Goodwill in Business

Check out more papers on Accounting Corporate Finance Economy

Introduction 

Goodwill is an extremely interesting business phenomenon. It enables a firm to derive competitive advantage because of issues like reputation, stability, technical excellence, perceived quality and other intangibles, and thereby allows it to earn higher profits, than it would otherwise have, by selling its products or assets. While the need for valuation or accounting of goodwill does not arise in the normal course of a business or in its growth on a periodic basis, (because of the absence of physical assets to back it up), it becomes an extremely important aspect when a running business goes up for sale, or changes ownership, through mechanisms like mergers, or acquisitions. Goodwill can be considered from two different points of view: an economic and an accounting approach. The economic approach regards goodwill as the present value of the additional profits the acquiring company is expecting to gain in the future resulting from the acquisition. These additional profits arise from a “favourable attitude towards the firm” and from synergies. From an accounting perspective, goodwill is the difference in valuation between the purchase price and the book value of the acquired firm. (Lycklama, 2006) The dilemma faced by accountants in valuing goodwill is best illustrated by the sign Albert Einstein had in his Princeton office that stated, “Not everything that counts can be counted, and not everything that can be counted counts.” (Bullen and Cafini, 2006) 

Don't use plagiarized sources. Get your custom essay on

“Goodwill in Business”

Get custom essay

Businesses with strong goodwill are valued at prices much higher than the value of their net assets, the differentials being asked and paid because of the intrinsic ability of these businesses to earn profits higher than what their assets would warrant. The accounting of goodwill thus arises at the time of change of ownership of a business, pursuant to its sale, merger or acquisition, and on a regular basis thereafter. Countries have historically followed different ways of accounting for many items, including goodwill. The USA and UK, for instance, have adopted accounting treatments for goodwill that have sometimes been similar, and sometimes markedly different. The ongoing process of globalisation has affected accounting practices worldwide. Businesses have never been as globalised as they are today. Numerous corporations from developed, newly industrialised and developing countries operate on a global basis and need to create financial statements, using the accounting practices of their home country, as well as those existing in their areas of operations. The divergence in accounting practices of different countries necessitates not only the preparation of separate financial and accounting statements, but also the subsequent reconciliation of differences. The international accounting fraternity is now steadily moving towards global commonality in accounting practices and procedural reporting. The International Accounting Standards Board (IASB) has been working towards convergence of global accounting standards. Its mission is to develop and enforce a single set of global accounting standards, based on preparation of high quality, transparent and comparable financial statements for local and global users. The IASB has been working on compiling a stable set of International Financial Reporting Standards (IFRS) for first time users. 

The IFRS became mandatory for all publicly listed companies in the European Union in 2005, and was also adopted by other advanced nations like Australia. The IASB has also been working very closely with the US Financial Accounting Standards Board (FASB), since 2002, to bring about convergence between US GAAP and the IFRS. However, significant work on harmonising IFRS with US GAAP has already occurred, and while some pending issues are currently under study for corrective action, the two systems are steadily approaching a state of convergence. “It is notable that some European firms that have been using US GAAP but are now adopting IFRS report a relatively minor impact” (Higson and Sproul, 2005) in their financial statements. It is the purpose of this essay to study the accounting treatment of goodwill under US GAAP and the IFRS, especially the developments of the last ten years, and analyse the reasons for the various changes, not only to assess the current situation, but also to determine what to expect in future. 

Commentary a. Goodwill under US GAAP 

Goodwill is an intangible asset and represents the difference between the cost of an acquisition and the fair value of its identifiable assets, liabilities and contingent liabilities. A recent analysis by PricewaterhouseCoopers (PWC) estimates that intangible assets accounted for approximately 75 % of the purchased price of acquired companies in recent years. The histories of accounting treatment for goodwill in the US and UK have followed roughly similar paths even though developments have not occurred at the same time. In the past, i.e., prior to 2001, companies in the US could structure acquisition transactions using a choice of “pooling-of interests” or purchase accounting method. The “pooling of interest” method for acquisitions and mergers allowed companies to refrain from distinguishing buyer and seller, and did not entail recording of the price of the acquisition. Goodwill valued by the company, in these circumstances, could be amortised in equal instalments over forty years. 

