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The multitude of academic literature on the nature and issues of intangible assets and goodwill have highlighted the numerous approaches to measuring and reporting goodwill. These issues of identifying and measuring goodwill have provided great challenges in communicating the relevant value for an organisation. However, they are becoming increasingly more important in an environment where goodwill and other intangible assets are making up larger components of business purchase/combination prices. In determining the correct value of goodwill in the financial statements, there are three bases of measurement in accounting that can be applied; historical cost, market value and net present value. Each method has its own costs and benefits in the application to goodwill, however these costs and benefits have concluded that there is no one superior measurement approach for goodwill. This suggests that the focus should be on the disclosure and understanding of the reported goodwill amount.
Introduction: The Nature of Goodwill
Goodwill is an unidentifiable intangible asset, which cannot be individually identified and is an intrinsic part of a business (Deegan, 2005, p.274). It cannot be sold or bought separately from the entity and may be built over a number of periods. It arises from how the physical assets and human resources of the entity have been employed within the business environment and may be attributed to factors such as market penetration, an excellent distribution network, good industrial relations and superior management (Miller, 1995, p.7). As goodwill today constitutes a much larger part of acquisition prices (Chauvin & Hirschey, 1994, p.160), it has greatly impacted on figures shown on financial statements. Thus, it is very important to be able to measure the value of goodwill correctly during the buying and selling of an entity in accordance to the Ð²Ð‚Ñšrisks and benefits of the dealÐ²Ð‚Ñœ (Long, 2007, p54). Historical Cost, Market Value and Net Present Value are three such approaches to the measurement and reporting of goodwill.
Accounting for Goodwill Ð²Ð‚â€œ Historical Cost
Historical-cost accounting is the conventional method of accounting, whereby assets are valued at their original monetary value and are subjected in some cases to periodic write-offs in the form of depreciation, amortisation or impairment, and does not taken into consideration the market or present value of the economic item (CPA Handbook, 2007). The use of traditional accounting methods in the measurement of goodwill is aligned to the definition of goodwill being Ð²Ð‚?the difference between the cost of the investment to the parent and the value of the subsidiaryÐ²Ð‚â„¢s net assets at the time the investment is purchasedÐ²Ð‚â„¢ (McKinnon, 1983, p.65).
While goodwill can be internally generated or acquired through the purchase of an existing business, AASB136 specifies that only purchased goodwill can be shown on the financial statements as it can be measured more reliably on the basis of the amount paid for it. Furthermore, due to the absence of market-based values, subjectivity and uncertainty is created in the values of internally generated goodwill, thus distorting the financial statements if recorded (Dunse & Hutchison, 2003, p.237).
Under current standards, AASB136 requires that goodwill carried forward into future periods undergoes annual impairment testing. An impairment loss is incurred when the carrying amount of the asset exceeds its recoverable amount and should be recognised immediately by debiting an expense and crediting an asset. While an impairment loss is required to be recorded, the standards prohibit revaluing goodwill when the recoverable amount of goodwill assessed is greater than the carrying value. As the recoverable amount test is based on broad assumptions, impairment losses which may arise in any period should be treated with caution (Egginton, 1990, p.204).
The foremost major advantage of using historical cost accounting is that it leads to absolute certainty of the value of the asset as the amount paid is reflected onto the financial statements (Ijiri, 1982, p.446). The use of current market value measurement would require the use of indirectly obtained data as the basis for measurement, whereas historical cost accounting allows for a more reliable generation of information through its rigidity (Ijiri, 1982, p.446). Furthermore, relevance and reliability have been widely recognised in external financial reporting as the two primary qualitative characteristics of financial accounting information (CPA Handbook, 2007). By using historical cost accounting, information can be verified independently in an armÐ²Ð‚â„¢s length transaction.
Due to its rigidity, historical-cost accounting has adopted the practice of prudence, where the recorded amount is reduced if historical cost figures are greater than the current carrying value of the asset (CPA Handbook, 2007). This conservative approach ensures that the value of goodwill is not overstated and is reflected accurately on the financial statements. In addition, the use of historical cost accounting also has the capacity of prohibiting creative accounting practices, as the value recorded is the price paid to obtain it.
