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2008

Measuring and recognizing the nature of goodwill

Indra Abeysekera
University of Wollongong, indraa@[Link]

Publication Details
This conference paper was originally published as Abeysekera, IK, Measuring and recognizing the nature of goodwill, Critical Perspectives on Accounting Conference, Baruch College, New York, 2008.

Research Online is the open access institutional repository for the University of Wollongong. For further information contact Manager Repository Services: morgan@[Link].

Measuring and recognizing the nature of goodwill

Abstract

The nature of goodwill is ill understood, making it difficult to determine appropriate accounting measurement methods. Examining the use of historical cost, market value, and net present value as measurement methods, this review highlights pitfalls in determining the correct value of goodwill in financial statements for accurate profit measurement. The paper demonstrates that the use of market value as proxy for fair value determination of goodwill value for recognition in financial statements is more a convenience for verification to establish social order rather than a measure of the accurate economic worth of goodwill.
Publication Details

This conference paper was originally published as Abeysekera, IK, Measuring and recognizing the nature of goodwill, Critical Perspectives on Accounting Conference, Baruch College, New York, 2008.

This conference paper is available at Research Online: [Link]

Measuring and recognizing the nature of goodwill

by Indra Abeysekera University of Wollongong, Australia

Correspondence details Associate Professor Indra Abeysekera School of Accounting and Finance Commerce Building University of Wollongong NSW 2522 Australia Phone: Email address: +61 2 4221 5072 indraa@[Link]

Measuring and recognizing the nature of goodwill

Abstract The nature of goodwill is ill understood, making it difficult to determine appropriate accounting measurement methods. Examining the use of historical cost, market value, and net present value as measurement methods, this review highlights pitfalls in determining the correct value of goodwill in financial statements for accurate profit measurement. The paper demonstrates that the use of market value as proxy for fair value determination of goodwill value for recognition in financial statements is more a convenience for verification to establish social order rather than a measure of the accurate economic worth of goodwill.

Key words: goodwill, historical cost, market value, net present value, social order

1.

Introduction

Goodwill emerging from nowhere is one of the highlights in the group balance sheet. It is a topic worthy of investigation, because we can increase the quality of professional reporting if we aim to measure profits accurately and report the economic worth of assets, helping users to make well-informed decisions about resource allocation (Masters-Stout, Costigan & Lovata, 2007).

Two problems have confronted the accounting profession in accurately measuring the economic worth of firms: (a) the difficulty of identifying discrete items and (b) dealing with changes in the value of such items after their recognition in financial statements. We have devised various measurement methods to deal with them, but when we use a single measurement method for all, we may be inappropriately using a one size fits all measurement method. If we restrict our discussion to goodwill, does a given measurement method contribute to measuring the profits and economic worth of the firm more accurately in financial statements? In searching for an answer, Section 2 outlines the nature of goodwill and its source of origin. Section 3 examines historical cost, market value, and net present value as methods for measuring the economic worth of goodwill. Section 4 outlines how the preferred goodwill measurement method and its recognition in group financial statements has facilitated the establishment of a social order that does not necessarily reflect the economic worth of goodwill. Section 5 outlines how reliance on transactions to measure and recognize goodwill hinders accurate determination of the economic worth of goodwill. The final section offers some concluding remarks.

2.

The nature of goodwill

The nature of goodwill is its essential qualities or character. Goodwill comprises a bundle of unidentifiable non-tangibles which partly represents the economic value of a firm. Goodwill exists because there is a set of assets that are present in the firm, but not listed with intangible and tangible assets. These assets include the knowledge of staff, the educational qualifications of staff, corporate reputation, customer loyalty, and distribution channels. The sum of these assets comprises goodwill.

Assets have economic value that brings future economic benefits to the firm, such as. rights to future economic benefits, or the potential for such economic benefits (French, Key & Meyer, 1965). Goodwill and intangibles constitute a large proportion of the economic value of a firm, as demonstrated by acquiring firms paying a greater price for such assets than was previously the case (Chauvin & Hirschey, 1994). The recognition of goodwill has value relevance to investors (Amir, Harris & Venuti, 1993; Bugeja & Gallery, 2006; Godfrey & Koh, 2001; Gynther, 1969), but investors find it difficult to understand the implications of goodwill accounting (Duvall, Jennings, Robinson & Thompson, 1992). In estimating the value of goodwill in financial statements, firms measure goodwill in a number of ways.

