeholders and to the field of research.
The research develops an in depth study of the evolution of goodwill definitions, valuation methods, changes in goodwill components, accounting standards and accounting treatments, using time transversal methodology. Furthermore, our research supports the importance of the topic studied by measuring the significant influence and the impact goodwill has on investors' decisions through statistical methods, following the studies of Carrara et al. (2010), Van de Poel (2008) and Ely&Waymire (1999).
By the end of the 19th and beginning of the 20th century, business combinations were not very common, sole owners and family businesses were still the most spread types of businesses on the market. Meanwhile, the only form of existing goodwill referred to the quality of the services or products offered and the reputation of the business or the correctness of the owner. Before accounting institutions were formed, individual writers and researchers of the time based their writing on personal experience and referred to legal cases in common law. One of the first authors to give a definition for goodwill that is still popular today was Professor L.R. Dicksee in the first book dedicated entirely to goodwill, "Goodwill and Its Treatment in Accounts" (1906). Goodwill he says, "is the benefit arising from connection and reputation, the probability of old customers going to the new firm which has acquired the business" (cited by Courtis, 1973, p.3).
Although there is no internationally accepted definition of goodwill from a legal perspective, Courtis (1973) identifies numerous cases in common law where definitions were offered. One of the best legal perspectives was offered by Lord Macnaghten in 1901. He said goodwill "is the benefit and the advantage of the good name, reputation, and connection of a business. It is the attractive force which brings in the custom... Goodwill is composed of a variety of elements. It differs in its composition in different trades and in different businesses in the same trade". Macnaghten's view of goodwill is strongly related to the elements which comprise it. The comprising elements of goodwill have been subject to change over time, along with the creation of institutions or accounting bodies which regulated their valuation. One very illustrative example of how this idea will be approached in our study was first discussed by Mard et al. (2002) as cited by Bloom (2008).
Nelson's (1953) "Momentum Theory of Goodwill", refers to goodwill as to a momentum, a marketing push comprised of customer lists, trademarks, copyrights or patents. We consider this short list can be extrapolated to more elements included in goodwill and whether it is the advantage of intellectual capital acquired or the existence of administrative procedures which make the business work, we embrace the idea that the perspective of getting these advantages has an impact on the investors' decision. The empirical support for his theory is brought into the literature by Chauvin&Hirschey (1994), who find that goodwill is profitable and value relevant to the firm.
In addition to the elements mentioned above which constitute the going-concern goodwill (Johnson&Petrone, 1998, Gynther, 1969 as cited by Muller, 2010), Barlev (1973) introduces the idea that mergers and acquisitions produce synergies which should also be allocated to goodwill. Other researchers empirically support his idea, Berkovitch&Narayanan (1993) or Zhang (1998).
2. RESEARCH METHODOLOGY AND PERSONAL CONTRIBUTION
The main research question in the first part of the thesis is stated from the beginning in chapter 3: What is Goodwill? We answer this research question in two ways: first, we offer a complete view on the definitions of goodwill and second, we research and study the literature for the most comprehensive typologies of goodwill, which we analyze and state our own opinion on.
We consider the chronological content analysis conducted in this research to be important and adequate at the same time, because it is crucial to have a thorough understanding of the evolution of goodwill in order to properly work with the concept further along when demonstrating the importance of this intangible asset in investors' behavior on the market. By accomplishing this step in our research we will enrich the literature by completing the studies of Carsberg (1966), Courtis (1973) and Seetharaman et al. (2004) to the present time.
The descriptive part around the definition and the theories of goodwill is very important to our study because the more extensive the methods for identifying and valuating the elements which comprise goodwill become, the lesser the impact goodwill has on investors' decisions. If, for example, intellectual capital can be identified and valued separately, the impact of goodwill decreases by the amount the impact of intellectual capital as an independent asset increases.
3. WHAT IS GOODWILL?
The purpose of this chapter of our thesis is to offer a complete overview of the concept of goodwill, as it is etymologically explained and defined from an economical, legal and, most relevant to our field of research, an accounting perspective. We acknowledge and admit that this analysis is not exhaustive, nor do we intend for it to be so. What we aim to provide is a clear understanding of the term goodwill and guide the reader through the evolution of the term, even if at times, due to limitations of our research, a constant time traverse is not possible.
3.1. THE DEFINITION OF GOODWILL- A CHRONOLOGICAL OVERVIEW
Defining goodwill is a process which has spread over a long period of time, from the late 1800's until today, and has not yet found closure. The stretch over time and the continuity of this process was best explained by Hughes (1982):
"...there was no one Truth and never will be. The origin of goodwill can be revealed through history, but its nature is a matter of personal interpretation."
In this section of the doctoral thesis we will approach a chronological overview of the definitions and the conceptualization of goodwill starting from the late years of the nineteenth century to this day. The choice of this particular point in time when we start our analysis is motivated by the abundance of papers written on goodwill at the time. The legal encounters of the term goodwill are also numerous in that time specifically, and we think both these causes are due to an improvement in the world economy and the development of a business environment at a larger scale beginning in the late nineteenth century. By analyzing the etymological and economical perspective, legal encounters and accounting writings, our research reveals and projects a corroborated and extensive review of this concept and its nature. The diversity of definitions explaining goodwill for more than a decade will inherently advance criticism about the substantiality, complexity or logic abiding when formulating these definitions. In order to prevent such criticism we only considered for this paper the definitions which were given by prominent scholars of the time, published in articles or books which proved their substantiality over time, appeared in legal cases which are considered precedents and in the international accounting standards worldwide. In addition to the criteria of chronology, in choosing the definitions we cited in our thesis we used a personal criterion for the selection of the definitions. From all the papers which we analyzed, we only chose those papers which were meaningful in the sense of expressing nuances of goodwill related to accounting, to attributes and components of goodwill, as we understand it today.
