ACCOUNTING FOR GOODWILL - PART2
Accounting Treatment of Goodwill
Goodwill is acknowledged for accounting purposes only when it is purchased as part of a take-over. In practice all businesses develop internally generated goodwill as they grow and relations developed with suppliers, customers and the work force which take money and time to put in place (Cooke, 1985). The worth of all of such valuable intangible assets that are not separately identified on the balance sheet could collectively be termed "goodwill". Until 1988, no attempt was made to account for anything other than purchased goodwill. The reasons given by Lee (1971) were:
1. The acquired conservatism of accountants, combined with a fear that created goodwill may well be a fictitious asset introduced to improve the financial position of the business described in its balance sheet.
2. Certain generally accepted concepts of accounting which are extremely difficult to apply in practice to goodwill - that is, historic cost, objectivity and verifiability.
3. The difficulty of annually revaluing goodwill. Such an exercise has to be based on several assumptions, including the estimation of future profits and of what is a reasonable rate of return for the particular business.
4. The difficulty of capitalising the business costs which are contributing to the value of goodwill - for example, the cost of research or advertising expenditure. Which part of the total advertising expenditure of the business contributed to the sales which generated the profits related to goodwill? Such an allocation exercise would be, at best, artificial.
Grinyer et. al. (1990) summarises two characteristics of self-generated goodwill which need to be identified:
1. It is not included in the matching based balance sheet presumably because the benefit expected to result from it is considered too uncertain to allow it to be recognised under the prudence concept or because it is not feasible to disentangle the costs of establishing such goodwill from operating costs; and
2. the costs of establishing the goodwill are included as debits in a profit and loss account at some time (identified as staff costs, costs of advertising, training, personnel costs, etc.).
Thus the costs which were incurred by management to generate goodwill within the existing business have been charged at some time to a profit and loss account. Although the lag between recognising cost and recognising the resulting cash inflows obviously prevents an accurate matching, it may be considered that the orientation towards recognising realised achievements for the purpose of control justifies such a departure from strict matching. In the literature, the accounting treatment for purchased goodwill can be divided into three different viewpoints, i.e., immediate write-off, capitalised and capitalised and amortised.
Firstly, purchased goodwill should be written off completely as soon as it is purchased. Under this method, goodwill is immediately written off against an account in the shareholder’s equity section, generally retained earnings. Some advocates of the immediate write-off of goodwill reason that this treatment is consistent with the non purchased goodwill (for examples Taylor (1987) and Arnold (1992)).
Taylor (1987) suggests that the removal of purchased goodwill by immediate write-off treat purchased and non-purchased goodwill comparably by removing them both, which may be helpful when comparing two similar firms one of which has grown by acquisition and another by internal growth. Gray (1988) favours immediate write-off because the balance sheet is misleading if it includes only purchased goodwill which is likely to understate total goodwill including self-constructed goodwill.
Ma and Hopkins (1988) argue that where internally generated and purchased goodwill represent benefits with similar risk characteristics they should be accounted for in the same way and since it is often difficult to define precisely the economic benefits gained by goodwill payments, i.e. they cannot be identified with the present value of a defined stream of benefits, the systematic amortisation of goodwill is difficult to justify.
Others argue that capitalisation and amortisation are arbitrary and understate net income [for example Spacek (1964)]. Therefore, a better treatment is to write goodwill off immediately against retained earnings. Another rational for the immediate write off approach is that it is reasonable to expect that the goodwill relating to business at the time of purchase will eventually disappear over time. This argument is based on the fact that the products of the business purchased will decline in importance. Therefore the particular goodwill purchased might well be written off.
Secondly, goodwill should not be written off at all, unless there is strong evidence to support this procedure. According to Zeff and Thomas (1973), this school of thought base their argument on the major points stated below:
1. It is over-conservative to write goodwill off the books when it has not depreciated in value below the purchase price. To write off goodwill in such case creates a secret reserve while to recognise this reserve is thought to be unorthodox accounting. Goodwill suffers no actual decline in value so long as the earning capacity of the enterprise is maintained.
2. When goodwill has actually depreciated, it is not necessary to record that depreciation in the operating account. The degree to which goodwill exists is best shown by the profit and loss record. Its value fluctuates according to expected future earning possibilities of the enterprise. It is permissible to write goodwill off the books when it is declining in value or when it has lost its value but amortisation is not required.
3. It is impossible to determine accurately the extent to which the goodwill has depreciated. This fact has been accepted by some accountants as one of the major reasons why it should not be brought into published accounts, unless purchased. The owner of a business cannot make an impartial estimate of the extent to which goodwill has depreciated. Consequently, since appreciation of goodwill is not recognised in the accounts, neither should depreciation be charged.
Thirdly, goodwill should be amortised systematically over a reasonable period of time. In accordance with a primary function of accounting to match costs and income, the cost of purchased goodwill should be amortised as a means of matching the cost of securing the income actually received. All expenditure whether for advertising, stationery, buildings, machinery, employee services, goodwill, or the use of money or machinery, are made for the purpose of an income return greater than the output, or as an aid to that goal. The cost of these purchases is matched with that part of the income stream for which it is applicable. The matching is not in terms of the changed value of each of the assets (Walker, 1953).
Under stewardship accounting, management should be required to justify its acquisition of other companies by demonstrating that cash inflows from the acquisition exceed the cash outflows incurred when making the investment. It seems to be reasonable to claim that appropriate reporting for monitoring and control of the management can only be achieved if the cash outlay committed to achieve the future net profit inflows are charged as costs in a profit and loss at some time. To do otherwise is analogous to treating gross profit as the net gain from trading during a period by charging all overhead costs to reserves. It follows that payments for goodwill should be debited at some time to the profit and loss account (Russell et. al. 1989).