A major problem with using historical cost accounting is that historical cost is a limited subset of past data used in estimating future value (Ijiri, 1982, p.446). The difficulty in measuring goodwill arises from the identification of probable economic benefits and verifying an assetÐ²Ð‚â„¢s magnitude with reasonable certainty (Egginton, 1990, p.201). Accounts prepared under the historical-cost accounting convention has been widely criticised on the basis that this form of measurement bears no direct relation to the current value of the assets concerned (Deegan, 2005, p.201).
Another disadvantage of using historical cost accounting is that current standards prohibit upward revaluation of goodwill. Due to the nature of goodwill being unstable in value, the value of goodwill fluctuates with earnings and is more probable to increase in value (Deegan, 2005, p.276). Additionally, the problem of uncertainty can be approached by revising estimates of goodwill as new information emerges, which is presently being restricted by current standards (Egginton, 1990, p.201).
Furthermore, historical cost data can become easily outdated. During periods of high inflation, there is a greater divergence in historical cost figures as they become less reliable and reflective of the true value of goodwill (Ketz, 1983, p.52). The use of historical cost becomes insignificant when comparing corporate performance amongst entities. The value of goodwill is affected indirectly as the use of historical cost depreciation tends to overstate earnings. By understating depreciation and interest expenses, the reported value of the firm and the value of goodwill will be incorrect (Lee, et al, 2001, p.57). In addition, the economic value reflected through historical-costing figures may differ greatly to the economic value generated by the business (Inanga & Schneider, 2004, p.64). This potential problem may be resolved through using the market value accounting method.
Accounting for Goodwill Ð²Ð‚â€œ Market Value
Research has suggested that Ð²Ð‚Ñšrelative to the book values, goodwill is valued by the market [as an asset] at least as much as other assetsÐ²Ð‚Ñœ (McCarthy & Schneider, 1995, pg.80). Essentially this indicates the importance of the valuation of goodwill in the accounts to ensure meaningful, relevant information for stakeholder decision-making. In the context where balance sheets contain outdated information (Walker & Jones, 2003), financial statements are not an accurate reflection of the market value of a firm. The market value has consistently been higher than book values for a broad range of firms (Chauvin & Hirschey 1994), indicating the relevance of market values as the proxy for the measurement and reporting of goodwill.
As mentioned earlier, market values are an important source of accurate and timely information to stakeholders in making decision about investments and firms in general. Proposals to the use of market values have previously been suggested in such papers as the Corporate Law Economic Reform Program (CLERP) 1 in relation to the valuation of assets and liabilities, and the standard setting process (Walker & Jones, 2003). However, since the move to the adoption of International Accounting Standards, the role of local standard setters in promoting the use of current market values has, to a certain extent, been compromised (Walker & Jones, 2003).
While various standards have mandated the use of market value proxies (see for example AASB1008, AASB1033, and AASB1041), other standards have no clear definition as to the method of measurement. The question can therefore be raised as to the level of inconsistency in measurement of assets, liabilities, equity; and the argument posed that the comprehensive use of market values would convey more consistent and reliable information across the board (Liebler, 2003).
Another argument for the use of market values in determining the value of assets is that the reported amount would reflect the economic conditions at the time (White, 1990). This overcomes the limitations of historical cost in portraying consistent representations within differing economic realities (White, 1990).
Furthermore, the current method of recognising accounting goodwill looks at the Ð²Ð‚?residualÐ²Ð‚â„¢ method (Wiener, 1979-80) Ð²Ð‚â€œ Ð²Ð‚?the difference between the fair market value of the tangible assets (together with identifiable intangible assets) and the purchase price is simply assigned toÐ²Ð‚Â¦goodwillÐ²Ð‚â„¢(Wiener, 1979-80, pg.184). Some academics have argued that this current method of valuing goodwill already represents a Ð²Ð‚?market-book differentialÐ²Ð‚â„¢ via the reference to fair market values (White, 1990). However, the preference of the market value approach would be to determine the fair market value of purchased goodwill separate from other assets (Tearney, 1973 in Chauvin & Hirschey, 1994: 163). This would be possible under a market price system (if market prices were available), and would provide useful information about the underlying assets of a business combination (Chauvin & Hirschey, 1994).