Changes occurred in the US accounting procedure with the issuance of two new accounting standards, 141 and 142. The “pooling of interests” method stood eliminated from June 30, 2001 and it became mandatory for all companies to use the purchase accounting method for all business accounting transactions. Requests from industry also led to the scrapping of the practice of amortising assets over forty years, especially by virtue of standard 142. While goodwill thus became, in certain ways, a permanent asset, which would not reduce in value with the passing of years, it became essential for companies to test it for impairment every year to ensure that its value to the business, (as shown in the balance sheet), did indeed reflect its true worth. Under accounting standard 142, it became necessary to review goodwill for impairment, either at the operating level, meaning a business segment, or at a lower organisational level. Impairment must also necessarily be an annual accounting exercise, and can occur at even shorter intervals, if events indicate that the recoverability of the carrying amount needs reassessment. The procedure for assessment of impairment under IFS 142 comprises of two steps. The fist step involves a comparison of the computed fair value of a business segment with the carrying amount of the concerned unit, including the goodwill. In cases where the book value of the unit exceeds its fair value, no further exercise needs to take place and valuation of goodwill remains unchanged. If, however, the fair value of the reporting unit is lesser than its carrying amount, the procedure for treatment of impairment of goodwill requires application of a second step. Calculation of goodwill impairment, under US GAAP, occurs through the determination of the excess of the carrying amount of goodwill, over its fair value. The computation for this is simple and constitutes of determining the fair value of goodwill by allocating fair value to the various assets and liabilities of the reporting unit, similar to the procedure used for the determination of goodwill in a business combination. 

The calculated erosion in goodwill needs reflection in income statement as an impairment charge in the computation of income. In certain cases, negative goodwill can arise because of the fixation of a price less than that warranted by valuation of physical assets. US accounting procedures categorically specify the treatment of negative goodwill. The excess of fair value over the purchase price, requires its allocation, on a pro rata basis, to all assets, other than current assets, financial assets, assets that have been chosen for sale, prepaid pension investments, and deferred taxes. Any negative goodwill remaining after this exercise finds recognition in financial statements as an extraordinary gain. b. The Position under IFRS Goodwill, in accounting treatment under the IFRS, has evolved through stages similar to US GAAP, and is not amortised any longer, as was the case in the past. While the basic principle of treatment of goodwill has become similar under both the methods, differences do exist in the “nuts and bolts” treatment of the issue at the ground level, in the actual preparation of financial statements. IFRS procedures, like US GAAP, have phased out the method of “pooling of interests” for accounting of acquisitions and business combinations, and require the application of the “purchase” accounting concept. Many national GAAPs allowed the use of pooling, as was also the case in IFRS, under IAS 22, in the absence of identification of an acquirer. IFRS 3, which became applicable from March 31, 2004, however made it mandatory for EU companies to identify the acquirer, adopt the purchase method of accounting for accounting of business combinations, and discontinue amortisation of goodwill for accounting periods beginning after that date. Nowadays, the acquirer, at the date of the acquisition, needs to allocate the cost of the business combination by recognizing, at fair value, the identifiable assets, liabilities and contingent liabilities of the acquiree, as well as those of minority shareholders. 

