Accounting Treatments of Purchased Goodwill

Topics: Balance sheet, Asset, Generally Accepted Accounting Principles Pages: 9 (2367 words) Published: April 28, 2008
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...
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