Goodwill exists before a firm, part of a firm, or an asset is sold. Firms recognize goodwill only after purchasing another firm or part of another firm or an asset. The recognition of

goodwill has nothing to do with the nature of the goodwill but much to do with the measurement method used to value it.

If the goodwill originates in a subsidiary entity in a business combination, then the subsidiary controls the goodwill, although that goodwill is not recognized in its financial statement. The reason for non-recognition is the absence of a past event or past transaction. If goodwill is measurable in relation to the market value of the subsidiary entity at the date of acquisition for a business combination, then the subsidiary entity could measure goodwill using the same approach for recognition. The accounting framework further supports the view that ownership of an asset is not conclusive for recognition of that asset, but helps to support its case. If so, the subsidiary entity is more qualified than the parent entity or the group entity to recognize its own goodwill as the difference between the market value and net book value of assets in the subsidiary .

3.

Measurement methods

When examining measurement methods for goodwill we need to ask whether the method measures the nature (essential qualities or character) of goodwill accurately without errors. Let us examine this question in relation to each measurement method.

3.1

Historical cost

Historical cost is the market value or an equivalent realized by the firm due to a past transaction. The initial recognition of goodwill under the historical cost measurement method requires a transaction or a past event as the basis for measuring an asset. It is the

acquirer who initiates the past event or transaction and hence the acquirer becomes entitled to recognize goodwill. The firm recognizes goodwill not as a separate asset but as part of an investment that includes the tangible and intangible assets of the acquired firm. The investment asset hides within it goodwill and other assets of the acquired firm. The investment asset also includes any errors in measuring the tangible and intangible assets of the acquiring firm. At the time of purchase, the investment asset represents for the acquirer firm the transaction price of the acquired firm. However, it does not provide a dissection of the goodwill, intangible and tangible net assets of the acquired firm.

In the subsequent reporting period, the acquirer firm can revalue the investment asset to its market value. The time interval becomes the gestation period of revising historical cost to market value. However, such restatements of the value of the investment in subsequent periods do not measure the nature of goodwill, since historical cost hides goodwill within the investment. Historical cost measures investment rather than goodwill. For instance, the value of goodwill may have increased more than other assets in the acquired entity, whereas the value of other assets of the acquired entity may have decreased. The net increase in the investment asset thereafter may not accurately represent the net increase in goodwill. We subsequently, first write off any reduction in value of the investment against the revaluation reserve of investment, and then write off any excess to the income statement. The reduction in value of the investment could be attributable to a reduction in the value of the tangible or intangible net assets of the acquired firm, a reduction in goodwill, or all three.

3.2

Market value

When determining the economic worth of goodwill we can approach the use of market value from two perspectives: (a) determining the market value of the firms assets other than goodwill and subtracting them from the market value of the firm to ascertain the value of goodwill (i.e. goodwill as a residual value), and (b) ascertaining the value of goodwill in its own right. Let us look at the consequences of each of these perspectives.

The market value of a firm is conceptually the financial value of each asset in the net present value of market place. In other words, the overall market value of the acquired firm is the future market values of its assets and liabilities, discounted by probability and interest factors to indicate their present economic worth. However, the reality is that market value measures the present financial benefits rather than future economic benefits, as market value reflects the present cash flow relating to the present sale as a ceasing concern of the market place. The assertion that stating the market value leads to true and fair financial reporting (Leibler, 2003) does not hold true either, as in the first place, neither the accounting framework nor the legal system has defined a true and fair view.

Although market price is conceptually appealing as a way of measuring goodwill, it has three problems. First, we are unable to calculate directly the net present value of all assets of the acquired firm. The nature of goodwill is such that we cannot identify the assets representing goodwill, and hence we cannot measure them as single assets. Hence, we strike a compromise, to measure goodwill as a residual bundle of assets - the difference between the market value of the acquired firm and the net present value of its identifiable

