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The Nature Of Goodwill

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Autor:   •  July 23, 2011  •  3,588 Words (15 Pages)  •  8,866 Views

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Synopsis

The multitude of academic literature on the nature and issues of intangible assets and goodwill have highlighted the numerous approaches to measuring and reporting goodwill. These issues of identifying and measuring goodwill have provided great challenges in communicating the relevant value for an organisation. However, they are becoming increasingly more important in an environment where goodwill and other intangible assets are making up larger components of business purchase/combination prices. In determining the correct value of goodwill in the financial statements, there are three bases of measurement in accounting that can be applied; historical cost, market value and net present value. Each method has its own costs and benefits in the application to goodwill, however these costs and benefits have concluded that there is no one superior measurement approach for goodwill. This suggests that the focus should be on the disclosure and understanding of the reported goodwill amount.

Introduction: The Nature of Goodwill

Goodwill is an unidentifiable intangible asset, which cannot be individually identified and is an intrinsic part of a business (Deegan, 2005, p.274). It cannot be sold or bought separately from the entity and may be built over a number of periods. It arises from how the physical assets and human resources of the entity have been employed within the business environment and may be attributed to factors such as market penetration, an excellent distribution network, good industrial relations and superior management (Miller, 1995, p.7). As goodwill today constitutes a much larger part of acquisition prices (Chauvin & Hirschey, 1994, p.160), it has greatly impacted on figures shown on financial statements. Thus, it is very important to be able to measure the value of goodwill correctly during the buying and selling of an entity in accordance to the “risks and benefits of the deal” (Long, 2007, p54). Historical Cost, Market Value and Net Present Value are three such approaches to the measurement and reporting of goodwill.

Accounting for Goodwill вЂ" Historical Cost

Historical-cost accounting is the conventional method of accounting, whereby assets are valued at their original monetary value and are subjected in some cases to periodic write-offs in the form of depreciation, amortisation or impairment, and does not taken into consideration the market or present value of the economic item (CPA Handbook, 2007). The use of traditional accounting methods in the measurement of goodwill is aligned to the definition of goodwill being �the difference between the cost of the investment to the parent and the value of the subsidiary’s net assets at the time the investment is purchased’ (McKinnon, 1983, p.65).

While goodwill can be internally generated or acquired through the purchase of an existing business, AASB136 specifies that only purchased goodwill can be shown on the financial statements as it can be measured more reliably on the basis of the amount paid for it. Furthermore, due to the absence of market-based values, subjectivity and uncertainty is created in the values of internally generated goodwill, thus distorting the financial statements if recorded (Dunse & Hutchison, 2003, p.237).

Under current standards, AASB136 requires that goodwill carried forward into future periods undergoes annual impairment testing. An impairment loss is incurred when the carrying amount of the asset exceeds its recoverable amount and should be recognised immediately by debiting an expense and crediting an asset. While an impairment loss is required to be recorded, the standards prohibit revaluing goodwill when the recoverable amount of goodwill assessed is greater than the carrying value. As the recoverable amount test is based on broad assumptions, impairment losses which may arise in any period should be treated with caution (Egginton, 1990, p.204).

The foremost major advantage of using historical cost accounting is that it leads to absolute certainty of the value of the asset as the amount paid is reflected onto the financial statements (Ijiri, 1982, p.446). The use of current market value measurement would require the use of indirectly obtained data as the basis for measurement, whereas historical cost accounting allows for a more reliable generation of information through its rigidity (Ijiri, 1982, p.446). Furthermore, relevance and reliability have been widely recognised in external financial reporting as the two primary qualitative characteristics of financial accounting information (CPA Handbook, 2007). By using historical cost accounting, information can be verified independently in an arm’s length transaction.

Due to its rigidity, historical-cost accounting has adopted the practice of prudence, where the recorded amount is reduced if historical cost figures are greater than the current carrying value of the asset (CPA Handbook, 2007). This conservative approach ensures that the value of goodwill is not overstated and is reflected accurately on the financial statements. In addition, the use of historical cost accounting also has the capacity of prohibiting creative accounting practices, as the value recorded is the price paid to obtain it.

A major problem with using historical cost accounting is that historical cost is a limited subset of past data used in estimating future value (Ijiri, 1982, p.446). The difficulty in measuring goodwill arises from the identification of probable economic benefits and verifying an asset’s magnitude with reasonable certainty (Egginton, 1990, p.201). Accounts prepared under the historical-cost accounting convention has been widely criticised on the basis that this form of measurement bears no direct relation to the current value of the assets concerned (Deegan, 2005, p.201).

Another disadvantage of using historical cost accounting is that current standards prohibit upward revaluation of goodwill. Due to the nature of goodwill being unstable in value, the value of goodwill fluctuates with earnings and is more probable to increase in value (Deegan, 2005, p.276). Additionally, the problem of uncertainty can be approached by revising estimates of goodwill as new information emerges, which is presently being restricted by current standards (Egginton, 1990, p.201).

Furthermore, historical cost data can become easily outdated. During periods of high inflation, there is a greater divergence in historical cost figures as they become less reliable and reflective of the true value of goodwill (Ketz, 1983, p.52). The use of historical cost becomes insignificant when comparing corporate performance amongst entities.

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