3.1.1. The Etymological Perspective
The etymological approach of the definition of goodwill is not common among studies of goodwill. We consider it suitable to our purpose of analyzing the definition of goodwill from a chronological perspective. The word "goodwill" is derived of the two English words "good" and "will". At its origin in the English language, the common meaning of the two words combined, which still remains in use today, would mean a certain kind of attitude which was felt by a human being. With more than 100 variations of the meaning of "good" and more than 170 for the meaning of "will", which are documented in dictionaries, the resulting of approximately 17.000 possible combinations are clearly not all appropriate to define the word from a business point of view. The Oxford Dictionary of English Etymology documents the usage of these two words being used together as early as 200 A.D. in Latin under the expression "bona voluntas" and adopted in the English language as early as the 9th century. Courtis (1983) observes that until the usage of the word goodwill in a commercial context, sometime in the 16th century, its meaning would strictly point to a certain kind of attitude of a human being.
The 19th century brings along a flourishing business activity, especially in Europe and the USA, and it is this time when the word goodwill starts to be used with a business meaning. In the beginning, the word is used to "designate the patronage of the public" (Moore, 1891), but it gradually comes to a more elaborate meaning, thus denoting the attributes of goodwill: the advantage of the business or the transferability of an already established business as Leake (1983) so well resumes it: "Goodwill... is the transferable right which grows out of all kinds of past effort in seeking profit, increase of value, or other advantage."
Today, the meaning of goodwill is explained in English language dictionaries as well as business dictionaries. For example, one of the most used dictionaries in the UK, The Merriam-Webster Dictionary, defines the word goodwill from a business point of view as:
"1):Â the favor or advantage that a business has acquired especially through its brands and its good reputation;Â (2):Â the value of projected earnings increases of a business especially as part of its purchase price;Â (3):Â the excess of the purchase price of a company over its book value which represents the value of goodwill as an intangible asset for accounting purposes."
The business dictionaries usually borrow the explanation given by the accounting standards, but the Oxford Dictionary of Accounting, defines goodwill as:
"The established reputation of a business regarded as a quantifiable asset, e.g. as represented by the excess of the price paid at a takeover for a company over its fair market value."
3.1.2. The Economical Perspective
Goodwill is an interdisciplinary concept. Although it is usually used and most often met in accounting contexts, the concept of goodwill is also used in the fields of economy, marketing or human resources. In this subchapter we will briefly explain how goodwill fits into all these contexts.
We define economic goodwill as the value of the intangible leverages a business has over its competition and is determined when the business is sold or merged as the difference between a higher market value than the book value of the entity. This difference is created mainly by the synergies between the entity's assets which in their own turn create expectations of increased income. The famous economist and most successful investor on the capital markets around the world, Warren Buffet, explains that he always built his portfolios using economic goodwill as an underlying quality of a company. He says, that "businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill". The difference between economic goodwill and accounting goodwill resides in the perspective which goodwill is watched upon. While accountants also define goodwill using the economic perspective, the economists often consider that accounting goodwill is strictly the total value paid above the net value of the assets which are acquired. As accountant researchers we consider that the accounting view of goodwill cannot be so restrictive, and that we use economic leverages to define the term as well.
From a marketing point of view, the biggest debate is around goodwill and patents, trademarks, copyrights, brands and franchises. A good understanding of the differences between these concepts is important, because, they are evaluated and reported separately in the Annual Reports of an entity. From a historical point of view, the concept of goodwill comprised all these elements in the late nineteenth century, when our analysis commences. Today, even if there is no Goodwill Act sanctioned internationally, the World Intellectual Property Organization exists, and, in its own words "is dedicated to the use of intellectual property (patents, copyrights, trademarks, designs, etc.) as means of stimulating innovation and creativity", in a fair manner and with respect to the regulations of this worldwide organization. The importance of this institution to goodwill has proved to be crucial in time, because all the intellectual property elements mentioned above, which were prior to this included in goodwill, had now grounds to be valued on their own and not be considered goodwill components anymore.
Another milestone in close connection to the definition and components of goodwill, but related more to the specificity of human resources, happened in 1990, when the Swedish company Skandia, for the first time, gave meaning and draw a clear perspective of the concept of intellectual capital, which is a major component of goodwill. Until today, the intellectual capital is not accounted for separately, but there is an international interest, both in business and in academic research of how it could become an independent intangible asset. When this happens, goodwill will be short of one more important element, and its accounting value will drastically drop, meaning its value won't be as significant to the business as it is today.
3.1.3. The Legal Perspective
Very often we hear that goodwill is mentioned in commercial trials which make the headlines. But our analysis reveals that goodwill has been used as a legal concept for more than a century. Our overview of some legal definitions of goodwill relies on the three most comprehensive books written on goodwill: L.R. Dicksee and F. Tillyard's, "Goodwill and Its Treatment in Accounts" (1906), P.D. Leake's "Commercial Goodwill. Its History, Value and Treatment in Accounts" (1921) and G. Johnson's "Common Law Accounting: The Case of Goodwill" (1985). All three books have been published by authors researching mostly in a common law background, which implies that once a definition was used in a winning trial, it received the statute of precedent. Consequently, before standards were emitted, so that commercial courts would use an accounting standard documented definition, these definitions we will mention took priority.
