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April 1993

Goodwill - an eternal controversy. (Accounting)

by Johnson, Jeannie D.

    Abstract- Goodwill in business has long been the subject of debate in accounting. Although it seemed that the goodwill controversy had finally been settled by the Accounting Principles Board Opinions 16 and 17 on business combinations and goodwill amortizations, economic realities during the 1980s and the 1990s have rekindled discussions on goodwill. Some argue that requiring US firms to capitalize and amortize goodwill against income for financial statements and denying them any tax deduction for the amortization are hurting their competitiveness. It is said that US companies are on the losing end when competing with foreign firms for business acquisitions due to their lower reported post-consolidation earnings. It is recommended that acquiring firms and their accountants conduct a comprehensive assessment to determine assets being procured, both tangible and intangible. Then a depreciation deduction can be rationalized with an established individual value and a limited life.

Some authors have stated that U.S. companies are at a severe disadvantage compared to many foreign companies because U.S. companies must capitalize and amortize goodwill against income for financial reporting purposes, and are not permitted a tax deduction for that amortization. On the other hand, many foreign companies do not have to amortize goodwill against income for financial reporting purposes and those that are required to amortize it, are permitted a tax deduction for that amortization. Therefore, the argument is that U.S. companies when competing for a business acquisition with a foreign company are penalized because of lower reported post-combination earnings.


Going back to 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 definitions have evolved since that time and may be defined in two different manners today: The residuum and the excess profits approaches.

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 a 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. Both definitions imply that goodwill is the "leftover amount."

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.

One characteristic of goodwill that has emerged over the past century is that it is inseparable from the business. It can not be sold without selling the business that is associated with it. If you can sell what you are calling goodwill, then it is something other than goodwill. It may be contract rights, a client list, distribution channels, or any number of other things and should be labeled as such, instead of lumped into the goodwill account.

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.

Accounting Treatment

The treatment of goodwill has changed over the years. Goodwill was first treated as a deduction from the stockholders' equity section at the acquisition date. Next, capitalization without amortization occurred. Finally, current treatment requires capitalization and amortization.

Write-off. Under this method, goodwill is immediately written off against an account in the stockholders' equity section, generally retained earnings.

Some advocates of the immediate write-off of goodwill reason that capitalization and amortization are arbitrary and understate net income. Therefore, a better treatment is to write goodwill off immediately against retained earnings. Under the exit value approach, goodwill has no "severability" or value separate from the firm so it should not be shown on the balance sheet.

Other advocates argue that goodwill is not measurable and has no true future value. Thus, it should be written off against stockholders' equity. They state that to maintain the benefits of goodwill acquired, a company must still conduct business activities. Thus, it becomes impossible to separate the new goodwill generated from the previously purchased goodwill. They also argue that under the efficient market hypothesis, investors generally deduct goodwill from total assets in their analyses anyway.

Another rationale for this approach alleges that overpayment for the assets of an acquired company represents the expectation of superior future earnings. Since these earnings eventually end up in 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. The distribution results became depreciation of tangible assets becomes understated because of the undervalued assets leading to overstated net income.

Even though there are some good arguments for the write-off approach, it appears that this method was used because it was the easiest and most widely accepted, not because it was conceptually correct.

Capitalization. APB Opinions 16 and 17 require goodwill to be capitalized as an intangible asset for acquisitions after October 31, 1970. The APB did not break new ground with this practice. It was first promulgated by the Committee on Accounting Procedure in Accounting Research Bulletin 24 issued in 1944. This method of accounting generally is considered to be the most appropriate method.

One problem with capitalization of goodwill is determining the proper amount to capitalize. Current practice follows the residuum approach. The net effect of that approach is that the goodwill account includes all the errors, both positive and negative, made in identifying and valuing all other (non-goodwill) assets and liabilities acquired.

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 the fair market value of the assets is for assets that are not shown on or are hidden from the balance sheet. These hidden assets can be both tangible and intangible. They include typical assets like fully depreciated tangible assets still in use, small tools expensed when purchased, patents expensed when developed, as well as atypical assets such as market distribution rights, key personnel, and location contracts. Hidden assets should be identified and recorded on the balance sheet, then amortized over their appropriate useful lives. If they were, the goodwill account would probably be much smaller than in current practice and financial statements would probably be more useful.

