Goodwill has long been a controversial subject for its accounting treatments. The controversies started right from its inception. Controversies occur as GAAP develops over time but regulations or accounting standards bring changes that are not easily and readily acceptable to users. Entrepreneurs are puzzled as to why goodwill can only be acquired and not internally developed. Rules for goodwill accounting have been changed many times over the years disturbing the established GAAP. Therefore controversies were bound to occur. There were times when goodwill used to be deducted from shareholders’ equity upon its acquisition. Then capitalization of goodwill started but amortization over its useful life was not allowed. Thereafter acquired goodwill was allowed to be capitalized and amortized as well. Amortization of goodwill has now been banned. Goodwill at present is required to be tested for impairment on reporting dates or earlier as if goodwill has a ready market rate as and when required by corporations. Whenever users get accustomed to some established GAAP, regulators change the standards resulting in one controversy or the other. In other words, goodwill has always been surrounded by and lived with controversies. An effort has been in this write-up to discuss and analyze those controversies of the accounting treatment of goodwill.
What is Goodwill?
Goodwill comes into existence in two ways. It may be acquired as part of the acquisition of a business purchase transaction. Companies also incur costs for the purpose of establishing goodwill. In other words, goodwill may be acquired externally, and also it can be developed internally by the company. Then why the only time the cost of goodwill is capitalized or recognized when it results out of a business combination accounted for as a purchase. Why internally developed goodwill is not recognized?
The reason normally provided for non- capitalization of internal goodwill is that it is not measurable. ‘IASB Framework identifies internal goodwill as an item that is difficult to identify or measure reliably. Internal goodwill is a goodwill that business entity has created from its own efforts and activities. Internal goodwill has value. However, with an estimated valuation of internal goodwill, there would be a strong risk that the estimate would not be a faithful representation of its true value.’(Ifp, page 25)
The argument that it is virtually impossible to distinguish the costs of development of goodwill from ordinary costs associated with running the company’s business holds little ground. It is surprising that accounting standards-making agencies that deal with risk assessments of business activities at various levels are unable to devise standards to estimate a valuation of internal goodwill that provides a faithful representation of the creation of internal goodwill. At least some rules can be framed for entities to keep some authenticated records that can be certified by Chartered Accountants or CPAs providing a faithful number for internal goodwill capitalization.
The resolve of non- capitalization of internal goodwill points to basic controversy whether goodwill is an asset in the first place. Amortizations of purchased goodwill have been abandoned in favor of testing for impairment loss. That means the portion of purchased goodwill being written off as impairment loss is in fact a replacement of purchased goodwill with internally developed goodwill. If this can happen then why international and national accounting standards do not consider some identifiable portion of internally developed goodwill to replace purchased goodwill by treating that as assets. At least some internally incurred costs can be easily specified or identified for the purpose of creating goodwill. For example, participation in an international exhibition may not bring immediate revenue for the firm but creates goodwill for the firm to bring future revenue. This exactly is the requirement for expenditure to be treated as an asset. An asset is defined by the IASB framework (paragraph F 49 (a)) “is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise”. An interpretation and application of this definition of an asset to the above-stated expenditure on participation in the international exhibition make that a past event that would bring future economic benefits to the entity, like any other purchase of a subsidiary. Moreover, if some portion of purchased goodwill can be treated as impairment loss by the accounting standards, then some activities that occurred in past generated internal goodwill that can be termed as assets as per the conceptual framework of IASB, should be capitalized not only to the extent to which it replaces purchased goodwill. (Christian Leuz and others, page 211)
Even when the goodwill is the result of combinations of entities, controversies always surrounded its valuation. Earlier goodwill was calculated by reducing the book value of acquired assets from agreed consideration of acquisition. Now, book value has been replaced with a fair value of assets acquired. Goodwill today may be defined in two different ways. This first method is called the ‘residuum approach’ and the other method is known as the ‘excess profit approach’.
Using the residuum approach, Johnson and Jeanine D. (April 1993)[iv] has defined goodwill as the “difference between the purchase price and the fair value market of an acquired company’s assets. Goodwill is the leftover amount that cannot be identified, after a thorough investigation, as any other tangible or intangible asset. This is very similar to the nineteenth-century definition. Both definitions imply that goodwill is the leftover amount.”