In 1810, Judge Lord Eldon, who was an important British public figure and in addition to being a judge also held the position of Lord Chancellor of the United Kingdom, defined goodwill, as cited by Dicksee and Tillyard (1906):
"The goodwill which had been the subject of sale [the goodwill pertaining to a particular business as a whole] was nothing more than the probability that the old customers will resort to the old place."
Even though this is a very concise and even a restrictive definition, it was the cornerstone for other legal definitions on goodwill later on. It is also the first definition to make the connection between goodwill and the establishment of a business. The prima commercial location of a business is still considered a major component of goodwill today which could not, so far, be valued separately. One year later, in another commercial trial, again cited by Dicksee and Tyllard (1906), this definition was improved by the Lord Chancellor William Wood, an illustrious British lawyer and statesman of his time, who added the concept of transferability to goodwill. By transferability we mean the shift of property title from a former owner to the new owner. He defined goodwill as:
"Goodwill...must mean the advantage ... that has been acquired by the old firm by carrying on its business, everything connected with the premises and the name of the firm and everything with or carrying with it the benefit of the business...When a person parts with the Goodwill of a business, he means to part with all that good disposition which customers entertain towards his particular shop or house of business and which may induce them to continue their custom with it."
The choice for these two definitions is not random; these definitions were chosen because they have been used as classical examples to the legal approach of the term goodwill by other authors since, for example P.D. Leake (1921). Moreover, because they were among the first definitions of goodwill used in commercial trials, they perpetuated as precedents and became almost familiar to specialists. For many years, the commercial trials haven't offered much improvement to the definitions we mentioned above, expect perhaps that they added to the components of goodwill more.
Johnson (1985) conducts a detailed analysis of commercial trials on goodwill in the United States, and her analysis only goes back until 1930- to a case in Michigan, where the plaintiff claimed a share of the company's goodwill, for the time he worked in the company, but was denied by the court- and from then on, she mentions that relevant input for goodwill did not come from common law anymore, but from Statute Law, beginning with the 1970s, which regulated the term of goodwill.
These valuable resources which we used in our research only guide our analysis of the term goodwill through a legal perspective to very early ages when goodwill was defined in common law courts, and since a more in-depth analysis of the legal perspective is not the main purpose of our thesis, we are satisfied with the results we obtained at this stage.
Using an internet search of more recent trials involving goodwill, we found an interesting case which was trialed in 2006, the Murry case in Australia, and in which the decision ruling offers a definition of goodwill. This decision is public and was published and it seems like it has not gone a very long way from principles highlighted by Lord Eldon in 1810. Goodwill is defined as:
"[Goodwill is] the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means which in the past have attracted custom to the business."
From a legal perspective, until today, no international legal or financial institution has published a distinct act or another legal form of regulation with regard to goodwill. In many common-law countries some trials have been considered important precedents to others and many accounting related trials mentioned goodwill. By large, over the last hundred years we studied, what most cases referred to in connection to goodwill, was in fact connected to its components. We identified in our research several factors which appeared in common law definitions of goodwill which we encountered: the venue of the business, the character and popularity of the owner, the aptitudes and the behavior of the employees, the name of the business, the quality of the goods sold or the services provided, the use of marketing leverages and not least, the level of the surrounding competition, the social and business connections, trademarks, copyrights, patents, the customer loyalty. Legal opinions with regard to goodwill also highlight the importance of the element of advantage which we identified in almost every definition accountants give of this term.
3.1.4. The Accounting Perspective
The earliest reference to goodwill was cited by Leake (1921), "I gyue to John Stephen â€¦. My whole interest and good will of my Quarelle" (i.e. quarry) and goes back to 1571. This citation does not give a definition of the term, but it proves it has been acknowledged more than four centuries ago and it seems to be the oldest, most famous quote about goodwill researchers ever found.
The oldest definition authors refer to appeared in Bithell's "A Counting House Dictionary" in 1882 as cited by Courtis (1983):
"The advantage connected with an established business of good repute. A well-established business presents an expectation of profits to any one entering upon it, and is worth paying for. Anyone having such a business and who is willing to relinquish the expectation of the business by transferring it for consideration to someone else can do so by what is technically called "selling the Goodwill of that business"".
There are two important aspects in this definition which perpetuated over time: first, goodwill is viewed as an 'advantage' and to this day the international accounting boards refer to goodwill as such and the second aspect is goodwill's attribute of 'expectation of profits' which is also part of its description today.
In the first book ever written on goodwill, "Goodwill and Its Treatment in Accounts" Dicksee and Tillyard (1906) revise the most important legal cases of that time, which give definitions of goodwill, and summarize them into a very suggestive paragraph:
"...where the locality of the business makes the trade, Goodwill as a disposable asset represents the advantage derived from the chance that customers will continue to frequent the premises in which the business has been carried on; that where the business is one which depends upon the reputation of a firm, the Goodwill consists of the advantage which the owner (whether original or by assignment) derives from being allowed to represent himself as such; and that where the value of the business depends on its business connection, the Goodwill on sale consists of the right to be properly introduced to those connections."
Again we find the element in this definition which remained constant over time: the advantage associated to the concept of goodwill, derived from the location of the business, the reputation- brand significance- or the prior to the sale business connections.
