Goodwill - an eternal controversy. (Accounting) (2024)

Some authors have stated that U.S. companies are at a severedisadvantage compared to many foreign companies because U.S. companiesmust capitalize and amortize goodwill against income for financialreporting purposes, and are not permitted a tax deduction for thatamortization. On the other hand, many foreign companies do not have toamortize goodwill against income for financial reporting purposes andthose that are required to amortize it, are permitted a tax deductionfor that amortization. Therefore, the argument is that U.S. companieswhen competing for a business acquisition with a foreign company arepenalized because of lower reported post-combination earnings.

Definition

Going back to the 1880's, the first definition reflected goodwill as thedifference between the purchase price and the book value of an acquiredcompany's assets. Goodwill definitions have evolved since that time andmay be defined in two different manners today: The residuum and theexcess profits approaches.

In the residuum approach, goodwill is defined as the difference betweenthe purchase price and the fair market value of an acquired company'sassets. Goodwill is a leftover amount that cannot be identified, after athorough investigation, as any other tangible or intangible asset. Thisis very similar to the nineteenth century definition. Both definitionsimply that goodwill is the "leftover amount."

In the excess profits approach, goodwill is the difference between thecombined company's profits over normal earnings for a similar business.Under this definition, the present value of the projected future excessearnings is determined and recorded as goodwill. This concept is verydifficult to measure since future earnings have no certainty.

One characteristic of goodwill that has emerged over the past century isthat it is inseparable from the business. It can not be sold withoutselling the business that is associated with it. If you can sell whatyou are calling goodwill, then it is something other than goodwill. Itmay be contract rights, a client list, distribution channels, or anynumber of other things and should be labeled as such, instead of lumpedinto the goodwill account.

Goodwill can arise in two different ways: 1) It can be internallygenerated or 2) it can be acquired as part of the acquisition of anothercompany. 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 firsttreated as a deduction from the stockholders' equity section at theacquisition date. Next, capitalization without amortization occurred.Finally, current treatment requires capitalization and amortization.

Write-off. Under this method, goodwill is immediately written offa*gainst an account in the stockholders' equity section, generallyretained earnings.

Some advocates of the immediate write-off of goodwill reason thatcapitalization and amortization are arbitrary and understate net income.Therefore, a better treatment is to write goodwill off immediatelyagainst retained earnings. Under the exit value approach, goodwill hasno "severability" or value separate from the firm so it should not beshown on the balance sheet.

Other advocates argue that goodwill is not measurable and has no truefuture value. Thus, it should be written off against stockholders'equity. They state that to maintain the benefits of goodwill acquired, acompany must still conduct business activities. Thus, it becomesimpossible to separate the new goodwill generated from the previouslypurchased goodwill. They also argue that under the efficient markethypothesis, investors generally deduct goodwill from total assets intheir analyses anyway.

Another rationale for this approach alleges that overpayment for theassets of an acquired company represents the expectation of superiorfuture 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 whentangible assets are undervalued allowing goodwill to be overstated. Thedistribution results became depreciation of tangible assets becomesunderstated because of the undervalued assets leading to overstated netincome.

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

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

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

One way of correcting the misuse of goodwill is through the hiddenassets approach. Under this approach, the excess purchase price thatcompanies pay over the fair market value of the assets is for assetsthat are not shown on or are hidden from the balance sheet. These hiddenassets can be both tangible and intangible. They include typical assetslike fully depreciated tangible assets still in use, small toolsexpensed when purchased, patents expensed when developed, as well asatypical assets such as market distribution rights, key personnel, andlocation contracts. Hidden assets should be identified and recorded onthe balance sheet, then amortized over their appropriate useful lives.If they were, the goodwill account would probably be much smaller thanin current practice and financial statements would probably be moreuseful.

Non-Amortization. Capitalization of goodwill without amortization allowsthe most advantageous financial reporting figures. A company gets torecord an asset instead of a decrease in stockholders' equity and netincome is not periodically reduced. This allows higher assets,stockholders' equity, and net income amounts on the financial statementsrelative to any other method of accounting for goodwill. However, itprobably would result in more abuse than any other method also.

The rationale for non-amortization is premised on the notion thatgoodwill does not decrease in value. High managerial ability, good nameand reputation, and excellent staff generally do not decrease in value,they increase in value. A better treatment would be periodic valuationof goodwill with the appropriate write off against income orstockholders' equity for any decreases in value. Goodwill could beviewed as an investment and should stay on the balance sheetunamortized. Since goodwill has no limited term of existence and is notutilized or consumed in the earnings process, its amortization lessensthe reliability of the income statement.

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

Amortization. Support for amortization is based on the matching conceptof relating costs to benefits. Main arguments for amortization are theabuse of non-amortization and the unreliability of earnings without someattempt to recognize the impact.

