Accounting For Goodwill

  • Category: Business
  • Words: 1973
  • Grade: 82
Reporting Goodwill on Financial Statements
The Current Reporting Style for Goodwill (amortization)
        The reporting guidelines for goodwill are in APB (Accounting Principles Board) Opinions 16 and 17. Opinions 16 and 17 state the following basic guidelines to amortize goodwill:
¨        Amortize over its useful life not to exceed forty years.
¨        Charge the amortization of goodwill to operating expenses.
¨        Amortize goodwill using the straight-line method unless there is a more appropriate method.
¨        If the amortization is material, a disclosure of the charge is necessary, as well as the method and period of amortization (Kieso, pp. 611).
The reporting style of amortization of goodwill is appropriate for several reasons. First of all amortization is a good way of matching costs and revenues. After the purchase of a company, the acquired company begins to merge with the acquiring company. If goodwill continues for an extended period of time (5-40 years) there is a point that goodwill is continuing because the acquiring company has generated it, and since goodwill is not generated internally this goodwill should be written off. The amortization of goodwill must use a systematic and rational method over its life thus forcing the acquiring company to live by the original choice of the useful life. Amortization of goodwill is also in line with international accounting. The last advantage of amortization is that it is easier for investors to understand because they are familiar with it and it is similar to deprecation which investors also understand.
Although there are many reasons to amortize goodwill there are also many reasons not to amortize. The first disadvantage of amortization is that it does not represent the true value of the goodwill. There are many analysts who eliminate amortization from their analysis because it provides little information to users of financial statements.

The Proposed Reporting Style for Goodwill (impairment testing)
        The proposed style for goodwill is in FASB's exposure draft for Business Combinations and Intangible Assets-Accounting for Goodwill. Impairment testing of goodwill has several guidelines, and the basic rules include the following:
¨        Test goodwill for impairment when events or circumstances occur indicating that an impairment might exist.
¨        At the time of the impairment test all, assets and liabilities will also be looked at as a reporting unit.
¨        To insure that an entity develops and documents its process for performing future impairment tests, when a company creates a reporting unit the performance of a benchmark assessment will also occur.
¨        Write down goodwill in the period the impairment has occurred(
The reporting style of impairment testing of goodwill has a few advantages.
¨        The first is that impairment testing reflects the economic reality of the reporting unit.
¨        Testing the asset will show a more realistic value of goodwill.
¨        Impairment testing provides more useful information to financial statement users.
¨        This style is also more consistent with how an entity manages its business and how many investors view goodwill.
Impairment testing also has a number of disadvantages.
¨        The impairment test is difficult and costly for small companies to implement, giving another advantage to large companies.
¨        This would treat goodwill differently from other identifiable intangible assets.
¨        Many users ignore goodwill anyway thus adding cost without any real value.
¨        Entities that grow through acquisition will have an advantage over entities that grow through internal development since the proposed impairment model allows for the balance sheet to replace acquired goodwill with internally generated goodwill.
¨        If goodwill continues for an extended period of time there is a point that the goodwill has continued because the acquiring company has generated it making the goodwill asset on the internally generated.
¨        Impairment testing may lead to testing all assets for impairment instead of depreciation and amortizing them.
¨        Sophisticated investors would have one more advantage over the casual investor because of the difficulty in understanding impairment test.

Charging Goodwill off Immediately
        There is another way of accounting for goodwill that is not being considered. Charging goodwill off immediately to either the income statement, other comprehensive income, retained earnings, or recording it in a contra equity account. Goodwill is inseparable from the business to which it belongs. Because of this, it is not a real asset and cannot stand alone. This argument also states that it is difficult to measure the future benefits of goodwill. This idea has a couple of advantages. First it would be easy to account for on financial statements. The second is that it provides consistency with the idea that a company cannot generate goodwill internally. The problem with this idea is that the acquiring company is expecting a future benefit or they would not pay for goodwill. This would distort the acquired companies financial statement for the and not show the cost of the future benefit on future statements. For these reasons FASB is not considering this idea.

Effects that Goodwill has on a Theoretical Company
Financial Statements
        ABC Enterprises has just finished its financial statements for the 2000 fiscal year. They are accomplishing great things as a company and feel they have a bright future. Much of ABC's growth is do to acquiring several smaller companies and those companies continuing to do well. The assets of the consolidated balance sheets for the past year is in Table I.
Table I
Consolidated Balance Sheet
Current assets        15,638,000
Property, Plant, and Equipment(net)        1,535,000
Patents and trademarks        3,282,000
Goodwill        21,500,000
Total Assets        41,955,000

As shown in Table II goodwill is currently at $21,500,000 making up over 50% of the company's assets (total assets $41,955,000, Table I). The company has purchased six companies over the past seven years and has an amortization schedule of ten years using the Strait-line method.
Table II
Goodwill Schedule
Company/Date        Purchased Goodwill        Expense through 2000        Balance
BC/ 1/94        $6,000,000        $4,200,000        $1,800,000
CD/ 1/96        $5,000,000        $2,500,000        $2,500,000
DC/ 1/96        $6,000,000        $3,000,000        $3,000,000
EF/ 1/97        $4,000,000        $1,600,000        $2,400,000
FG/ 1/99        $8,000,000        $1,600,000        $6,400,000
GH/ 1/00        $6,000,000        $600,000        $5,400,000
                Total Goodwill on Books        $21,500,000