assets. Second, we assume that the earning potential of each asset that we discount is equal, by applying the same discount rate to all assets. But we know well that some assets have a higher earning potential and others have a lower earning potential than the discount rate. These differences in earning potential that can exist among assets belong to goodwill, intangible, and tangible assets. The errors in earning potential gives rise to errors in identifiable assets. Since goodwill (i.e. unidentifiable assets) becomes the difference between market value and the net present value of identifiable assets (erroneously valued), the errors in valuation embed in goodwill as the residual valuation. Additionally, human intervention by setting market values on identifiable net assets to reduce goodwill that may later dilute earnings is unavoidable (Schocker, Srivastava & Ruekert, 1994). Third, we are assuming that the market value is the net present value of the firm, i.e. the economic worth of the firm. If that is correct, the economic value of the firm should not change with the vagaries of market volatility. Further forces, not all of which are controllable by the acquired firm, affect the economic worth of the firm. Changes in uncontrollable forces such as inflation, customer preferences and the regulatory environment change the economic worth of the firm. In short, the firm operates in a contingent, semi-efficient market, and errors in valuing the economic worth of the acquired firm hence become embedded in the goodwill of the firm.

In other words, the market price reinforces the excess profit concept. The goodwill is an asset that gives rise to profits which are in excess of what the acquired firm could earn from its identifiable assets. If the identifiable assets were responsible for all profits of the firm, then the net present value of the identifiable assets would equal the economic worth

of the firm. Thus from the above discussion we may question the accuracy of the concept of excess profit earned from goodwill.

Under the market value measurement method, if goodwill is to be valued in its own right, then it should have a market value. The market value originates when an asset is exchangeable but that is not possible with goodwill as it is not separately identifiable for sale (Scheutze, 2004). Therefore, we can argue that goodwill is not an asset. But on the other hand, does the nature of goodwill warrant an exchange (i.e. transaction) that has an economic worth? The goodwill could remain within the firm, and not necessarily be sold or exchanged to generate future economic benefits.

According to the continuously contemporary accounting proposed as a workable solution to the market value measurement method, firms should state all assets at their cash amount or cash equivalent. It is suggested that the current selling price be verified by auditors for accuracy (Chambers, 1976; Clarke & Dean, 2007). Continuously contemporary accounting suggestively eliminates the necessity to reverse intra-group transactions and fair value adjustments to assets and liabilities of the subsidiary entity in the preparation of consolidated financial statements, by restating assets at the current selling price of both parent entity and subsidiary entity. However, it does not attempt to address measurement of the future economic worth of assets in the firm. Further, it restricts the measurement to financial exit value rather than economic worth, assuming that all assets will have accurate market selling prices. Such a notion becomes less

feasible for firms located in developing countries that have imperfect markets and for assets held by the public sector.

It is futile to think that goodwill must be exchangeable for cash because it necessarily equates economic value to an exchange value. This necessary exchange value concept goes back to transaction-based accounting, in which a transaction is a necessary condition for recognizing items in financial statements, and recognition in financial statements is a necessary condition for economic value. To transact an asset, it needs to be identifiable, and identifiability becomes a pre-condition for measure the economic worth of the asset in its own right. Further, exchangeability is not an attribute in measurement in the accounting framework of economic worth. However, such conditions are not consistent with the nature of goodwill, as goodwill is a bundle of unidentifiable non-tangibles that represents economic value to a firm.

3.3

Net present value

The net present value often becomes an estimate of future cash flow from the firms perspective, subject to accuracy of the discount rate. This measurement method hence has its flaws, as much as other measurement methods that have different types of flaws. In relation to goodwill, however, the question is whether net present value depicts the economic worth of goodwill more accurately: a contest in accuracy between verification and economic worth. It does so for the following two reasons. First, net present value measures future economic benefits, not past or present economic benefits. Second, it removes the approximation of goodwill as the difference between fair value of the entity

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and fair value of identifiable net assets. The practice of calculation of purchased goodwill equates to the fair value difference between the two as a workable solution.

There is evidence, however, to state that the indirectly calculated figure for purchased goodwill includes other unidentifiable assets and liabilities. First, investors have not perfected the valuation of assets including purchased goodwill in the market (Lev, Sarath & Sougiannis, 2005), with the result that firms are often bought at prices far exceeding market capitalisation (Guthrie & Petty, 2000). Second, the economic, social and political environment of a country influences the market value of a firm. For instance, the market value of a firm in an emerging economy may be different from that of a similar firm in a developed economy. Research demonstrates that among stock markets in developed economies that have strong public investor property rights there is a higher firm-specific market value (Morck, Yeung & Yu, 2000). Third, the psychology of the share market and forecasts of a companys economic potential above and beyond its regular business both contribute to the market value of a firm (Tissen, Andriessen & Deprez, 2000). Fourth, the use of fair value (market value as proxy) to measure the identifiable net assets of an entity relates to present economic benefits under a ceasing concern. Fifth, the concept of a cashgenerating unit to measure goodwill as a residual suffers from ambiguity in relation to determination of the business segment and method employed to determine recoverable value (Carlin, Finch & Ford, 2007).