In 1921 the illustrious chartered accountant P.D. Leake publishes the second book dedicated entirely to goodwill called "Commercial Goodwill. Its History, Value and Treatment in Accounts", where he elaborates the "Super-profit Valuation Theory of Goodwill". He defines goodwill as:
"...the right which grows out of all kinds of past effort in seeking profit, increase of value or other advantage... The exchangeable value of the right depends upon the probability of earning future super-profit- the term "super-profit" meaning the amount by which revenue, increase of value, or other advantage received exceeds any and all economic expenditure incidental to its production".
The main idea of Leake's theory is that the value of commercial goodwill is the current value of a super-profit which diminishes annually on a straight line pattern. He also identifies the "advantage" associated to goodwill which results from the difference between revenue and expenditure incurred in obtaining that revenue.
For the first time, in 1937, H.D. Seed relates goodwill to law associated with its components- namely trade names, trademarks, patents or copyrights. He develops the thesis that goodwill should only be valued in association to the valuation of the whole business. The influence of his predecessors is evident in the qualities Seed attributes to goodwill when defining it:
"The advantage which arises from the good name, reputation and connections of a business; alternatively, the benefit which accrues to the owner of a business from the likelihood that such business will earn, in the future, profits in excess of those required to provide an economic rate of remuneration for the capital and labor employed therein."
In 1946, in an attempt to probably express the frustration of some writers to find the best definition for goodwill, Harry Norris, in his book "Accounting Theory. An Outline of Its Structure", brings a little true humor into the definition of goodwill:
"If X is a live pedigree dog, and Y a dead one, then perhaps X-Y=Z. But Z doesn't mean anything in itself. The label 'goodwill' in business accounts closely resembles Z; its use is as sensible as trying to find what makes a dog tick by dissecting it."
What Norris probably means is that what gives value to goodwill are precisely its components, which cannot be valued separately, therefore are all included under the name of goodwill. Even though a funny definition, the truth behind it still emerges to the surface today, when accountants admit that the notion of goodwill contains elements which cannot be separately valued as assets.
In 1969, Gynther admits that goodwill has been a "thorny problem" of accountants over time and the motive for that may be the fact that the real definition has been replaced by just means of calculation for goodwill. He says:
"Goodwill exists because assets are presented, even though they are not lined with the tangible assets. For example "special skill and knowledge", "high managerial ability", "monopolistic situation", "social and business connections", "good name and reputation", "favorable situation", "excellent staff", "trade names", "established clientele" are assets in this category. The sum of the value of these assets...is the value of Goodwill".
The list of the elements which form goodwill that Gynther mentions is definitely not an exhaustive one, but our attention will be directed to those elements in another section of this paper. He draws attention to an aspect that is still troubling accountants today: what is the value of goodwill and what does components does it encompass? His concerns are still valid today, as researches on this topic ask similar questions and use empirical studies to answer them.
In 1975, Gibson and Francis are among the first researchers to define goodwill with connection to consolidation. In our research, this was the first encounter of a definition of goodwill in connection to consolidation. A possible explanation as to why this happened is that mergers and acquisitions, which are cause for consolidation, were highly used in the period of 1965-1969 in the United States of America.
"Goodwill on consolidation is the term used to describe the excess of the cost of investment in subsidiaries over the book value of the equity acquired."
This is the time when mergers and acquisitions have made their mark on the definition of goodwill, and started placing goodwill in the context of consolidations.
In 1981, Fess and Niswonger, define goodwill with relation to the higher rate of return it can bring to a business combination:
"Its (goodwill's) existence is evidenced by the ability of the business to earn a rate of return on the investment that is in excess of the normal rate for other firms in the same line of business."
Ma and Hopkins (1988) defined goodwill as:
"The capitalized value of the future stream of superior earnings of the business to be acquired."
By this definition, which records earnings to the value of goodwill, it would be very difficult to measure goodwill, because earnings may not be predicted accurately.
Klaassen and Helleman (2004) define goodwill as the value of a firm on top of the value of equity which is presented in the financial records. Goodwill, they say, "is a resultant whose size depends on two pillars. The first pillar is the value of the business and the second is the meaning of the term equity."
Having covered and selected, in our opinion, the best definitions for over a century, using the criteria explained in the beginning of the chapter, we can now asses that the accounting notion of goodwill has been defined in the literature using two main approaches: first, we distinguish a qualitative approach, when the definitions mainly highlight the attributes of goodwill and then, there is he quantitative approach, when authors define goodwill using methods of calculation. The definitions given by the international accounting standards, which are covered in the next paragraphs, use the second approach, of defining goodwill by the method of its calculation.
After the 1990s, the most representative definitions of goodwill come especially from international and national accounting bodies such as the IASC or the FASB. The reason why we think this happened is because researchers chose to focus more on the accounting treatment of goodwill and the implications of this treatment for the companies, rather than on the definition, especially since accounting bodies worldwide offered clear definitions. The goodwill definitions we find in the standards are consistent with either the "top down" or the "bottom up" perspective. This means that goodwill is either viewed as a residual or viewed through its components.
The glossary of the IFRS 3 "Business Combinations" defines goodwill as "any excess of the cost of the acquisition over the acquirer's interest in the fair value of the identifiable assets and liabilities acquired as at the date of the exchange transaction". Goodwill is thus defined in terms of the method for its calculation rather than in terms of its components, attributes or characteristics, although the standard makes several comments about components as well.
The United States Generally Accepted Accounting Principles advance their own goodwill standard, the SFAS 142 "Goodwill and Other Intangible Assets", emitted in 2001, currently known as the Accounting Standards Codification 350 "Intangibles- Goodwill and Other":
"Goodwill is the excess of the purchase price compared to the net assets acquired."