ABC believes that it will continue to purchase other competing companies to help continue its growth. Although few companies have such a high percentage of goodwill this helps to illustrate the change in reporting goodwill.
Amortization of Goodwill
        ABC Enterprises is currently amortizing goodwill as required by APB Opinion 16. In 2001, ABC will not purchase any companies. The company will amortize $3,500,000 to goodwill amortization expense for the year 2001. This expense will reduce the value of the goodwill asset as well as the net income number. Because ABC has chosen to amortize over ten years, the company is forced to do so and thus does not have to use personal judgment each year. ABC also does not have to write the goodwill off in the purchase year making the numbers distorted the year of the purchase. Overall amortization is systematic, not subjective, and allows the goodwill of a company to transfer over an extended period of time.

Impairment Testing of Goodwill
        ABC Enterprises is currently amortizing goodwill, but will have to begin doing impairment testing for the year 2001. If goodwill has an impairment, the write down will be almost the same as amortization, debiting the expense and crediting the write down. In 2001 an independent firm does an impairment test for ABC. This firm has found only one of the companies has an impairment. ABC writes down CD Company for 1 million dollars to bring it to its fair market value. The net gain on the change in accounting principle is 2.5 million dollars. The CEO issues a statement concerning the income for 2001; The headline reads "ABC to exceed analyst expectations of EPS." Nothing really is changing in the company besides this change in accounting. Many investors will not understand the real reason for the increased EPS and invest in this company basing their decision on the increase in net income and EPS.
ABC likes the change in accounting for several reasons. ABC now has another way to manipulate the income numbers to meet analyst expectations simply by making judgments in their favor. Impairment testing does reflect more of the true value of the asset. This may make the numbers more useful for investors, but at the same time will make them more subjective to the judgments of humans. As long as ABC continues to do well with the acquired companies they may never have to write off the goodwill assets.

Effects the Impairment Testing Change will have on the U.S.
Companies Manipulating Financial Numbers
        This change in accounting will allow companies to manipulate the financial statements more now than ever. Leaving judgments to individuals that are trying to attract investors in dangerous. General Electric has met analyst quarterly EPS mark for the past twenty years by manipulating accounting numbers to meet expectations. This change will allow more manipulation of numbers across the board. If a company is having a bad year it will find ways to defer the a write down on an impairment to the next year. This may help them make the "EPS mark" that analysts are predicting. This change will also use several estiments and these sometimes will be biased.

No Added Value to Companies doing the Test
        The impairment test will cost money with no real value for the company in return. The company will be required to pay an outside appraiser to come in and appraise the value of the acquired company. This cost may be difficult for smaller companies and may become a deterrent for small companies in acquiring other companies. The only possible value the testing may have is a negative one to write down the goodwill asset.
The Future of Financial Statements with Impairment Testing
What may impairment testing of goodwill lead to? Moving to an impairment test on goodwill will open the door to the possibility of impairment testing of all assets. One argument is that with this change, accounting is now treating assets differently and therefore is not being consistent. Impairment testing also reflects the economic reality of the other intangible and tangible assets. Testing assets will show a more realistic value. Impairment testing provides more useful information to financial statement users. Impairment testing is also more consistent with how an entity manages its business and how many investors view asset. Basically, all the arguments that are for impairment testing of goodwill are also for other assets.

FASB's responsibility to Investors and Creditors
The Objectives of Financial Reporting
        There are three basic objectives of financial reporting. First, provide information that is useful to those making investment and credit decisions. Second, provide information that is helpful in assessing the amounts, timing, and uncertainty of future cash flows. Last, provide information about economic resources, the claims to those resources, and changes in them (Kieso, pp. 36). Which of the two styles of reporting goodwill meets these objectives? Impairment testing is more difficult to understand than amortization. Impairment testing is more useful, but it is also more subjective to judgments.

Characteristics of Accounting
        The characteristics of accounting are understandability, relevance, reliability, comparability, and consistency (Kieso, pp. 51). Amortization is easier to understand for those individuals looking at financial statements. The relevance will vary depending on the company. Impairment testing may cause the reliability to decrease because the numbers will become subjective to individual's opinions. This change will take US GAAP further away from international accounting and make the statements less comparable to other countries. There will be no consistency with other assets with a change to impairment testing.

Making the Decision
        FASB has a responsibility to all groups and individuals looking at financial statements. The objectives and characteristics talked about above are important to everyone analyzing financial statements. FASB needs to take in all the information it is receiving from outside sources, but also remember many associations are bias. Facts and what will improve the objectives and characteristics of accounting are the deciding factors.

        Everyday millions of Investors and companies use Financial statements to help them decide to invest, sell, hold, and/or loan money to companies. Amortization a better way to report goodwill because it is more in line with the objectives and characteristics of accounting. An impairment only approach makes accounting for goodwill more subjective, unreliable, costly, and confusing. For these reasons I hope the Financial Accounting Standards Board will reconsider its decision to change goodwill to impairment testing.
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