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. This allows higher assets, stockholders' equity, and net income amounts on the financial statements relative to any other method of accounting for goodwill. However, it probably would result in more abuse than any other method also.

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, they increase in value. A better treatment would be periodic valuation of goodwill with the appropriate write off against income or stockholders' equity for any decreases in value. Goodwill could be viewed as an investment and should stay on the balance sheet unamortized. Since goodwill has no limited term of existence and is not utilized or consumed in the earnings process, its amortization lessens the reliability of the income statement.

All of the above arguments may be sound, but without amortization, abuse may occur, and the goodwill account would lose what limited significance it now has.

Amortization. Support for amortization is based on the matching concept of relating costs to benefits. 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. APB 17 confronted this question by stating that all intangibles must be amortized using the straight-line method over the life of the asset, if determinable. If the life was not 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 net income.

Tax Treatment

Currently, IRC Reg. Sec. 1.167(a)-3 specifically prohibits the write off of "goodwill." Amortization is allowed on other intangible assets as long as the asset meets the following criteria established in Rev. Rul. 74-456: 1) A specific useful life can be determined and 2) the asset has a value separate and distinct from goodwill.

IRC Sec. 1060, resulting from TRA 86, requires both the seller and the buyer to use the residual method for measuring goodwill. Under this method, goodwill is computed as the difference between the purchase price and the fair market value of the "assets" of the acquired company. Obviously this is the same as the residuum method discussed earlier. The purchase price is to be allocated to assets in the following order: 1) Cash and items similar to cash, 2) marketable securities and similar items, 3) tangible and intangible assets excluding goodwill and going concern value, and 4) goodwill and going concern value. Going concern value resembles goodwill and is treated similarly.

The allocated purchase price must be reported to the IRS by both companies in their tax returns filed in the year of acquisition. Goodwill is considered a capital asset. Therefore, the seller will want to allocate as much of the selling price to goodwill as possible. Even though current capital gains rates are the same as the regular corporate rates, this could change with future legislation. Also, capital gains created can be used to offset any previous capital loss carryforwards.

The buyer will want to allocate more of the selling price to non- goodwill assets because goodwill amortization is not tax deductible while depreciation and amortization of other assets is tax deductible. This "negotiated" goodwill will stand as the IRS value. Thus, the IRS has effectively forced the controversial goodwill determination on the buyers and sellers of the acquired companies. This makes it even more imperative for buyers to specifically identify any hidden assets they are acquiring at the time of purchase.

Recent court decisions have allowed depreciation for several intangible assets where separate and distinct values from the business could be established and limited useful lives existed. Newspaper subscription lists have proven separable in two instances. In Donrey v. U.S., separate existence was proven for the subscription list because it was used in determining advertising rates and in selling advertising. In Newark Morning Ledger Co. v. U.S., a separate fair market value was established for the subscription list by using the income approach. Life annuity tables were then implemented to determine the useful lives of the subscribers.

Customer lists have proven to be deductible in several cases including Manhattan Company of Virginia v. Commissioner, Panichi v. U.S. and ABCO Oil Corp. v. Commissioner. Customer lists are considered to have a separate existence as long as one of the individuals on the list continues as a customer for more than one year.

Deposit bases of banks have recently been allowed as intangible assets. In Citizens & Southern Corporation v. Commissioner, a depreciable intangible asset separate from goodwill was identified for the present value of the future stream of income from the core deposits of the bank. The amount of annual amortization was the difference between beginning and ending present values.

A variety of contracts--location, employment, management and general business--have been held deductible as long as a specified life and separate existence has been established. Unlimited renewal options preclude the deduction. In Business Service Industries v. Commissioner, the location contracts acquired in a merger were used to obtain a bank loan. The bank's recognition of the separate existence of the contracts helped establish the tax basis for the depreciable intangible asset.

Tax incentives, which affect real cash flow, are usually reason enough to allocate as much of the residual value as possible to intangible assets other than goodwill. The above cases show that certain intangible assets do have value and lives separate from the ongoing business.