This definition is in agreement with the definition given by the IASB, in IFRS 3 and again, it mentions that components of goodwill should be disclosed in the Notes attached to the Annual Report.
The definition of goodwill that was provided in an Exposure Draft in 1999 by the FASB, is substantial with the bottom-up perspective, because it considers goodwill existence through its components rather than just as a residual.
"The amount recognized as goodwill may consist of one or more unidentifiable intangible assets and identifiable intangible assets that are not reliably measurable. The elements of goodwill include new channels of distribution, synergies of combining sales forces, and a superior management team. Because those and similar elements cannot be reliably measured separately from each other, they are accounted for separately as goodwill. "
Bloom (2008), notices that what this definition makes "clear, however, is that goodwill needs to be defined and considered in terms of intangible items existing within an entity, and that it is not sufficient to attempt to understand or account for goodwill in the context of the residual, or "top-down" view alone". Indeed this definition brings attention on goodwill's components and it was supported by the amendment in the standard that all components of goodwill should be mentioned within the financial statement.
Before it adopted the IFRS, the UK Accounting Standards Board, in the standard FRS 10 "Goodwill and Intangible Assets", issued in 1997, had its own definition of goodwill which was very different than the IFRSs:
"Goodwill arising on acquisition is neither an asset like other assets nor an immediate loss on value. Rather, it forms the bridge between the cost of an investment shown as an asset in the acquirer's own financial statements and the values attributed to the acquired assets and liabilities in the consolidated financial statements. Although purchased goodwill is not in itself an asset, its inclusion amongst the assets of the reporting entity, rather than as a deduction from shareholders' equity, recognizes that goodwill is part of a larger asset, the investment, for which management remains accountable".
The Australian standard which regulates goodwill, the AASB 1013 "Accounting for Goodwill", which was abandoned in 2005 along with the adoption of the IFRSs, defines goodwill:
"Goodwill...must be measured as the excess of the cost of acquisition incurred by the entity over the fair value of the identifiable net assets acquired."
The two definitions above, which are no longer in effect, consider goodwill has an existence beyond just its measurement and ways of determination, through its components. What we also find interesting in these definitions is that they use the concept of fair value before it was introduced by the IFRS and consequently became a term of reference in accounting standards and procedures.
3.1.5. The Author's Perspective- in Conclusion
The thorough analysis we accomplished for defining goodwill has lead us to the conclusion that the word has evolved over time into many meanings. Before giving a definition of goodwill, one will most importantly have to ask from which perspective this definition is required.
For the remainder of this doctorate thesis, for the purpose of accurately using the term in an accounting context, we will resort to the definitions given by the international standards, which are in power in the business environment as well as in judicial context.
The purpose of this subchapter is to offer an overview of goodwill definitions, going back for longer than a century and to understand how goodwill evolved, through the definitions given by academics, professional bodies of accountancy and courts of law. We have, therefore, covered accounting, legal and etymological definitions. Our findings indicate that goodwill has been defined over time in two different ways: by academics who indicated mostly the elements comprising goodwill and its characteristics and by the international accounting boards which define goodwill through the way it is measured. The most common characteristic which we encountered was the advantage brought by goodwill in a business combination, which is the only constant characteristic mentioned both by academics and institutions over time.
This study is the result of a chronological qualitative analysis of the concept of goodwill and it brings novelty to the literature by improving on existing studies dating in 1980s, and completing them to the day. This study brings added value to the literature through the brief yet comprehensive analysis of goodwill definition over time.
We will continue this study with a similar chronological analysis the accounting treatment of goodwill in another chapter. We consider that following the chronology of the changes in the accounting treatment is important as it gives us a better understanding of the present regulations and the reasons why these regulations are in place today.
3.2. THE CLASSIFICATION OF GOODWILL
The classification of goodwill has become as important as its definition, because the approach of each type of goodwill is characteristic to a different accounting treatment and the accounting treatment applied to goodwill is important in the economy of a business. Inadequate classification of goodwill has been critiqued by Nobes and Norton (1996):
"Failure to distinguish between types of goodwill has led to errors of fact which invalidate some of the hypotheses of several frequently cited papers."
This is an important point which Nobes and Norton (1996) make, that encouraged us to develop the current subchapter of our thesis.
3.2.1. Purchased Goodwill- Consolidation and Non-consolidation Goodwill
In this section of the thesis we discuss the concept of purchased goodwill; we analyze the approach in the literature as to how it can be classified and briefly mention the accounting treatments of purchased goodwill, which we discuss thoroughly in Chapter 5.
Purchased goodwill has been the center of the debates around goodwill. Authors have given it a lot of attention and accounting standard setters around the world have agreed to only include purchased goodwill in the balance sheets, which easily made purchased goodwill the most familiar type of goodwill worldwide. Purchase goodwill appears when a company acquires another company for a consideration greater than just of that of the fair value of the assets acquired. The revised IFRS 3, 2008, addresses the way to determine purchased goodwill: "Consideration transferred to obtain control plus Amount of non-controlling interest plus Fair value of previously-held equity interest less Fair value of the identifiable net assets of the acquiree (100%)", paragraph 32, under IFRS 3 Revised 2008. This means that goodwill, as a going concern valuation, is only recorded into accounts at the time of the purchase, as the residual between the excess of cost over the fair value of the identifiable net assets which are acquired. The current view of the standards agrees to the top down perspective that regards goodwill as a component of a larger asset which has identifiable intangible assets and the rest allocated to goodwill. The opposite perspective, the bottom up perspective, regards goodwill in terms of the components which it is comprised of, and is discussed later on in this paper.