The case for use of current market values and/or the introduction of a market value accounting framework is substantial (White, 1990). There is however, an element of definition within the market value approach which must be considered: current market values can be determined upon the basis of entry or exit prices, or net proceeds. All of these methods, however, have a problematic application to goodwill.
Entry prices can be related to the present cost of acquiring the asset or the current cost of obtaining the inputs into the firm to reproduce the asset being valued (Edwards & Bell, 1961 in Egginton, 1990). This focus on the price at which the resources can be purchased or replaced in the market indicates its use for separable assets (Egginton, 1990). However, entry prices would pose difficulty in the entry valuation of goodwill where this separation from the entity or other classes of assets cannot be achieved (Egginton, 1990).
The logical argument that exit prices is the superior alternative is identified in Walker & Jones (2003) on the basis that exit prices are consistent with the only option available to firms Ð²Ð‚â€œ to sell assets they already own. This logic is not easily transferable to the case of goodwill. Although this method reduces the subjective cost allocations typical of other methods, issues of separability and lack of availability of market prices for the components of goodwill are significant limitations in its application (Walker & Jones, 2003).
White (1990) identifies that when a comprehensive market price accounting method is put in place, goodwill assets would be created less frequently, if at all. This is because purchased assets [and therefore subsidiaries] would always be valued at the price paid for them - anticipated excess returns are included in the base assets (Egginton, 1990). Hence, because goodwill cannot be separated and would be included in the base value of the other asset[s] purchased, it would be difficult to regard Ð²Ð‚?goodwillÐ²Ð‚â„¢ as an asset under the market based accounting (Deegan, 2005).
Even if a separate market could be established for an aspect of goodwill, the problems associated with Ð²Ð‚?thin tradingÐ²Ð‚â„¢ must still be considered. This is a major issue where the components of goodwill are traded infrequently or affected heavily by one or two major traders (Staubus, 1985). This creates uncertainty as to the reliability of the prices as predictions of the value of goodwill within an organisation, and provides evidence of an incomplete market (Staubus, 1985). This situation is further accentuated where there is no reference/existence of similar transactions in the marketplace against which to make comparisons (Walker & Jones, 2003). This major problem sees accounting attempting to determine the value to place on goodwill using an adaptation or estimation method (Walker & Jones, 2003; Staubus, 1985). The Net Present Value Method is one such approach.
Accounting for Goodwill Ð²Ð‚â€œ Net Present Value
While goodwill was traditionally measured as the premium paid on top of the value of the identifiable assets the buyer acquires, the Ð²Ð‚ÑšNet Present ValueÐ²Ð‚Ñœ (NPV) method is an alternative technique used in order to calculate goodwill. The NPV method operates on the basis that goodwill is the present value of the Ð²Ð‚Ñšfuture stream of superior earnings of the business to be acquiredÐ²Ð‚Ñœ (CPA Handbook, 2007). Therefore, the premium paid for goodwill is equal to the present value of future cash flows from the business entity. Like historical cost accounting, NPV calculation is applied only to purchased goodwill and not internally generated goodwill.
The NPV technique is also utilized in order to calculate the impairment of goodwill, according to AASB136. To find impairment, goodwill is initially allocated to cash-generating units or groups of the acquiring entity. Then the carrying amount of the cash generating unit is compared to its recoverable amount, which is the amount that is higher between the fair value less costs to sell and its value in use. The Ð²Ð‚?fair valueÐ²Ð‚â„¢ is the price that could be obtained from an armÐ²Ð‚â„¢s length transaction, where the NPV method can be used to calculate the value in use (Deegan, 2005, p.276). Therefore the NPV method can be used to calculate the goodwill of an entity and the amount of goodwill after impairment.
Applying the NPV method in valuing costs can prove to be advantageous. It is incorporated within other accounting models, as demonstrated by the historical cost method, where NPV is used to determine the net recoverable amount. It is important when calculating goodwill of a firm to make sure that its price accurately reflects its value. This allows the seller and buyer to trade the entity at a price equal to its value, preventing the entity being sold under the value, or over the value. The NPV method calculates the value of the entity by taking into account the value of future cash flows in which the purchaser is expected to receive, making the price paid approximately equal to the present value of the payoff.
