times since Aug.01, 1998.
Goodwill is an intangible asset, probably the most intangible of all intangible assets, hard to measure and even more difficult to account for. Goodwill today constitutes a much larger part of acquisition prices than it did previously, resulting in a much greater impact on financial statements.
In this paper, a search of literature dealing with the various methods of measuring goodwill, its definition and methods of accounting for it has been carried out.
Key words and phrases: Accounting methods, Amortization, Business combination, Capitalization, Financial statement, Goodwill, Intangible assets.
During the twentieth century the concept of goodwill has changed significantly. In the earlier days goodwill was thought of as the good and valuable relationships of a proprietor of a business with his customers. The present concept is broader in that it encompasses many more intangible economic factors of a business enterprise and accountants now consider that goodwill results from the evaluation of the earning power of a business by investors.
From an accountant's perspective, goodwill appears in accounts of a company only when the company has purchased some intangible and valuable economic source. Intangibles such as patents and copyrights are examples of identifiable intangible assets. On the otherhand, intangibles such as favourable government regulations, outstanding credit ratings, superior management and good labour relations are examples of unidentifiable intangible assets. Goodwill comprises the complete set of unidentifiable intangible assets held by the reporting entity.
Generally, goodwill has appeared to be an umbrella concept embracing many features of a company's activities that could lead to superior earning power, such as excellent management, an outstanding workforce, effective advertising and market penetration.
In the following sections, the definition and nature of goodwill, and the different methods of accounting for goodwill are discussed.
Definition and Nature of Goodwill
A major part of the problem of accounting for goodwill is agreeing on a definition of the term itself.
In the 1880's, the first definition reflected goodwill as the difference between the purchase price and the book value of an acquired company's assets. Goodwill definition's have evolved since that time and may be defined in two different manners today:
The residuum approach and the excess profits approach
In the residuum approach, goodwill is defined as the difference between the purchase price and the fair market value of an acquired company's assets. Goodwill is an 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.
In the excess profits approach, goodwill is the difference between the combined company's profits over normal earnings for a similar business. Under this definition, the present value of the projected future excess earnings is determined and recorded as goodwill. This concept is very difficult to measure since future earnings have no certainty.
Goodwill can arise in two different ways:
1) It can be internally generated or
2) it can be acquired as part of the acquisition of another company. Both types of goodwill have been recorded in the past. However, only acquired goodwill is currently allowed to be recorded.
Purchased Goodwill
Purchased goodwill arising on the acquisition of one business by another is defined as the excess of the purchase price of the acquired business over the fair value of its net tangible and identifiable intangible assets. The pronouncements on accounting for goodwill in the United States and Canada apply equally to goodwill arising upon:
Internally Developed Goodwill
A broader concept of goodwill recognizes the economic value of a business' internally developed nonpurchased goodwill such as name, developed markets, managerial talent, labour force, government relations, ability to finance operations easily, etc. Such nonpurchased goodwill has not been recognized in the balance sheet and expenditures which may result in internally developed goodwill have not been capitalized. The primary reason for not accounting for goodwill developed in this manner is the absence of generally accepted objective methods of measurement.
Business Combination and Goodwill
Business combination are events or transactions in which two or more business enterprise or their net assets, are brought under common control as a single accounting entity. The term "Mergers and acquisitions" are also referred to as business combination.
Product diversification and integration are two of the more common reasons for business combinations. Diversification refers to the production or sale of many different products, while integration means production or sale of the same product. Integration may be horizontal,i.e, combining two companies selling the same product, or vertical, i.e, two businesses engaged in different of production or distribution of a common product. Diversification and integration can be accomplished by internal growth, but external acquisitions result in faster accomplishment of goals.
Accounting for business combination is a very complex and controversial issue but extremely important due to the magnitudes of transactions involved.A business combination is handled in either of the two basic ways: 1) as a Pooling of interest or 2) as a purchase.
Pooling of Interest Method
In this method, the consolidated balance sheet is constructed by simply adding together the balance sheets of the combined companies. In essence, the concept of a pooling of interest is that nothing of real economic substance has occurred in the combination. All the previous shareholders remain as shareholders, the assets of the combined companies are same as before.