Purchased goodwill has been divided into types. The most used and cited in the literature have been the typologies identified by Ma and Hopkins (1988) and Nobes and Norton (1996). Ma and Hopkins (1988) examine goodwill in three situations:
Internally generated goodwill, which we discuss in a following section of the thesis.
'Independent' purchased goodwill, where the acquired company is expected to operate autonomously and no synergies are formed in the process of the acquisition. The preexisting goodwill of the acquired company remains the same, if the company previously had any goodwill, and the goodwill of the acquirer does not change either. This type of goodwill still remains in an abstract form, which we think is seldom, if ever, applicable.
'Dependent' purchased goodwill, where the operations of the acquired company are wholly or partially integrated with those of the purchaser. This is the most encountered type of goodwill, because usually mergers and acquisitions are made with the precise purpose of integrating the acquired entity in the business combination, in such a way that synergies may arise from these operations. The synergies Ma and Hopkins discuss of in their paper are one of the most important components of purchased goodwill. These synergies occur when the systems of the acquired and acquirer companies interact, the synergies which are formed when the enlarged business combination interact with the rest of the business environment and the benefits which the acquirer receives along with the diversification of their business group.
Nobes and Norton (1996) develop another typology of goodwill, which is again divided into three categories:
Internally generated goodwill, which we discuss in a following section of the thesis.
Nonconsolidation goodwill, which "can arise when a company buys some of the net assets of another company without buying the company itself, that is, without buying shares in the company. No parent-subsidiary relationship is created, and no consolidation processes are triggered. However, since it is common to pay more than the fair value of the net assets acquired, goodwill often arises."
Consolidation goodwill, which is the common goodwill treated by the international standards, that appears when a company is paying more than the fair value of the net assets acquired to buy another company.
Nobes and Norton (1996) underline that the distinction between the last two types of goodwill is necessary for the accounting treatment of consolidation, accounting reports of the parent company and the group and not least, it is necessary for taxation purposes.
The difference between the two classifications, which are brought in the literature less than a decade apart, address purchased goodwill. Ma and Hopkins (1988) do not differentiate between consolidated and nonconsolidated, instead, they differentiate between the choice of the purchaser to integrate the bought company into their existing business or keep the purchased company independent. Nobes and Norton (1996) choose to make a clear distinction from the viewpoint of the consolidation process, between consolidation and nonconsolidation goodwill, because this distinction is important to the accounting and fiscal duties of a company.
Nobes and Norton (1996) give examples of a few countries where the distinction is made at a linguistic level as well: in France, consolidation goodwill is translated as "écart d'acquisition", and nonconsolidation goodwill is referred to as "fonds commercial". In Italy they refer to consolidation goodwill as "differenza da consolidamento" and to non-consolidation goodwill as "avviamento. We will further analyze the evolution of accounting practices concerning consolidation goodwill in the Chapter "Accounting Treatment for Goodwill".
Even though the debate on goodwill has been going on for more than a century, professional bodies and most academics have so far only agreed on one thing: purchased goodwill is the only identifiable type of goodwill which can be measured at a reliable cost, and which can be easily isolated for valuation. As for the accounting treatment of the recognition, depreciation or writing-off of goodwill, several methods have been effective: recognition of goodwill at its nominal value, writing-off goodwill more often against reserves, amortization of goodwill against reserves for five to as many as forty years and the latest treatment of impairment due to loss of value. Chapter 5 "Accounting for Goodwill" is entirely dedicated to a thorough analysis of these accounting treatments.
We find the arguments which Nobes and Norton (1996) bring in favor of their classification to be very persuasive and the evidence they bring in support of their arguments are also compelling. We adopt the classification they offer and we declare in favor of it. For the remainder of our thesis, we agree that consolidation purchased goodwill arising in a business combination is the goodwill which we will address further in the accounting analysis and in the empirical study of our thesis.
3.2.2. Negative Purchased Goodwill
The overall controversy of overall goodwill spreads to negative goodwill as well. While some authors think it is a logically impossible concept (Burton at al., 1981), others simply deny the possibility of its existence (DeMoville and Petrie, 1989). Other authors choose to be more prudent and accept that the possibilities of a bargain purchase in the current market conditions may still occur and that each situation should be evaluated separately (Morris, 2004). Pahler (2003) expresses doubt about why a seller would not choose to sell individual assets but the company as a whole, when those assets sold separately would worth more than selling them together. Indeed all these opinions may be right to some extent, as it can prove difficult to understand the discount arising between the surplus of the fair value of the assets over the cost of acquisition. While the debate may continue between academics, the accounting standard setters regulated the definition and valuation of the concept and its accounting treatment.
The IFRS 3, paragraph 35, defines negative purchased goodwill:
"A bargain purchase is a business combination in which the net fair value of the identifiable assets acquired and liabilities assumed exceeds the aggregate of the consideration transferred, the non-controlling interests and the fair value of any previously-held equity interest in the acquiree."
The standard stipulates that if such a bargain purchase acquisition occurs the excess fair value of the assets acquired should be recorded in the financial statements as a gain for the current period. The USGAAP SFAS 141 "Business Combinations" adopts a similar approach in defining and accounting for negative purchased goodwill, but in addition, it stipulates that the acquirer need to motivate and explain the reasons why the bargain purchase happened.