Clarke and Dean (2007, p. 111), referring to cash generating units, dismiss the net present value of asset measurement as an exercise more conducive to feral manipulation and

11

creativity, considering net present value measurement as pure guesswork as to future income streams. This evaluation, however, raises a contradictory duality. On one hand, the accounting profession is believed to be astute enough to manipulate measurement as claimed by Clark and Dean. On the other hand the same accounting profession is accused of dullness in detecting such manipulation. Hence, it is less than judicious to settle for market value to avoid human manipulation of net present value as a measurement method that can provide an accurate assessment of the economic worth of future economic benefits.

4.

Establishing social order through recognition

The recognition of assets begins with satisfaction of the criteria of the definition of an asset in the accounting framework, followed by measurement of its value due to a past transaction or event. However, the nature of goodwill challenges this stereotypical sequence. Firstly, the starting point of recognition of goodwill is measurement. Second, unlike direct measurement, firm measures goodwill indirectly, in relation to the market value and fair value of identifiable net assets value of an entity. Third, unlike measuring a single asset, a firm measures and recognizes goodwill as a collection of assets.

Recognition of goodwill therefore becomes a vessel that contains measurement errors of other assets. Although the accounting standards require distinguishing other assets from goodwill on the basis that they are identifiable and measurable, those standards apply diverse measurement methods to assets. Often the differences in measurement methods used for recognition of identifiable assets arise from whether similar assets are exchanged

12

in a liquid market or not, as if the identifiable assets will be liquidated in the market place. In such measurement methods, the liquidation of identifiable assets is not required, but rather a necessary condition of identifiable assets, labeled as exchangeability.

The accounting regulators must be congratulated for confronting the convenience of nonrecognition of goodwill and the issues resulting from recognition. The pooling of interest method has been replaced by the purchase accounting method, giving rise to goodwill recognition in group financial statements around the world. However, the success of negotiations to embrace the purchase accounting method still leaves the profession far from being able to state the economic worth of goodwill. Rather, we have the exercise of seeking verification by reference to figures stated in the group balance sheet. The market value as a proxy and indirect measurement allows the creation of social order through verification with reference to the market, to the new label called goodwill included through purchase accounting in group accounts. Verification of accounting numbers is dependant on the ability to identify them either individually or collectively. That is the reason why goodwill represents a collection of assets, because when treated thus they are identifiable for verification as an accounting number.

Although the accounting framework does not advocate a preferred measurement method, for assets, the revisions to the accounting standards tend to favor the market value of measurement method with exchangeability as a necessary condition. This method is portrayed as displaying objectivity of measurement, and hence objectivity of recognition. Objectivity and accuracy of measuring economic worth are nevertheless two different

13

attributes of measurement that lead to recognition of identifiable assets in the financial statements. Objectivity of measurement may not necessarily lead to accuracy of measurement of economic worth, and vice versa.

The less than fully efficient market measures assets with less than full information, leading to measurement errors and financial statements reflect these measurement errors through recognition. Firms measure goodwill in relation to the market value and fair value of identifiable net assets value of the firm. The market value in a less than fully efficient market becomes a contributor of errors in the measurement and recognition of goodwill. The individual asset measurement value representing the identifiable net assets value similarly becomes a contributor of errors.

Goodwill is recognized in group accounts due to a business combination on the basis that it is brought into being by the synergy of the combination of two entities. However, the parent entity pays for goodwill in the subsidiary at the date of acquisition. The goodwill therefore resides in the subsidiary entity, and if group accounts are prepared at the date of acquisition, the group recognizes goodwill in its accounts because the parent entity paid for the goodwill in the subsidiary entity. In that case, we cannot say that the goodwill arose due to synergy, as there is hardly any time for the business combination to create any economic value for goodwill due to synergy. Thus the argument that goodwill is a result of synergy is contestable.