One of the main such intangible assets is key personnel. However, this intangible generally can not be recognized as an acquired asset for tax purposes. For example, in the electronics industry key employees play a big part in the success of a business. In acquisitions of these companies, substantial amounts are paid for key personnel. The ability to identify the amount paid for key personnel and list separately and amortize over an appropriate life, would hold significant advantages.

International Treatment

Accounting for goodwill is not only controversial in the United States, it is a worldwide debate.

United Kingdom. In the U.K., goodwill is usually written off against reserves in the stockholders' equity section. It can also be capitalized and amortized, but very few companies do so. When capitalized, tax deductions for "know-how"--a certain form of goodwill--are allowed.

The U.K.'s Accounting Standards Committee is considering changing its position on goodwill. The new treatment would require capitalization and amortization over a period not exceeding twenty years. This is more in line with the position taken with the International Accounting Standards Committee's Exposure Draft on Comparability. Regardless, it would appear that there are currently no cash flow differences in accounting for goodwill in the U.K. and the U.S. Amortization of goodwill in the U.S. does not impact cash flow and should not place U.S. companies at a disadvantage to U.K. companies.

Australia. Australia's treatment of goodwill is addressed in the Australian Accounting Standard 18 written in 1984. For financial statement purposes, capitalization and amortization over its determinable life is recommended. For tax purposes, no goodwill amortization deduction is allowed.

On the surface, it appears that Australian goodwill treatment is much like the U.S. treatment. However, in Australia, most companies immediately write off goodwill to stockholders' equity, keeping with the common practice of going against official accounting standards if they do not agree with them. In any event, since the tax laws are similar to U.S. laws, it does not appear that there are any cash flow differences between accounting for goodwill in Australia and the U.S.

Japan. Japan's government, which sets accounting standards, allows an option between capitalization and immediate write-off of goodwill against income. Write-off is encouraged. Companies opting to capitalize goodwill must amortize it over a maximum of five years.

Goodwill amortization is tax deductible in the year it is deducted on the financial statements, regardless of whether immediate write-off or capitalization is chosen. This follows the requirement that goodwill be treated the same for both financial statement and tax purposes.

Effective tax rates in Japan (excluding the per capita levy) are 51.38% for large corporations and 41.19% for small and medium-sized corporations with income of eight million yen or less. These rates are considerably higher than U.S. corporate rates on the surface. However, after consideration of state and local taxes, U.S. corporate rates are comparable to Japanese rates. Also, the magnitude of the goodwill deduction may offset the benefits of the lower U.S. tax rates. It appears that there are cash flow implications (tax deductibility of goodwill) that may provide Japanese companies an advantage over U.S. companies in business combination negotiations.

Canada. Canadian companies following the Canadian Institute of Chartered Accountants (CICA) Handbook capitalize goodwill and amortize it over 40 years. The only difference between the U.S. and the Canadian treatment of goodwill is that a tax deduction is allowed in Canada.

Tax rates in Canada are even less than in the U.S., with an effective corporate tax rate of 28% after deduction for a 10% provincial tax. Thus, Canadian companies appear to have an even bigger advantage than Japan over U.S. companies in business combination negotiations.

Goodwill Is Not Land

The current accounting standards on goodwill promulgate that it is an asset with a limited life. Regarding its status as an asset, we believe it meets all the criteria for an asset established in Statement of Financial Accounting Concepts 6. It represents a probable future economic benefit obtained or controlled by a particular entity as the result of a past transaction. Moreover, since it is not land, we believe it has a limited life albeit impossible to measure.

If there is a problem, it is the accountants accounting for businesses combinations, not how goodwill is accounted for. The problem is especially acute where the financial statements of the entity being acquired show liabilities in excess of assets. As we have shown, the IRS appears to permit amortization of numerous intangible assets. The normal and most logical strategy for an acquiring company, and more importantly its accountants, should be a thorough investigation to identify assets-- tangible and intangible--being acquired. A separate and distinct value and a limited life can then be established for proving a depreciation deduction. Of course, it is always necessary to consider whether the immediate cash flow advantage outweighs the investigation costs.

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