Treatments of Goodwill and the Iasb Framework

Over the years, there have been various accounting treatments of purchased goodwill as follows:

1. Immediate write off against reserves

2. Capitalisation with amortization over a pre-selected number of years

3. Capitalisation with annual impairment reviews

Using the IASB Framework, you are required to evaluate each of the above alternative treatments.

Introduction

Goodwill is the difference in monetary value between the amount paid by a purchasing company and the book value of the purchased company’s net assets (Moehrle and Reynolds-Moehrle, 2001). However, there has been debate over the recognition of goodwill as an asset. The Concept Statement No.6 (Financial Accounting Standard Board, 1985, p.16) defines an asset as having two characteristics. Firstly, future economic benefits are expected to arise, a view accepted by Nethercott and Hanlon (2002, cited Dagwell et al, 2004, p.2) in regard to goodwill. The second characteristic concerns how controllable an item is as a result of past events. Harrington (1999) argues that goodwill is not independently reliasable, a point agreed by Sundararajan (1995), and that management has little control over it, which was the school of thought behind an immediate write off against reserves. However, Johnson and Petrone (1998) explain how, in 1997, the Financial Accounting Standards Board (FASB) agreed that goodwill met the definition of an asset as described in the Concept Statement No. 6.

The International Accounting Standards Board (IASB) Framework, concerning the preparation and presentation of financial statements, identfies four qualitative characteristics that should be inherent (Deloitte, 2008). This essay will consider the implications of each method of treating goodwill in relation to the relevance, reliability, understandability and comparability of financial statements for users.

Relevance

Appendix 1 shows a simple example of company purchase involving goodwill. The three methods of handling goodwill are compared and their impacts on the financial statements apparent. The purpose of this information is to show how each method has a differing impact upon the financial statements, which will therefore affect the economic decisions of users. From the appendix, the following data can be concluded.

An immediate write off against the reserves leads to the highest profit margin but also the highest gearing ratio. The higher gearing and the increase in risk experienced by the company will make the company less attractive to investors, which could restrict long-term growth. A fall in share price would be expected as a result of the increased risk. Elliott and Elliott (2007, p.458) as well as Huefner and Largay (2004) argue this method acts to distort primary ratios, which is due to a fall in shareholders funds and, therefore, capital employed.

The amortisation method gives the lowest profit margin, the result of the amortised amount being deducted from profit. Njeke (1991, cited in Wiese 2005, p.109) furthers this point by commenting on how by reducing profits by an amortisation charge, earnings are no longer measured meaningfully. It is arguable that the dividends paid to shareholders in further years will fall as a result of the reduced profit, which would be exacerbated during a poor trading year where the amortisation of goodwill represents a larger percentage of revenue. Another point regarding short-term profit concerns a potential error as a result of the choice of years to amortise over.

The impairment test method contrasts to an immediate write off by resulting in the lowest gearing ratio. This makes the company more attractive to invest in as well as lowering risk, which will aid in the arrangement of external finance. During years where the value of goodwill becomes impaired and amortisation having to occur, the same logic can be applied as with the amortisation method regarding dividends and a poor trading year. The impairment test method also maximises shareholders’ funds and maximises profit (Elliott and Elliott, 2007, p.458).

Reliability

It could be argued that an immediate write off of goodwill against reserves removes an element of bias that may exist. The amount is clearly not subjective or estimated. Elliott and Elliott (2007, p.454) consider the income statement ramifications in that by failing to account for the loss in value of goodwill here, a company would be ignoring the fact that goodwill loses value over its entire life.

The determination of the pre-selected number of years, concerned in the amortisation