Accounting Treatments Of Purchased Goodwill

1. Introduction

It is rather surprising that it has taken so long to develop standards of accounting principles and practices for something as essential as goodwill. These developments are particularly important because of the Accounting Standards Board’s (ASB) Statement of Principles (SOP) focus on assets and liabilities (Lawrence 2000).

Goodwill is defined as “the excess of the cost of the business combination over the acquirer’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities” (Elliott and Elliott 2007, p.450). However, goodwill can only be recognised when an entity has acquired another entity, as goodwill cannot be purchased or sold as a separate item (Dagwell et al. 2006).

Goodwill could be seen as a grey area of the financial statements, and will thereby lead to differences of opinion. Some do not think goodwill meet the requirements of an asset because of worries about exchangeability and controllability of assets, and equating costs and assets (Johnson and Petrone 1998). However, in 1997, ASB determined that goodwill meets the definition of assets as it contributes to generate cash inflows in conjunction with other assets. However, goodwill differs from other identifiable assets in that it lacks legal basis and is not separable from other assets (Nishikawa 2003).

In this essay, treatments of purchased goodwill will be analysed by using the four qualitative characteristics (Relevance, Reliability, Comparability and Understandability) given in the SOP. These characteristics are used to make decisions that will maximise the usefulness of the financial information (FRC 1999).

The three treatments being discussed are:

1. Immediate write off against reserves,

2. Capitalisation with amortisation over a pre-selected number of years, and

3. Capitalisation with annual impairment reviews underpin

2. Treatments of Goodwill

2.1 Immediate write-off against reserves

SSAP 22 (Accounting for Goodwill) recommends the immediate write off of goodwill against reserves, justified on the basis that the treatment is consistent with not recognising internally generated goodwill (Seetharaman et al. 2004). Supporters of this method, claim that capitalisation and amortisation are arbitrary and understate net income (Johnson 1993). However, it has been stated that this method was used because it was the easiest and most widely accepted, not because it was theoretically correct (Johnson 1993).

This method certifies that there will be no charge to the income statement unless there is a disposal or closure of the business involved. However, the balance sheet of an acquisitive group could become ended quickly, which could give the impression that the group has very low or even negative net worth, by using this treatment (Seetharaman et al. 2004). This could reduce user’s understandability as the financial statements could lead to misinterpretation of a company’s financial position.

As Goodwill is not measurable and has no true future value, some argue that it therefore should be written off against reserves (Sundararajan 1995). However, writing off goodwill instantly is inaccurate, as the value of goodwill does not decrease immediately, which reduces the relevance of this method. It may also lead to distorted results when tangible assets are undervalued, which lead to an overstated goodwill, which again could lead to unfaithful representation of the financial statements. The statements may therefore not be perceived correctly by users, and it could also weaken their ability of comparability between entities (Sundararajan 1995).

This treatment would also reduce shareholder’s interests severely, which affects the capital gearing of the company (Bendrey et al. 1996). This could reduce user’s comparability of information across different reporting entities. As an effect of this, user’s understandability will be severely lowered.

2.2 Capitalisation with amortisation over a pre-selected number of years

The second treatment, allowed by both SSAP 22 and IAS 22, is to capitalise goodwill with amortisation over a pre-selected number of years . One of the most discussed aspects of amortising goodwill is the write-off period. As Seetharaman states; “any period of amortisation is in essence arbitrary, as the life of goodwill is indefinite and that the selection of an arbitrary period for amortisation can lead to an understatement of net income during the period and an overstatement later” (Seetharaman et al. 2004, p.142). Also, an estimate of its useful life becomes less reliable as the length of the useful life increases. This could reduce the faithfulness and neutrality of the representation, as the method for amortisation is subjective and the write-off period affects a company’s gearing ratio (FASB 2006).

Companies using this treatment may be disadvantaged, because it is possible that goodwill could be intact at the end of the amortisation period (Dagwell et al. 2006). This could reduce user’s comparability of information across different reporting entities (FASB 2006).

Another problem with this treatment is determining the proper amount to capitalise. The goodwill account includes errors incurred when recognising and valuing all assets and liabilities acquired (Johnson 1993). This would reduce the reliability and relevance of the goodwill account, as it will not show the true effect of past, present or future transactions.

Companies could write off a large amount of goodwill when profits are greater than normal to promote an even income (Dagwell et al. 2006). This allows room for management interpretation, judgment and bias, as amortisation can be used as a smoothing device by manipulating income (Seetharaman et al. 2004).

However, Johnson states that the main arguments for amortisation are the mistreatment of non-amortisation and the unreliability of earnings without some attempt to recognise the impact (Johnson 1993).

2.3 Capitalisation with annual impairment reviews

Capitalisation with annual impairment reviews is the standard companies now need to employ to their goodwill account. Companies will have to make annual impairment tests at each reporting date or more frequently