The ability for the NPV method to accommodate market risk when valuing an entity is also a useful advantage. This can be done through using a Ð²Ð‚?risk adjusted discount rateÐ²Ð‚â„¢ in order to Ð²Ð‚?determine the best estimate for future cash flowsÐ²Ð‚â„¢ (Lander et al, 2003). Although choosing the appropriate discount rate is a difficult task, it is an attempt to account for changes to cash flows due to external causes and can assist in creating a close approximation of goodwill. Similar to the Market Value Method, this method of approximating goodwill attempts to reflect the value of goodwill, by taking into account external factors contributing to its value. The NPV method can be more accurate then the historical cost method in this sense, because it considers all the presently available facts and data, and thus cannot become outdated due to this.
A problem with using the NPV method is that it calculates acquired goodwill on the basis of subjective estimates of the future cash flows which the acquired business will expect to receive (Grinyer, et al, 1990, p.225). An obvious shortcoming of this method is the need for approximations of future cash flows, which can be unreliable, as well as difficult to calculate and forecast (Seetharaman et al, 2004). There are numerous considerations in forecasting the cash flows such as, Ð²Ð‚Ñšcommercial judgments, technology risk, discount rates, net realizable valuesÐ²Ð‚Â¦ and future economic trends in small sectors of the economy (Davies & Davies, 2005, p.77). To consider all these factors when calculating an accurate NPV is a costly and timely affair.
The NPV method also relies on estimating the cash flow projections from a business entity, which are derived from the assets of the company that are Ð²Ð‚Ñšimpossible to find and value separatelyÐ²Ð‚Ñœ (Gynther, 1996, p.247). This implies that the ambiguity of a specific source in which goodwill derives its value, results in the capacity for the quantity of the future cash flows to be very subjective. Sources of goodwill are often inseparable and derive their value from the businessÐ²Ð‚â„¢ economic activity (CPA Handbook, 2007, para. 31). The problems resulting from this include the ability for the goodwill value to be revised and fabricated leading to under and over-valuation of the goodwill figures and its resultant impact on the reliability on financial statements to users (Seetharaman et al, 2004).
The Ð²Ð‚Ñšsubjectivity and potential volatilityÐ²Ð‚Ñœ of this method in calculating goodwill is one the reasons it is not often used in practice (Eggington, 1990, p.106). The NPV method is volatile due to the nature of goodwill, allowing an Ð²Ð‚Ñšunending series of revised expectations which are incapable of confirmationÐ²Ð‚Ñœ (Eggington, 1990, p.106). This implies that entities would be able to manipulate the value of goodwill as they please to Ð²Ð‚Ñšcompensate for current shortcomingsÐ²Ð‚Ñœ (Eggington, 1990, p.106).
The AASB Framework states that the recognition of elements in the financial statements must be able to be measured reliably, and have probable future economic benefits. However from the points made above, the goodwill value calculated through the NPV method may not always be Ð²Ð‚?free from material error and biasÐ²Ð‚â„¢ (CPA Handbook, 2007, para. 31). The Framework accounts for these situations, realizing that Ð²Ð‚?estimates are a part of the preparation of financial reports and does not undermine their reliabilityÐ²Ð‚â„¢.
It is evident from the above discussion that each of the three approaches (Historical Cost, Market Value and Net Present Value) has a problematic approach to the measurement and reporting of goodwill.
While the relative certainty of the historical cost method is consistent with the prudent approach to financial statements, the relevance of the past data can be questioned. This is somewhat overcome with the market price method in which asset prices are determined to purely market forces. However, this approach brings its own limitations associated with the non-separability of goodwill components and the lack of active markets. The very definition of goodwill as an asset may become uncertain. These shortfalls have seen the use of valuation techniques, such as Net Present Value arise in determining expected excess future earnings of the asset or the acquired business. Although this approach seems plausible in theory, the volatility of the markets (and thus calculations), combined with the potential for subjective parameters to be used in the calculations (for example in the selection of the discount rate, life of the asset/company) highlight its restrictions in practice.
Although there seems to be no one superior approach to the valuation and measurement of goodwill, is it critical to recognise that, regardless of the method used, each approach brings both benefits and costs. Therefore, perhaps it could be said that disclosures of the method used and reasons behind it become vital to the reporting of financial information.
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