Concepts of Accounting for Goodwill | Literature Review

Concepts of Accounting for Goodwill | Literature Review Accounting Goodwill Treatment Introduction Arnold, J., Egginton, D., Kirkham, L., Macve, R. and Peasnell, K., ‘Theoretical Considerations’, in Goodwill and Other Intangibles, The Research Board, London, pp3-18. According to the authors, financial reporting of goodwill has assumed importance just recently. In its earlier definition goodwill just meant customer loyalty. They attribute two main reasons for the increase in goodwill’s importance. First is the increase in merger and acquisition (MA) activities in the market and second is the rising stock market. This has created a wide gap between the book value and market value and also between the fair value and paid value of assets of a firm. As a result, the increasing importance of recognition, valuing and accounting of goodwill was widely felt. Definition Catlett, G. and Olson, N. 1968, ‘Accounting Research Study no 10’, Accounting for Goodwill, American Institute of Certified Public Accountants, New York, pp.1-21. The authors have taken Accounting Research Study no.5 by the Accounting Principles Board as a base for their study on Accounting for Goodwill. In their study, they say that the definition of goodwill has evolved and changed over time to reflect the true picture of its nature. Goodwill is difficult to measure and its accounting treatment is also very controversial. They have included the definition of goodwill from the Webster’s Third New International Dictionary. It defines goodwill as ‘the capitalized value of the excess of estimated future profits of a business over the rate of return on capital considered normal in the related industry’. In general, goodwill is a result of good reputation of the firm in the market. Superior quality goods and customer service, integrity and efficiency of management, good employee relations and many other factors helps a company earn goodwill. Nowadays, technological advantages, efficient manufacturing process, ability to raise finance also assume great importance. The earning power of goodwill is the most relevant concept as of today. Different Concepts Gynther, R. 1969, [Abstract of ‘Some â€Å"Conceptualizing† on Goodwill’, The Accounting Review, vol. 44, no. 2, pp.247-255], [Electronic], Available: JSTOR [2007, Nov 11]. Gynther has cited two main concepts of goodwill, the ‘residuum concept’ and the ‘future excess profits concept’. Under the residuum concept, goodwill is measured as a difference between purchase price and book value of a company’s assets. Goodwill is the residual value after taking into account all the tangible and identifiable intangible assets. According to future excess profits concept, goodwill is the present value of all the excess profits expected in the future, over and above the normal/average profits in the industry. It is difficult to measure goodwill using this concept as there is no certainty of the future profits. Nature and Characteristics Arnold, J., Egginton D., Kirkham, L., Macve, R. and Peasnell, K., ‘Theoretical Considerations’, in Goodwill and Other Intangibles, The Research Board, London, pp.18. Goodwill can be of two types. Goodwill can either be internally generated or purchased. Goodwill is said to be internally generated when a firm earns super profits. On the other hand, purchased goodwill is a result of merger and acquisition activities. However, goodwill is accounted only when a business is purchased or sold. Internally generated goodwill cannot be accounted otherwise. Catlett, G. and Olson, N. 1968, ‘Accounting Research Study no 10’, Accounting for Goodwill, American Institute of Certified Public Accountants, New York, pp.20-21. The value of goodwill cannot be directly attributed to a particular cost. Goodwill is sometimes created due to favorable conditions and certain other factors, and sometimes even without any efforts by a company. The value of goodwill is directly attached to a business. It cannot be separated and sold differently. Several factors can affect the value of goodwill. As such, the value of goodwill may rise or fall due to changes in those factors. The investors’ perception reflected in the stock prices forms the base for calculating goodwill. Treatments of goodwill Non-purchased goodwill Walker, G. T. 1938, [Abstract of ‘Non-purchased Goodwill’, The Accounting Review, Vol. 13, No. 3. pp. 253-259], [Electronic], Available: JSTOR Arts and Sciences 4 [2007, Nov 11]. In this paper Walker argued that almost all the accountants agree that non-purchased goodwill should not be recognized in account. â€Å"They are fully aware that goodwill created by a concern is just as valuable and in most instances, more valuable- to that concern than to the firm which might make a specific purchase of that goodwill†. Montgomery has pointed out this view in his Financial Handbook that goodwill may have economic value even without being purchased by another entity. But it was considered to be bad practice to record goodwill on the books since many frauds happened in the early days, when the term goodwill was freely used. Seetharaman, A., Balachandra, M. and Saravanan, A.S. 2004, [Abstract of ‘Accounting treatment of goodwill: yesterday, today and tomorrow: Problems and prospects in the international perspective’, Journal of Intellectual Capital, Vol. 5, Iss. 1, pp. 131-153], [Electronic], Available: Proquest ABI/INFORM [2007, Nov 11]. Seetharaman also argued in the article that only purchased goodwill is acknowledged for accounting purpose. Although, in reality, with the development of the relationship with suppliers, customers and the work force, all the business generate internal goodwill as they grow. But it seems that no attempt was made to account for non-purchased goodwill. Lee (2004) gave the reasons why there is no accounting for non-purchase goodwill: (1) The accountants adopt conservative view, together with the fear that internally generated goodwill may turn out to be a fictitious asset in order to make the balance sheet look better. (2) Certain accounting rules such as historical cost, objectivity and verifiability are extremely difficult to apply in accounting for non-purchased goodwill in practice. (3) It is difficult to revalue non-purchased goodwill annually. Some assumptions have been made to carry out the test, such as the estimation of future profits and of what should be a reasonable rate of return for a particular business. (4) The business costs which attribute to the value of goodwill are difficult to measure. For instance, it is difficult to bifurcate which part of the cost of RD or advertising expenditure contributed to the sales that in turn generated goodwill. Purchased goodwill 1. Immediately write off For: Hughes, H, P. 1982, ‘Goodwill in Accounting: A History of the Issues and Problems’, United States of America. Under this method, goodwill is immediately written off against an account in the equity part, generally retained earnings. Hughes presented in this book that the fundamental concern about immediately write off treatment is that goodwill was not an asset. Spacek expressed the view that the total expenditure of buying an entity or business over the fair value of the company is â€Å"a cost to the buyer of earning over and above the cost of the assets required to produce those earnings†. And Spacek points out that goodwill may generate future economic benefits, but those benefits are not secured (Cited in Hughes, 1982). Massoud, F. 2003, [Abstract of ‘Accounting for goodwill: Are we better off?’] Review of Business,Vol.24, Iss.2, p.26], [Electronic],Available: Proquest ABI/INFORM [2007, Nov 11] Spacek’s view is supported by the idea that goodwill is neither something that can be really used, nor it can produce earnings. But, it represented the investors’ appraisals of earnings or expectations of earnings. In such case, goodwill carried a risk of facing wide fluctuations which related to the investors’ decision. Therefore, the value of goodwill has no reliable or continuing relation to costs incurred in its creation, its purchase or its maintenance.