Bargain purchases seldom occur, but even so, negative goodwill represents an interesting topic to study. The most interesting aspects to determine about negative purchased goodwill are the reasons why it appears. Comiskey et al., 2010, made an extensive list of potential sources of negative goodwill, presented in Table 1, below:
Table 1. Disclosures by Acquiring Firms of Potential Sources of Negative Goodwill
Acquired Firm was in Distress or in a Hurry: management believes the negative goodwill occurred in large measure due to the seller's desire to exit the Texas insurance market, combined with the seller's need for additional capital for its ongoing business units (Republic Companies Group, Inc, Form 10-K, 12/31/2005, p. 67).
Valuation Changes Occurred Prior to Final Consummation of the Acquisition: the Company attributed the negative goodwill primarily to the value of the land, which increased dramatically between the time the purchase agreement was executed and the time the Nevada Gaming Commission approved the acquisition and it was consummated (AWI Gaming Inc., Form 10KSB,1/31/2007, p. 46).
Other Negative Goodwill Sources:
A substantial portion of this unallocated negative goodwill was generated 31/2005, p. 27).
The Company believes the acquired brands have underperformed in recent years, largely due to limited marketing support. Because these brands had not been adequately supported in the recent past and there was no intent to invest the marketing support necessary to turn them around, the Company acquired the brands at an attractive price (Smithfield Foods, Inc., Form 10-K, 4/29/2007, p. 29).
by the recognition of anticipated federal income tax benefits that we expect to realize over the allowable 20-year carryover period by offsetting the net operating loss carryover obtained as part of the acquisition of Le Mars against taxable income generated by our consolidated affiliates (Donegal Group, Form 10-K, 12/
The negative goodwill arose primarily as the result of a negotiated discount between the cost of acquisition and the fair value of net assets acquired for an acquisition where indemnities for aggregate adverse loss development were received. The aggregate adverse loss development indemnities provide coverage capped at the worst plausible loss and loss adjustment expense reserve levels (Enstar Group Ltd., Form 10-K, 12/31/2006, p. 73).
During the fourth quarter of 2004, we realized certain previously unrecognized tax assets and recorded an additional extraordinary gain of $2.1 million, bringing the total extraordinary gain from this transaction to $12.5 million. This extraordinary gain is the result of the acquired net assets, including certain tax assets, having a fair value in excess of the total consideration paid (QLT Inc., Form 10-K, 12/31/2004, p. 61)
(Sursa: Comiskey et al., 2010: 335)
Comiskey et al., identified these sources of negative goodwill from a sample 127 companies which they included in their study.
Negative purchased goodwill is an interesting concept and the controversies around its existence, its evaluation and treatment in accounts make it a topic which should be researched more.
3.2.3. Internally Generated Goodwill
In this section of the thesis we examine internally generated goodwill in detail. We determine the meaning of internally generated goodwill, then we perform an accounting treatment overview and point out the reasons for and against non-recognition, we present two innovative methods for recognition and valuation, Bloom's (2008) and Casta, Paugam and Stolowy's (2010) and we conclude with a few remarks we found to be relevant along this analysis.
Johnson and Petrone (1998) define internally generated goodwill as:
"the ability of a stand-alone business to earn a higher rate of return on an organized collection of net assets than would be expected if those assets had to be acquired separately (reflecting the synergies of the net assets of the business and factors related to market imperfections, such as where a business has the ability to earn monopoly profits or where there are barriers to entry to the market by potential competitors)."
Therefore, internally generated goodwill is the result of synergies within a company, of particular expenditures in research and development, human resources activities improvement, new marketing strategies, which lead to an increase in value of the company's assets, but it is not always and not entirely generated by these factors. Ma and Hopkins (1988) place internally generated goodwill in the context of the firm as an open and dynamic system. They argue that it is economically meaningful because it is a result of the synergies in which the assets of a company are engaged. In the case of purchased goodwill, the connections between synergies and identifiable assets are not always observable, which means that purchased goodwill may not even be as economically significant to a company as internally generated goodwill.
Accounting standards worldwide have never recognized internally generated goodwill on the balance sheets, with one exception which we will discuss later on. In many of the standards dealing with goodwill, the reasons why internally generated goodwill is not accepted are explained. We have selected a few examples which are presented below.
IAS 38 "Intangible Assets" issued at January 1st 2012, stipulates that internally generated goodwill is not to be recognized as an intangible asset because "it is not separable nor does it arise from contractual or other legal rights". A 1994 Exposure Draft on intangible assets also explains that even though some expenditure is incurred in order to generate future benefits to the company, it cannot be assimilated to the creation of new intangible assets such as internally generated goodwill, because it is not an identifiable asset which can be measured reliably at cost.
The USGAAP Accounting Standards Codification 350 "Intangibles- Goodwill and Other", previously named SFAS 142 "Goodwill and Other Intangible Assets" carries forward with no reconsideration the 1970 APB Opinion 17 which stipulates that all costs pertaining to research and development, maintenance and restoration of unidentifiable intangible assets should not be recognized as internally generated goodwill, but instead they should be expensed.
AASB 1013 "Accounting for Goodwill" from 1996, before Australia adopted the adapted IFRS, stipulates that "Goodwill which is internally generated by the entity should not be recognized by the entity" for two main reasons: first, the inability of identifying the events or activities which lead to goodwill formation and second within the company, the actual extent to which these events and actions generate future earnings to the company.