When amortization became required, the period for write-off became thefocus. APB 17 confronted this question by stating that all intangiblesmust be amortized using the straight-line method over the life of theasset, if determinable. If the life was not determinable, which isnormally the case with goodwill, amortization over a maximum of fortyyears should be used. This lengthy period was set to allow a minimumimpact to net income.

Tax Treatment

Currently, IRC Reg. Sec. 1.167(a)-3 specifically prohibits the write offof "goodwill." Amortization is allowed on other intangible assets aslong 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 hasa value separate and distinct from goodwill.

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

The allocated purchase price must be reported to the IRS by bothcompanies in their tax returns filed in the year of acquisition.Goodwill is considered a capital asset. Therefore, the seller will wantto allocate as much of the selling price to goodwill as possible. Eventhough current capital gains rates are the same as the regular corporaterates, this could change with future legislation. Also, capital gainscreated 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 deductiblewhile depreciation and amortization of other assets is tax deductible.This "negotiated" goodwill will stand as the IRS value. Thus, the IRShas effectively forced the controversial goodwill determination on thebuyers and sellers of the acquired companies. This makes it even moreimperative for buyers to specifically identify any hidden assets theyare acquiring at the time of purchase.

Recent court decisions have allowed depreciation for several intangibleassets where separate and distinct values from the business could beestablished and limited useful lives existed. Newspaper subscriptionlists have proven separable in two instances. In Donrey v. U.S.,separate existence was proven for the subscription list because it wasused in determining advertising rates and in selling advertising. InNewark Morning Ledger Co. v. U.S., a separate fair market value wasestablished for the subscription list by using the income approach. Lifeannuity tables were then implemented to determine the useful lives ofthe subscribers.

Customer lists have proven to be deductible in several cases includingManhattan Company of Virginia v. Commissioner, Panichi v. U.S. and ABCOOil Corp. v. Commissioner. Customer lists are considered to have aseparate existence as long as one of the individuals on the listcontinues 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 depreciableintangible asset separate from goodwill was identified for the presentvalue of the future stream of income from the core deposits of the bank.The amount of annual amortization was the difference between beginningand ending present values.

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

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

One of the main such intangible assets is key personnel. However, thisintangible generally can not be recognized as an acquired asset for taxpurposes. For example, in the electronics industry key employees play abig part in the success of a business. In acquisitions of thesecompanies, substantial amounts are paid for key personnel. The abilityto identify the amount paid for key personnel and list separately andamortize 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 againstreserves in the stockholders' equity section. It can also be capitalizedand amortized, but very few companies do so. When capitalized, taxdeductions for "know-how"--a certain form of goodwill--areallowed.

The U.K.'s Accounting Standards Committee is considering changing itsposition on goodwill. The new treatment would require capitalization andamortization over a period not exceeding twenty years. This is more inline with the position taken with the International Accounting StandardsCommittee's Exposure Draft on Comparability. Regardless, it would appearthat there are currently no cash flow differences in accounting forgoodwill 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 adisadvantage to U.K. companies.

Australia. Australia's treatment of goodwill is addressed in theAustralian Accounting Standard 18 written in 1984. For financialstatement purposes, capitalization and amortization over itsdeterminable life is recommended. For tax purposes, no goodwillamortization deduction is allowed.

On the surface, it appears that Australian goodwill treatment is muchlike the U.S. treatment. However, in Australia, most companiesimmediately write off goodwill to stockholders' equity, keeping with thecommon practice of going against official accounting standards if theydo not agree with them. In any event, since the tax laws are similar toU.S. laws, it does not appear that there are any cash flow differencesbetween accounting for goodwill in Australia and the U.S.

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

Goodwill amortization is tax deductible in the year it is deducted onthe financial statements, regardless of whether immediate write-off orcapitalization is chosen. This follows the requirement that goodwill betreated 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-sizedcorporations with income of eight million yen or less. These rates areconsiderably higher than U.S. corporate rates on the surface. However,after consideration of state and local taxes, U.S. corporate rates arecomparable to Japanese rates. Also, the magnitude of the goodwilldeduction may offset the benefits of the lower U.S. tax rates. Itappears that there are cash flow implications (tax deductibility ofgoodwill) that may provide Japanese companies an advantage over U.S.companies in business combination negotiations.

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

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

Goodwill Is Not Land

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

If there is a problem, it is the accountants accounting for businessescombinations, not how goodwill is accounted for. The problem isespecially acute where the financial statements of the entity beingacquired show liabilities in excess of assets. As we have shown, the IRSappears to permit amortization of numerous intangible assets. The normaland most logical strategy for an acquiring company, and more importantlyits accountants, should be a thorough investigation to identify assets--tangible and intangible--being acquired. A separate and distinct valueand a limited life can then be established for proving a depreciationdeduction. Of course, it is always necessary to consider whether theimmediate cash flow advantage outweighs the investigation costs.