14

Which entity recognizes the goodwill, due to synergy or not, depends on which entity controls goodwill. In a business combination, there are three entities: two legal entities the parent and subsidiary entities, and a fictitious entity the group. The goodwill exists in the subsidiary entity prior to the business combination, and is the reason why the parent entity decided to pay an excess for the goodwill asset. If the goodwill existed prior to the business combination, the subsidiary entity then controlled goodwill prior to the parent entity gaining control over it. However, the subsidiary entity cannot recognize goodwill, because there have been no transaction to bridge the gap between the fair value of identifiable net assets value and market value of the subsidiary entity. Yet the absence of a transaction does not alter the nature of goodwill and the fact that it exists in the subsidiary. It also does not alter the fact that the subsidiary entity controls the goodwill. As much as the subsidiary entity recognizes other assets, it must then surely recognize goodwill that it controls, but the absence of transaction precludes such recognition.

When a parent entity gains control over the assets of a subsidiary entity, the parent entity recognizes its control over the assets of the subsidiary entity. The parent entity shows that control not by recognizing individual assets in its financial statements, but by substituting a single label that covers all the assets, called investment in the subsidiary entity. This label disguises the fact that the control by the parent entity of the subsidiary entitys assets creates a new social order of financial reporting communication. According to Grojer (2001), the purpose of categorizing accounting elements (i.e. assets, liabilities, equity, revenue, and expenses) in financial statements is to create social order to control the interpretation of events and phenomena through their recognition in financial

15

statements. The control of goodwill therefore exists at two levels: the level of the subsidiary entity (unrecognized), and the level of the parent entity (recognized as investment in the subsidiary). The two entities accordingly establish the social order of interpretation of goodwill phenomena.

The business combination then gives rise to the need to unravel the investment in the subsidiary entity by the parent entity into individual assets of the group. The group becomes the ultimate location for recognizing the unidentifiable assets that exist in the subsidiary entity, controlled by the subsidiary entity and the parent entity, with the label goodwill, establishing a new social order of interpretation of events in the group. The goodwill of the group is the product of a mathematical technique that combines the two entities. If the combination of entities followed the equity accounting method, then investment in subsidiary entity would remain with goodwill hidden in it, with no distinct label for interpretation. None of these events has changed the nature of goodwill.

An interesting fact that emerges here is that transaction is a necessary condition that triggers the recognition of goodwill, but is not a necessary condition for recognizing goodwill. If transaction were a necessary condition, then the parent entity would recognize goodwill as it could identify and differentiate identifiable assets from unidentifiable assets. The accounting regulation mediates the recognition of goodwill by how it foresees the establishment of social order through the process of labeling accounting elements for interpretation.

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The social order established in presenting financial information about goodwill therefore varies among subsidiary entity, parent entity and the group. If measurement using market value to establish verification of accounting numbers had been in the forefront, then all three entities would be in a position to recognize goodwill. The subsidiary could measure goodwill as the difference between the market value and fair value of identifiable net assets at the time of reporting. The parent entity could dichotomize investment in the subsidiary as investment in identifiable net assets and purchased goodwill, in its recognition in financial statements. Additionally, the parent entity could recognize its own goodwill using the same criteria applied in measuring goodwill of the subsidiary entity. But it is the group that recognizes goodwill as a residual in the business combination. The social order of the accounting regulation is therefore that goodwill becomes a seriously measurable asset in business combinations only. Thus a conception of organizational reality shapes organizational participants views about organizational functioning and economic discourse. The group, a fictitious construct with no legal personality, recognizes goodwill originating elsewhere in a real entity with a legal personality.

The Financial Accounting Standards Board (FASB) examined two methods of accounting for business combinations (the purchase method and the pooling of interest method). Noting that one method highlights goodwill if any (purchase method) and the other does not (pooling of interest method), the FASB issued a special report stating that the existence of two methods to account for identical transactions can lead to firms managing accounting for the transaction with the method that produced results desirable to them

17

(FASB, 1997). Evidence suggests that under the pooling of interest method, firms are prepared to make a significant wealth transfer to target shareholders. Firms prefer the pooling of interest method to report higher earnings, avoiding amortization and depreciation expenses that otherwise reduce earnings (Ayers, Lefanowicz & Robinson, 2002; Weber, 2004), and managers deriving benefits from stock-based compensation, act opportunistically to structure acquisitions to increase earnings (Aboody, Kasznik & Williams, 2000). The preference for the purchase accounting method therefore is an acknowledgement of the economic worth of goodwill, but it is a mere shift from no verification of acquired goodwill to verification of acquired goodwill with reference to the market. Guthrie and Petty (2000) point out that firms are sold at prices different from their market prices prior to initiation of their sale, and this fact challenges the accuracy of recognition of the economic worth of goodwill based on market value, as the residual between market value of the subsidiary entity and fair value of its net identifiable assets when the cash generating unit is the entire entity.