The UK standard FRS 10 "Goodwill and Intangible Assets", issued in 1997, simply states, with no further explanation, that internally generated goodwill should not be capitalized.
In summary, there are two main arguments which the standards and some authors use to advocate for non-recognition: first, the impossibility to isolate the cost of the internally generated goodwill and second, the difficulty to make an accurate and reliable valuation for the internally generated goodwill. Moreover, Paton (1962), as cited by Bloom (2008), adds two more reasons which have proven solid for the last fifty years: first, he claims "that recognition of internally generated goodwill would duplicate the credit to Owner's Equity when the profits generated by that goodwill are subsequently brought to account" and second "bringing internally generated goodwill to account as an asset, by definition, mean that all comparable companies would show a similar rate of return on Owners' Equity, so that the company that does earn an exceptional rate of return would no longer be distinguished."
Ma and Hopkins refer to the accounting for internally generated goodwill as "Alice in Wonderland Accounting", based more on what we choose to account for, "for convenience rather than reality" which was inevitably going to lead to skepticism towards the accounting professionals. By choosing to conveniently not account for internally generated goodwill, Ma and Hopkins believe that accountants are merely avoiding an issue which they simply ignore, rather than work together to solve it.
In an attempt to support the recognition of internally generated goodwill in the financial reports, several authors have developed complete strategies of how, contrary to the arguments of the standards, this could be done. We chose to discuss here two of the strategies proposed by Bloom (2008) and Casta, Paugam and Stolowy (2010).
Bloom's (2008) solution to the problem of accounting for goodwill, which includes both purchased and internally generated goodwill, is convenient, easily applicable and could be managed by the entities without much effort or cost, in order to offer stakeholders the information they need to make the best decisions. The solution is called the Market Capitalization Statement, the MCS and it was designed as a separate financial statement which is meant to be included in the Annual Report of an entity, just as the Balance Sheet or the Income Statement. In the MCS the value of goodwill is obtained by subtracting the net carrying value of other components of the Financial Position Statement from the value of the market capitalization of a company. More details on the structure are provided in an extended chapter of Bloom's book "Double Accounting for Goodwill". The advantages of the MCS are numerous and are listed in the book on more occasions. First, it provides means of calculation for goodwill, whether it is purchased or internally generated, and second, it provides details on other Identifiable Intangible Assets, IIAs, which are not captured by the traditional financial statements. As a response to the problem identified by Guthrie, Petty and Johanson, 2001, who say that "particularly for companies in non-traditional industries, book values of assets tend historically to correlate poorly with market capitalization. This renders an understanding of how value is represented problematic from the perspective of an ordinary accounting calculus, and has the potential to further erode the currency of accounting as a function that supports informed decision making by external stakeholders" and their concern that new metrics should be used to determine the intellectual capital of an organization, the MCS strictly focuses on goodwill and other intangible assets which are not separately recognized in the traditional accounting statements. As a major advantage, the MCS provides information that is not currently available from any of the other statements of the Annual Reports for both goodwill and other IIAs. Another advantage which directly addresses the topic in question in this section of our thesis refers to the aggregation of purchased and internally generated goodwill, which are "inextricably merged as a commercial imperative", as demonstrated by Ma and Hopkins (1988). Even though the MCS recommends the elimination of the reference to all goodwill types from other financial statements, it does not simply eliminate them, but manages to propose a way of disclosing them in a way which is relevant to stakeholders.
Casta, Paugam and Stolowy (2010) begin with the assumption that is it critical to know how internally generated goodwill is created in order to be able to measure it. They enter the so called "black- box" of the creation of goodwill and the solution they propose is strongly linked with the synergies created between assets. By focusing on valuating internally generated goodwill through the synergies which are associated to it and not simply aggregating the elements which explain it, the authors obtain a new model of understanding synergies. The main aspects which differentiate this valuation method from existing ones are that the method considers goodwill to be a result of positive interactions between assets, hence also using the expression "synergy goodwill" with regard to internally generated goodwill. Casta, Paugam and Stolowy's (2010) model is validated by using it against the Ohlson Residual Income Model as a benchmark and obtaining better results against this. The authors take on the challenge of valuating internally generated goodwill and offer a different perspective of how this could be done, should accounting standard setters ever decide to step out of the "Alice-in-Wonderland accounting of goodwill" and step in the real world where goodwill is an increasingly important asset to many companies worldwide.
We conclude our analysis of the internally generated goodwill with the acknowledgement that it is another piece of the goodwill puzzle. The most interesting aspects of this enigma are the anomalies which arise when it comes to how much consideration internally generated goodwill is given. The one exception we mentioned earlier is found for a short and unique period of time, during the 1920s, when US companies used to write up internally generated goodwill. Hughes (1982), as cited by Bloom (2008), notes that "justification for this practice seems to have relied on an attempt to record the value of goodwill in the accounts. A firm might be experiencing extraordinary return, and its management might feel that this good fortune was due to the goodwill built up from advertising. Instead of capitalizing the advertising costs in the goodwill account, a practice itself that was open to controversy, the firm might appraisal the goodwill. Goodwill would be debited for this amount, and some surplus account would be credited." But this practice only lasted for a short period of time, until after the 1930s crisis, when the common practice returned to non-recognition of internally generated goodwill. Walker (1938) remarks: "accountants, almost without exception, agree that goodwill should not be recognized into accounts until a bona fide purchase has been made." We can call this the goodwill anomaly, because, interestingly enough, the US standard setters became, ever since, the most ardent supporters for non-recognition, which is the treatment internally generated goodwill still receives today.