When a company is involved in a purchase, it will allocate the amount paid for the other company based on the fair value of the underlying net identifiable assets. When the amount paid for the company exceeds that amount, the excess is reported as goodwill.
In this theory goodwill instead of being treated directly as an asset, is considered as of leftover value as soon as all other assets including the other intangibles have been identified, measured. When excess premium paid becomes unexplainable, it is called goodwill which in fact is leftover, and accounting treatment attests to this.
The controversy is why another method of excess profit approach, which is more scientific, is not adopted into the valuation of goodwill. As per this method, goodwill is calculated deducting normal earnings of a similar business from the profits of the combined company. Goodwill is the present value of these exceeding profits. This appears to be a more scientific way of goodwill valuation and does not treat goodwill as leftover. This method is not adopted by accounting standards perhaps because of complications involved in its application for computation of goodwill. When fair value can be assessed on basis of present values of future cash flows for purposes of calculating leftover goodwill in residuum method, then calculations of similar nature can also be made for goodwill computation under the excess profit approach.
At least excess profit method will not come up with a result showing negative goodwill as under residuum approach. There will be goodwill or no goodwill but never negative goodwill as may result in residuum approach. IFRS 3 has suggested writing off negative goodwill to income statement. This may be a measure that follows the principle of conservatism. One can say that this move is a part of faithful representations of financial position as envisaged in the IASB conceptual framework. This may also be as deferment of negative goodwill will only pollute the financial statements. A serious thinking would reveal that negative goodwill is the effect of application of residuum method in our standards. Excess profit approach will never consider anything like negative goodwill. There can be gains when less than fair value of assets is paid in a business purchase and that should not be termed or treated like something known as negative goodwill.
There is another controversy in defining the goodwill as per residual methods. In a business combination an acquired intangibles other than goodwill are recognized only when those arises on basis of some contractual or legal rights. Otherwise those shall be identified and recognized when those are separable to establish their identification. Intangibles may also be identifiable with any of assets or liabilities. There may be instances of certain intangibles that neither separable nor identifiable. For example a group of specialized technical employees acquired with combination will not be identifiable separately as they are not bound by any separate contract are attached to any asset or liability. That means using residuum approach value of such workforce will be clubbed with goodwill as goodwill is value leftover consideration, though value of such workforce does not constitute goodwill by any imagination.
Controversies over amortization and testing for impairment of goodwill
As per present accounting standards goodwill is required to be tested for impairment. The process required is to test each reporting unit for impairment on reporting date or earlier on accurance of an event. There are two steps to check the impairment. First an examination is made to determine the existence of a potential impairment. When potential impairment is established, then the second step is taken to measure the extent of impairment in goodwill. Under the amortization method the recognized goodwill is amortized over the periods of estimated useful life of the goodwill. Since it was very difficult to determine the useful life of goodwill, most companies would establish policies as to the useful life over which they would amortize goodwill. However, a ceiling of 40 years of useful life of goodwill was fixed. Further the accounting for combinations will now be executed in accordance with purchase method only and not as per pooling of interests method.
Though amortization of goodwill has been banned both by IFRS 3 and SFAS 142, controversies have still remained surrounded the goodwill vehemently on these issues.
The major controversy surrounding the banning amortization of goodwill is that why pooling method that does not advocate amortization of goodwill has been banned. Effectively, the opponents now believe that banning pooling of interest method will encourage bidders to pay high premiums in acquisitions, while proponent believe that analysts ignore the goodwill created in acquisition process.(Peter A Hunt, page 174).
There is an argument that when ‘amortization of purchased goodwill is in line with the matching concept of accounting, in that the cost of purchasing the synergistic benefits attributable to purchased goodwill must be charged to earnings over the period of the consumption of such benefits’ (Sacho, Zwi Y, February 2005)[vi], then why amortization has been altogether banned when we still follow matching concept of accounting.