The difference between purchase price and value of net assets comprises the money paid for goodwill. In certain cases, some intangible assets form part of the assets acquired for the business combination. These become eligible for separate recognition on the fulfilment of certain conditions, to elaborate, these assets they need to be separately identifiable, controlled by the entity, capable of yielding future economic benefits, and have values capable of measurement. IFRS procedures stipulate that goodwill, on an ongoing basis, will be subject to measurement at cost, and annual tests for impairment, in accordance with IAS 36. This is a significant departure from the provisions of IAS 22, which treated goodwill as a wasting asset, needing amortisation over a specific period. Negative goodwill, as stated earlier, arises when the cost of acquisition is less than the fair value of the identifiable assets, liabilities and contingent liabilities of the company. While its occurrence is rare, it can well arise in the case of acquisition of loss-making units, or if a distress sale gives a company the opportunity to acquire a bargain. Negative goodwill, as per IFRS 3, needs immediate recognition in the profit and loss statement for the period. This requirement also differs significantly from previous accounting practice that allowed the allocation of negative goodwill over a range of assets, or allowed it to be amortised over a period. Goodwill, as stated earlier, is not eligible for amortisation, with effect from March 31, 2004, under IFRS procedures and is now considered to be an asset with indefinite life. It however requires the application of a stringent impairment test, either annually, or if the need arises, at shorter notice, for assessment of erosion in value. In the event of impairment, the Profit and Loss Account is charged with the computed impairment amount to ensure the immediate highlighting of poorly performing acquisitions. The accounting treatment of goodwill, as stipulated by IFRS 3, is not that of a steadily wasting asset, but one with indefinite life; and with a value linked to the performance of the unit. 

The test for impairment of goodwill under the IFRS, unlike US GAAP, occurs at the level of the Cash Generating Unit, or a group of CGUs, representing the lowest level at which internal managements monitor goodwill. The IFRS also stipulates that the level for assessing impairment must never be more than a business or a geographical segment. The test is a one-stage process wherein the recoverable amount of the CGU is calculated on the basis of the higher of (a) the fair value less costs to sell or (b) the value in use, and then compared to the carrying amount. In case the assessed value is lesser than the carrying cost, an appropriate charge is made to the profit and loss account. The goodwill appropriated to the CGU is reduced pro rata. The IFRS requires detailed disclosures to be published regarding the annual impairment tests. These include the assumptions made for these tests, and the sensitivity of the results of the impairment tests to changes in these assumptions. M/s Radebaugh, Gray and Black, in their book “International Accounting and Multinational Enterprises” stress that these disclosures help in giving shareholders and financial analysts more information about acquisitions, their benefits to the acquiring company and the efficacy and reasonableness of impairment reviews. Both the IFRS and US GAAP have certain commonalities in the accounting treatment of intangible assets. In case of acquisitions, managements are enjoined to isolate specific intangible assets and value them separately from goodwill. All these assets have to be identified, valued and indicated separately in the balance sheet. The list of intangible assets that need to be recognised separately, because of IFRS 3, is extensive and includes a host of things like patents, brands, trademarks and computer software. 

IFRS 3 demands that the identification and valuation of intangible assets should be a rigorous process. Experts however feel that while valuing intangibles is essentially associated with subjectivity, logical mental application and the use of working sheets should be able to satisfy the demands of regulators. IAS 38 deals with a number of issues that pertain to intangible assets other than goodwill. This standard, as per experts, represents a major change from previous practice. It allows firms to capitalise some internally generated intangible assets, and attempts to correct the incompleteness of previous accounting practices in this regard. This argument, however, very possibly exaggerates its implications because IAS 38 primarily tries to recognise a wider range of acquired intangibles, but only at the expense of residual goodwill, and maintains a continuum with the historical British approach of treating internally developed intangibles as expenses. Items like Research and Development Costs in Process, costs that were ineligible for recognition before the acquisition, are now allowable as capital items in the balance sheet of the acquirer. On initial recognition as part of the acquisition process, the cost of the intangible is measured as the fair value at the date of acquisition. The fair value of an intangible assert is the amount the entity would have paid for the asset at the acquisition date in an arm’s length transaction between knowledgeable and willing parties, on the basis of the best information available. (IFRS and US GAAP, 2005) IFRS procedures call for expensing of all research cost. Assessment of development costs for the purpose of valuation for long-term benefits is now essential for their amortisation over their determined benefit period. 

