Accounting for Goodwill

Accounting for Goodwill

In the accounting sector, the treatment of goodwill remains one of the most controversial topics. Goodwill is defined as an intangible asset that is paid for when one purchases a company. It is the extra amount that makes the purchase price higher than the sum of all fair tangible and intangible asset value acquired during acquisition as well as the liabilities assumed. The cost of goodwill intends to gather the purchase of solid customer base, company’s brand name, and good employee relations among other intangible assets that cannot be directly attached to a financial value (Hamberg, Paananen, and Novak  2011). The difference between goodwill and other intangible assets is its indefinite life, while others have a definite life. The problem with the fact that goodwill cannot be attached an exact financial value allows the managers to have increased discretion in calculating the amount of goodwill. In the recent past, many standards of accounting, such as IFRS 3, replaced historical cost with the measure of fair value thus giving managers increased discretion in estimating the fair value without using the actual market value of an asset (Shoaf, and Zaldivar 2005). The increased discretion in the evaluation of the value of goodwill has triggered an intense debate in the accounting field on its impact on impairment test since it allows managers to be biased. According to IAS 36, impairment of assets aims to ensure that assets of a company are not carried more than the amount that can be recovered during its disposal.

The change of accounting principles concerning the way goodwill is calculated, where IFRS 3 eliminated amortization of goodwill, forced managers to make annual impairment test for goodwill, irrespective of the presence or absence of any indication that it might be impaired (Li, and Sloan 2017). Besides, it gave a room of accounting discretion by allowing managers to make critical accounting decisions through assumptions (Egginton 1990). For example, the managers may assume in determining the units of generating cash, the allocation of subsequent goodwill to those units, and the amount that can be recovered when those units are disposed of (Schuetze 1993). The managers may take advantage of the authority of using discretion to opportunistically distort the actual financial position of their company by being biased in making choices during the impairment test of goodwill. This has resulted in great critics on the use of discretion in testing goodwill impairment. Watts (2003) argued that the approach is not objective, and the fair value estimated used cannot be verifiable. He further explained that SFAS 142 could be lead to an error in judgement because estimation of impairment calls for the need to evaluate the future cash flows (Ramanna, and Watts 2012). Since it is difficult to verify the future cash flow objectively, the impairment test is more likely to be a subject of manipulation. Massound and Raiborn (2003), added that managerial judgement and discretion in the impairment approach could reduce the quality of earnings figures.

An instance of managerial discretion is the flexibility evident in determining the units of generating cash. The impairment of goodwill is tested at the cash-generating unit level. According to IAS 36, the cash-generating unit is the smallest category of assets generating cash inflows without relying on other assets in an organization. There is no specific division, component, subsidiary or branch assets are provided in the definition of cash-generating units (Avallone, and Quagli  2015). The lack of specificity in defining cash-generating unit give managers in a company a lot of flexibility in identifying these units that generate cash for impairment purposes. In a situation where managers have the incentive to minimize or maximize the losses associated with impairment, they will subjectively select units that serve their interest. In cases where the cash-generating units are many and more substantial, the managers, therefore, have greater flexibility in determining the value of goodwill and their impairment in future (Duangploy, Shelton, and Omer 2005).

According to the impact of the accounting theory of contracting, managers have an opportunity to exploit discretion during the impairment test to transfer wealth and enrich themselves at the expense of other contracting stakeholders, resulting to goodwill impairment not reflecting the actual financial position of the firm. According to Massoud and Raiborn (2003), stated that managers might opt to control earning through a cursory instead of intensively reviewing the impairment of goodwill. For instance, managers may choose to make colossal goodwill impairments when the business is declining after a ‘big bath’ behaviour. At the same time, managers may take goodwill impairment losses in times when the accrued earning are more than anticipated after the income smoothing behaviour (Johnson, and Petrone 1998).

The respondents who expressed concern on the impairment approach in calculating goodwill and in favour of amortization approach argue that the first method can only be used when there is an indication that goodwill may be impaired. They argued that the acquisition of goodwill is wasting of assets that are used and replaced over time, with goodwill that is generated internally (Avallone, and Quagli 2015). As a result, it is essential to amortize the acquired goodwill so that internally generated goodwill is not classified as assets in line with accounting principle of not recording goodwill make internally in the books of accounts (Eloff, and de Villiers  2015). The respondent in favour of amortizing goodwill also argued goodwill must be allocated to realize an accurate allocation of future operation cost, that are in line with the used in other tangible and intangible fixed assets without indefinite beneficial live span (Beatty, and Weber 2006). Another argument against impairment approach is that it is not possible to predict with accurate reliability the useful life of goodwill acquired. Besides, it is not possible to determine the pattern in which goodwill loses value. On the contrary, systematic amortization of goodwill provides a proper balance between operationality and conceptual soundness at an acceptable cost. According to the most respondent, the only appropriate solution to the intractable problem in accounting for goodwill in amortization.

Despite the critics against impairment approach in accounting for goodwill, there are several other advantages that this approach can offer yet amortization cannot provide. Impairment test was, therefore, intended to solve the shortcomings evident in amortization (Churyk, and Chewning Jr  2003). The main reason for dropping the traditional amortization approach in calculating goodwill is because it does not reflect economic reality, thus failing to provide critical information to accounts users. In most cases, accountants can determine the economic life for assets that have depreciated, even if it is impossible to find an effecting way of allocating cost over their productive life. In the case of goodwill, it is either impossible or challenging to allocate value to its life. It was observed that the pattern in which useful life of acquired goodwill depreciated could not be predicted, yet amortization heavily relied on predictions. Consequently, the amortized amount at any given time remains an arbitrary estimate of the amount of goodwill consumed over the period (Camodeca, Almici, and Bernardi 2013). As a result, the Board concluded that using amortization to compute goodwill do not provide critical information, thus opting for impairment test, which gives far much more valuable information.

The second argument against amortization and in favour of the impairment test is the fact that the former find it challenging to interpret the charge to goodwill.  Many accountants and financial experts ignore the expense associated with goodwill amortization while analyzing the earnings per share. Consequently, many companies were prone to neglecting the amortization expense of goodwill in determining the operating performance in the accounting records for internal purposes.  For instance, Jennings et al. (2001), studied if the total incomes with the amortization of goodwill have more information than total income before amortization. Their findings showed that revenues before the amortization of revenues provide more explanation on the distribution of share prices than when it is amortized, and that amortization just makes it difficult for users of accounting statement to predict the profitability in future. Besides, Moehrle et al. (2001) also argued that there is little evidence supporting the argument that amortization of goodwill provides information with relevant value. As a result, they suggested that amortization of goodwill does not provide useful information on decision making, thus, supporting the use impairment test in calculating goodwill instead of using amortization. Besides, amortization is based on the belief that goodwill is a wasting asset and as a result ignoring the fact that parts of goodwill may also have a useful life that lasts as long as the business is operational.

From the above discussion, it is evident that there is a great debate on the suitability of using impairment test versus amortization. There are some elements of truth among both those supporting and those against it. The main reason why impairment test is not the best option is the fact that it is usually used even in a situation where there are no signs of impairment. Secondly, the point that is based on the accounting discretion, managers can be biased, thus using it to benefit themselves at the expense of others. Despite, these weakness, impairment test tend to give more valuable information than when amortization is used.