The value of goodwill after business combination can increase over time, and it is a grey area whether to attribute an increase (or decrease) in the value of goodwill to synergy (or problems) of the business combination. The issue is whether the change in goodwill is attributable to the business combination. The calculation jargon adopted in consolidation takes credit for the excess paid for acquisition of another entity as goodwill due to synergy from the business combination, but the framework lays no blame if the excess paid reduces in value after business combination; it merely devalues the goodwill of the group to its recoverable value.

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None of the three entities (group, parent, and subsidiary entity) recognizes an increase in the economic value of goodwill, on the basis that entities cannot link that increase to identifiable transactions or events. The accounting regulation does not deny the increase in the economic worth of goodwill, but the rules for goodwill interpretation facilitate recreation of the social order. Lack of recognition of any increase in the economic worth of goodwill challenges the regulators approach of recognizing goodwill as the difference between the market price of the subsidiary entity and its fair value of identifiable net assets value, especially where firms can establish market value through liquid share price.

In relation to recognition of goodwill in the accounting framework as the creation of social order, two aspects are pertinent. First, an acquiring entity attempts to recognize identifiable assets of the subsidiary entity separately. In this context, group financial statements provide an all in one label called goodwill on acquisition, to represent the unidentifiable economic worth of a subsidiary entity in the groups financial statements. Second, an acquiring entity does not attempt to recognize identifiable assets of the subsidiary entity separately. In this context, the parent entitys financial statement hides the unidentifiable economic worth of the subsidiary entity under the all-inclusive label called investment in subsidiary entity.

If the parent entity controls the identifiable assets of the subsidiary entity due to a past transaction, then it could be thought that the parent entity should recognize them as assets of its entity. However, the parent entity classifies them into a single label, investment, to

19

create a new order to condense the information. The combination of the parent and subsidiary entities expands the information condensed into investment to represent the individual assets of the subsidiary entity, including goodwill, to create a separate social order of group financial statements. In one context, the economic worth of the goodwill is hidden (in the parent entity), whereas in the other context it is disclosed (in the group entity) in the financial statement. Consistent with the accounting framework, the parent entity has an opportunity to recognize the goodwill of the subsidiary entity in its own financial statements, as the purchase of goodwill resulted from past transaction, but does not do so. The conceptualization of goodwill drives the recognition of goodwill in business combination. The entity and parent-entity concept of consolidation, and the proprietary entity concept of consolidation, result in recognition of two different amounts of the same goodwill.

The social order of goodwill is manifested in three different ways. First, it establishes goodwill as an asset that is objectively measurable with reference to market value. Second, a transaction is a prerequisite for recognition of goodwill. Third, the conceptualization of goodwill determines its recognition, that is, whether it should be embedded in another asset or shown separately. The three different ways of manifesting social order are independent of ascertaining the economic worth of goodwill, but they determine the world view communicated to stakeholders through recognition or nonrecognition of goodwill.

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5.

Goodwill recognition and measuring the nature of goodwill

Should financial statements recognize goodwill in order to represent its economic value consistent with its nature? The nature of goodwill is that it is a bundle of identifiable nontangibles representing economic value. The role of financial statements has been to recognize identifiable assets either directly or indirectly in a transaction. Goodwill is recognized in group financial statements for the same reason, because group financial statements can refer to a transaction that took place to show all possible net assets of two entities (i.e. the parent and subsidiary entities) in a single financial statement. That is a plausible reason why the acquired entity (i.e. subsidiary entity) does not recognize goodwill in its financial statement there is no transaction by which to refer to it directly or indirectly.