According to the momentum theory of goodwill the buyer of a company normally pays a large sum of money for the goodwill because he wants a starting push in his new company, rather than to start fresh in a similar business and devote so much effort and money over a long period of time to develop such goodwill. This push is not a continual, everlasting one, but rather it is like momentum or running start. The money which is spent on goodwill is just as good as the money spent on plant and equipment. Thus, the investment ought to be charged against income over the estimated life of the momentum (Nelson, 1953).
If acquisition is based on momentum theory, Grinyer (1995) argued that the most significant element of the benefit from acquiring an existing company is the avoidance of the start up costs of establishing the infrastructure of the alternative business, its production and service capacity and skills and the market for its product. Thus, those costs are likely to fall particularly heavily on the early years of a new business.
One could anticipate wide variations between industries. Nevertheless, it is likely that, because of the heavy commitments of time and resources required to established and develop a fledging organisation, the pattern of the start-costs will show a decline over time and the costs will not be incurred over a very lengthy period. As a result, Grinyer argued that this cost should be amortised but in the shorter period compare to the current practise.
As mentioned before, in an ideal world a rational analysis of the conceptual issues might lead to a clearly preferred accounting method. The above analysis makes it clear that there are competing claims for that preferred accounting method. Basically, opinion is divided on whether goodwill should be "capitalised and amortised" or "written off on acquisition", and both policies have their supporters. One could ask question - why does this happen?. The next section will briefly discuss one possibility that might answer the above question.
Goodwill - Matching or Valuation?
According to Grinyer et. al. (1990),
"...........a root cause of apparent confusion concerning the treatment of goodwill, as in many other accounting matters, arise because of a failure to identify what the accounts are trying to measure and the purposes that they serve."
They proceed their argument by listing two distinct conceptual models (matching and valuation approach) which are essentially mutually exclusive within a single profit and loss account, yet, in practice many theorists failed to differentiate between the two models and as result they believed their model should be superior to the others.
Since the above issue seems to be very important when discussing accounting for goodwill in UK both conceptual models in financial reporting will be briefly discussed below. The valuation concept in accounting can be defined as the difference of values at two different dates.
Hendriksen(1977) defined valuation in accounting as a process of assigning meaningful quantitative monetary amounts to assets, since the business enterprise is not a consuming unit, economic values based on subjective utility are not relevant in accounting. Therefore the relevant valuation concepts should be based on exchange or conversion values. There are two types of exchange values.
First, the output values which reflect the expected funds to be received by the firm in the future, based particularly on the exchange price for the firm’s product or output. Secondly, input values which reflect some measure of the consideration given up in obtaining the assets used by the firm in its operations (Hendriksen, 1977).
An example of a valuation model which implies the above definition can be found in Bodenhorn (1961) when he described the definition of depreciation. According to him, depreciation of any asset during a year is the difference between the present value of the future earnings of the asset at the beginning of the year and at the end of the year.
One important characteristic of valuation-based approaches is because they consider that the gains recognised as attributable to a trading period should include all gains (realised and unrealised) which occurred in the period and only gains which occurred in the period. Wealth is therefore considered to be the total worth of business at a point in time. Profit is then the increment in wealth during the accounting period after adjusting for transfers of wealth to or from the owners.
The matching concept has been defined by the AAA (American Accounting Association) committee in 1964 as the process of reporting expenses on the basis of a cause-and-effect relationship with reported revenues. The committee advocated that costs (defined as products and services factor given up) should be related to revenue realised within a specific period on the basis of some discernible positive correlation of such costs with the recognised revenues (Hendriksen, 1977). This approach is the one which is conventionally practised under accruals-based historical cost accounting.
Thomas (1969) regards matching as an attempt to relate costs directly to revenue. He argues that most of the matching approaches are arbitrary, incorrigible and indefensible because they fail to apportion costs by reference to a clearly defined economic model. However this argument can be challenged because in practice, direct cost are matched, as far as possible, with revenue whilst period costs are matched with accounting periods (Skinner, 1979). Such costs may then be perceived as being necessary to establish and maintain the capacity to operate during the period, and therefore as overheads to be recovered before identifying any surplus wealth arising from the activities of the period.
Compare to valuation approaches, matching-based approaches are all realised profit systems. They recognise inflows, and hence gains, only when the outcome of the series of transaction leading up to the inflow is virtually assured. Thus matching recognises gross income from completed activities and then deducts the direct expenses that were incurred to generate that gross income. Period costs are then typically charged as overheads of the period.
The valuation and matching concepts illustrate two completely different approaches in financial reporting. The concepts are totally different in the sense of the purpose of financial reporting. Although both concepts identify the purpose of the business as the creation of wealth, the valuation approach differs from matching because it recognises both realised and unrealised gains in one trading period as explained before. However it has been argued that matching concepts are more useful for controlling and motivating managers and valuation concepts are more useful for decision making purposes (Grinyer, 1990).
It is also important to note that the matching concept is predominant to the valuation concepts in UK GAAP. SSAP 2 stated that the fundamental concepts of accounting are going concern, accruals, consistency and prudence. The standard defined accruals as follows:
"revenue and costs are accrued (that is, recognised as they are earned or incurred, not as money is received or paid), matched with one another so far as their relationship can be established or justifiably assumed, and dealt with in the profit and loss account of the period to which they relate"
With respect to accounting for goodwill, it is arguable that any decisions by managers to acquire other companies should have to be justified to the shareholders by showing that cash outflows from the acquisition is less than the corresponding cash inflows. It seems that the only way the above objective can be achieved is by debiting the cost of the acquisition at some time to the profit and loss account.
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