Those who favor amortization also argue that acquired goodwill plays a role in developing internal goodwill. In accordance with Robert N. Waxman (2001)[vii] “potential for an economic benefit that was purchased initially is being progressively replaced by the potential for economic benefits resulting from subsequent enhancements of goodwill. In other words, the goodwill that was purchased is being replaced by internally generated goodwill. IAS 38, ‘Intangible assets’ prohibits the recognition of internally generated goodwill as an asset. Therefore, it is appropriate that goodwill is amortized on a systematic basis over the best estimate of its useful life.”
In specialized technological industries, amortization of goodwill or intangibles plays an altogether different role. Interpreting the present situation of non- amortization of goodwill in respect of technological companies, Roy E Johnson (2001,page 80)[viii]states that “unless there is no goodwill or intangibles, uncommon for most technological companies and those firms growing through acquisition, I believe we should add back the amortization and calculate operating income on more of a cash flow basis. This treats the goodwill (or any other intangible) as a sunk cost, which is what it is.”
It is true that there are bound to be some effects on financial statements under such circumstances. With abolishment of amortization of goodwill, the cost of goodwill purchased becomes a sunk cost and non- amortization will hike the shareholders’ value through inflated income, as impairment losses on goodwill do not occur in successful ventures. Eventually there will be artificially inflated EPS creating positive but unreal impact on market value of shares. Should this hike in EPS be treated a real one or artificial can be any body’s guess. This certainly is an artificial creation after goodwill becoming the sunk cost, as explained above. Considering such an impact of debarring amortization, the ISAB should once again consider the provisions of IFRS 3, and bring back amortization in a refined form.
Even impairment testing process of goodwill has not remained away from controversies. IFRS 3 seeks goodwill to be tested for impairment on annual basis or even more frequently if the situation so warrants. It also suggests that goodwill impairment will not be reversed. This fair value process of judging goodwill from the angle of impairment is controversial because of two reasons: firstly, the process of impairment test is very complicated particularly for intangibles; and secondly internal goodwill generated over a period of time by the use of acquired goodwill is not recognized under the accounting standards. Moreover, the impairment approach violates a technical accounting principle that each asset should be recognized and valued separately. Treatment of some portion of goodwill as impairment loss recognizes a mixture of both. Some argues that under these circumstances the non- amortization of goodwill is not fair.
However, those who favor impairment present an altogether different version of the impact of abolishment of amortization of goodwill. They profess that financial statements will now be constituted in different manners. Assets appearing at fair value and visibility of intangibles are likely to show more volatility in earnings of the acquirer. Goodwill will be treated as an asset, and rightly so as it has all the capabilities of bringing future economic benefits to the entity. Goodwill that has been acquired will raise both the capital base and asset base of the acquirer’s financial statements. With the result ratios like ROA, ROE, and ROCE may go down. During the initial periods of acquisition there will be few impairment losses as fair market value of intangibles will approximate book value. With amortization out of reckoning and fewer impairment losses, the increase in profits for shareholders will provide a hike in earning per share (EPS) and may affect the market value of shares accordingly.
Issues relating to goodwill are complex mainly because goodwill in most of industries fashions the revenue in an effective way. Every industry has right to stress its own point of view. Therefore it appears that controversies will continually remain attached to the accounting treatment of goodwill, unless the authorities develop flexible standards to suit the needs of different industries.
Ifp, Acca p2 (Int) Corporate Reporting, International Financial Reporting, 2007, page 25
Deloitte, IAS Plus, Summaries of International Reporting Standards, IASB Framework, The Elements of financial statements, Asset, Web.
Christian Leuz and others, The Economics and Politics of Accounting, Oxford University Press, 2005 page 211
Johnson and Jeanine D., Goodwill- an eternal controversy (Accounting), The CPA Journal Online, 1993, Web.
Peter A Hunt, Structuring Mergers and Acquisitions, Aspen Publishers Online, 2004, page 174
Sacho, Zwi Y, Goodwill Accounting, Accountancy SA, Web.
Robert N. Waxman, Goodwill Convergence. The CPA Journal, 2001, Web.
Roy E Johnson , Shareholder Value, Butterworth- Heinemann, 2001, page 80