Capitalisation of development costs is allowed only when development efforts result in the creation of an identifiable asset, e.g. software or processes, whose beneficial life and costs can be measured reliably. If however a Research and Development project is purchased, IFRS provides for the treatment of the whole amount as an asset, even though part of the cost reflects research expenses. In the case of further costs being incurred on the project after its purchase, research costs will need to be expensed out while development costs will be eligible for capitalisation, subject to their meeting the required criteria. US GAAP however stipulates that all Research and Development costs be immediately charged to expenses. Certain development costs pertaining to website and software development are however allowed to be capitalised. Research and Development assets, if acquired are valued at fair value under the purchase method. However if the assets do not have any alternate use they are immediately charged to expense. 

Conclusion 

Both methods of accounting, US GAAP and IFRS, while they have taken different routes, and have changed their accounting standards at different times, have now arrived at similar positions in the treatment of a number of items, including valuation and treatment of goodwill. The differences that exist today in this area are primarily in the area of detailing, methods of computation and in the treatment of individual components of the accounting requirements, like for example, in the computation of impairment of goodwill. Both PWC and Deloitte publications opine that US GAAP will most probably move further towards the IFRS position intangible assets as part of the ongoing convergence exercise. 

Bibliography 

  1. Bullen, H, and Cafini, R, 2006, Accounting Standards Regarding Intellectual Assets, UN Department of Economic and Social Affairs, Retrieved April 16, 2007 from unstats.un.org/unsd/nationalaccount/ia10.pdf 
  2. FASB: Financial Accounting Standard Board, 2006, Retrieved April 16, 2007 from www.fasb.org IFRS and US GAAP, 2005, IAS Plus Deloitte, Retrieved April, 2007 from deloitte.net/dtt/cda/doc/content/dtt_audit_iasplusgl_073106.pdf 
  3. Higson, C and Sproul, M, 2005, Coping with IFRS, London Business School, Retrieved April 16, 2007 from www.london.edu/assets/documents/PDF/Chris_Higson_paper_IFRS.pdf – 
  4. Intangible assets: brand valuation, 2004, IFRS News Brand Valuation, Retrieved April 16, 2007 from www.pwc.com/gx/eng/about/svcs/corporatereporting/IFRSNewsCatalogue.pdf 
  5. Lycklama, M.P., 2005, Goodwill and value creation of acquisitions, Retrieved April 16, 2007 from www.bedrijfswetenschappen.leidenuniv.nl/content_docs/PDF/goodwill_and_value_creation_of_acquisitions.pdf 
  6. Nobes, C. and Parker, R., 2004, Comparative International Accounting (9th edition), Prentice Hall Radebaugh, L.H., Gray, S.J., Black, E.L., 2006, International Accounting and Multinational Enterprises, 6th edition, John Wiley and Sons, inc., USA 
  7. Roberts, C, Weetman, P, and Gordon, P, 2005, International Financial Reporting: A Comparative Approach, 3rd edition, FT Prentice Hall, USA 
  8. Similarities and Differences, 2005, A comparison of IFRS, US GAAP and Belgian GAAP, PriceWaterhouseCoopers, Retrieved April 16, 2007 from www.pwc.com/extweb/pwcpublications.nsf/docid/74d6c09e0a4ee610802569a1003354c8
Did you like this example?

Cite this page

Goodwill in business. (2017, Jun 26). Retrieved October 1, 2022 , from
https://studydriver.com/goodwill-in-business/

Save time with Studydriver!

Get in touch with our top writers for a non-plagiarized essays written to satisfy your needs

Get custom essay

Stuck on ideas? Struggling with a concept?

A professional writer will make a clear, mistake-free paper for you!

Get help with your assigment
Leave your email and we will send a sample to you.
Stop wasting your time searching for samples!
You can find a skilled professional who can write any paper for you.
Get unique paper

Hi!
I'm Chatbot Amy :)

I can help you save hours on your homework. Let's start by finding a writer.

Find Writer