If financial statements represent transaction-based items only, then goodwill has little place in single legal entities. Even when goodwill is recognized because it is triggered by a transaction, the financial statement does not reveal the composition of the bundle of assets within it, and that bundle remains a mystery. The group financial statement recognizes other assets singly but goodwill as a bundle a place for sundry assets seemingly divisible but unidentifiable individually due to the absence of transactions that can be assigned to each to accommodate it into the transaction model. Whether a firm should identify any asset individually or collectively is irrelevant to the transaction-based financial statement; the only necessary condition is a transaction. For goodwill, measurement of a transaction is verification referenced to market value as proxy for fair value. If a firm has a transaction for an asset (individual or collective), it is a given a label

21

(i.e. goodwill or any other) to display in the body of the financial statement. The labels have little to do with the economic worth of assets but they are assigned to build order into the financial statement.

Hence, the problem with goodwill recognition relates to imposition of the necessary condition of transaction for it to be recognized as an item in financial statements. Measurement methods that require a transaction as a pre-condition for measurement do not measure goodwill in a single entity, but in the group entity only. This is the reason that historical cost and market-selling price accounting do not recognize goodwill as an asset in a single entity, only in a group entity. Further, when a goodwill transaction takes place, it relates to a bundle of assets that are individually unidentifiable, and the transaction model has little capacity to untangle the bundle and recognize the assets separately.

All the above measurement methods entail the bold assumption that we can measure goodwill in a similar manner to measuring tangible and intangible assets. But this assumption ignores the fact that the nature of goodwill is that it is an unidentifiable bundle, although real. Coming back to where we started, must we use the same measurement methods when the nature of the item is different? We as a profession have not addressed this issue sufficiently.

All this time, we have assumed that goodwill comprises a bundle of assets, and that there are no liabilities involved. When there is a drop in the value of goodwill, we attribute it to

22

a drop in value of the bundle of assets. However, the bundle of goodwill can surely comprise both assets and liabilities. If the nature of goodwill is unidentifiable nontangibles, there is clearly the possibility that it comprises both unidentifiable non-tangible assets and unidentifiable non-tangible liabilities. For instance, if an acquirer purchases a firm for a value greater than its fair value of identifiable net assets value, we call it goodwill, but comprising unidentifiable non-tangible assets. If an acquirer purchases a firm for a value less than its fair value of identifiable net assets value, we call it a discount on goodwill (or negative goodwill). That should be attributable to unidentifiable non-tangible liabilities, because the unidentifiable assets have a negative value, and assets do not generate negative net cash flows. The concept of goodwill as comprising assets only is more for convenience of fitting into a mathematical equation than led by evidence-based research.

6.

Concluding remarks

If the accounting profession has not adequately addressed the recognition of goodwill by the historical cost and market value measurement methods, how can firms recognize the value of goodwill in financial statements? The answer to this lies in seeking a measurement method that does not impose a transaction as a necessary pre-condition for ascertaining the economic value of goodwill. But adopting a measurement method that does not imposes a transaction or event as necessary pre-condition clashes with the definition of an asset in the accounting framework. The accounting framework defines an asset as requiring a transaction or event.

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The net present value is a measurement method that does not require a transaction or event to ascertain economic value, and measurement of assets is driven by the value determined by the firm as a going concern, rather than the value determined by the market (which would be the case if the assets were to be sold out as a ceasing concern). If a firm can ascertain the economic worth of goodwill using the net present value, each legal entity can recognize goodwill not just as a bundle of assets, but also as single asset items (Tearney, 1973). When that occurs, according to transaction-based financial statements the asset items are identifiable and measurable, and hence they are no longer goodwill. However, that is not relevant, when we think that the composition of goodwill still reflects its economic worth in the financial statement, whether under the label goodwill or under its revised label intangibles. Nevertheless, net present value is not foolproof, since estimating the present worth of future cash flows is prone to error. The time, the interest rate, and the forecast cash flows become estimates that can create errors in the present worth of goodwill. Human intervention that misuses the measurement is a different matter, and is independent of its capacity to offer an accurate economic worth of goodwill. The presumption that some factions of the accounting profession (preparers) can manipulate estimates to their personal advantage, whereas other factions of the accounting profession (auditors) are unable to detect them does not make much sense. It is more a test of personal integrity rather than of technical skills. The purpose of measuring goodwill is to communicate its economic worth, not as an absolute truth but as a proportional truth, and the objective is to increase proportional truth, since communicating absolute truth about accounting is not the ontological view of the profession (Archer, 2003; Hines, 1988). The accounting profession cannot offer an

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epistemology that meets the diverse ontological views held by different stakeholders of accounting within it (Leibler, 2003).

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