Canadian accounting requirements are such that the pooling of interests method is rarely used, but it is fairly common in the United States.
There are two conditions to be met before the pooling of interest method may be used:
Purchase method
The purchase method is based on the assumption that a business combination is a transaction in which one entity acquires the net assets of other combining companies. The acquiring company records net assets received at fair value at the date of combination. Any excess of cost over the fair value of net assets acquired is allocated to goodwill and amortized over a maximum period of 40 years.
Comparison of the two methods
When business interest of two companies are combined under this method, there is no recording of goodwill. Under the purchase method, goodwill is recorded as a result of purchase of a going concern, if the purchase cost is greater or less than the fair value of net tangible and identifiable intangible assets acquired. The goodwill has to be amortized over the years and is a non-tax deductable expense. As a result, the earnings of the new entity reduces and lower earnings are recorded per share. For example, when Philip Morris acquired Kraft Inc. for $12.9 billion in 1988, the fair value of the Krafts assets was only $1.3 billion. The difference , a staggering $11.6 billion, or 90% of the purchase price was goodwill. Philip Morris has to amortize this amount in 40 years, deducting $290 million a year from earnings - about $1.25 a share.
In the pooling of interest method, there is no goodwill and thus no amortization expense is involved resulting in higher EPS. Also, there is no uncertainties in determining the purchase price under the pooling of interest method.
Accounting Methods For Goodwill
The three qualitative characteristics most directly concerned with goodwill are reliability, prudence (not deliberate understatement) and consistency. Although much has been written on the problem of accounting for goodwill during the past century, a solution remains elusive. The treatment of goodwill has changed over the years. The four different methods of accounting for goodwill are discussed in the following paragraphs.
1. Write-off
Under this method, goodwill is immediately written off against an account in the stockholders' equity section, generally retained earnings. Advocates of this method argue that goodwill is not measurable and has no true future value. Thus, it should be written off against stockholders' equity.
Another rationale for this method is that overpayment for the assets of an acquired company represents the expectation of superior future earnings. Since these earnings eventually endup in the stockholders' equity, they can be offset against the excess acquisition payment.
Writing off goodwill immediately can lead to distorted results when tangible assets are undervalued allowing goodwill to be overstated. Even though there are some good arguments for write-off method, it appears that it was used because it was the easiest and most widely used and not because it was conceptually correct.
2. Capitalization
This approach's proponents argue that if goodwill is as important as asset as many beleive, it belongs on the balance sheet. One problem with capitalization of goodwill is determining the proper amount to capitalize. Current practice follows the residuum approach.
One way of correcting the misuse of goodwill is through the hidden assets approach. Under this approach, the excess purchase price that companies pay over fair market value of the assets is for assets that are hidden from the balance sheet. Hidden assets should be identified and recorded on the balance sheet, then amortized over their useful life. If they were, goodwill account would probably be much smaller than in current practice and financial statements would probably be more useful.
3. Non-Amortization
Capitalization of goodwill without amortization allows the most advantageous financial reporting figures. A company gets to record an asset instead of a decrease in stockholders' equity and net income is not periodically reduced. However, it probably would result in more abuse than any other method.
The rationale for non-amortization is premised on the notion that goodwill does not decrease in value. High managerial ability, good name and reputation, and excellent staff generally do not decrease in value but they increase in value. Goodwill could be viewed as an investment and should stay on the balance sheet unamortized. But, without amortization, abuse may occur, and the goodwill account will lose what limited significance it has now.
4. Amortization
Amortization enables companies to match the cost of intangible assets over the period deemed to benefit from their acquisition. Main arguments for amortization are the abuse of non-amortization and the unreliability of earnings without some attempt to recognize the impact. When amortization became required, the period for write-off became the focus. If the life of the asset is non determinable, which is normally the case with goodwill, amortization over a maximum of forty years should be used. This lengthy period was set to allow a minimum impact to the net income.
Conclusions
In this paper, a search for the different methods of Goodwill and the accounting methods used record them have been discussed. Firstly, the definition and nature of goodwill were stated. Then, business combination and the different methods of accounting for goodwill from United States, Canada, U.K and Australia were discussed.
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