Market Value, Book Value and Goodwill
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MARKET VALUE, BOOK VALUE AND GOODWILL A Thesis Submitted to the University of Wales in Fulfilment of the Requirements for the Degree of Doctor of Philosophy By Muhd Kamil Ibrahim Bachelor In Accountancy (Malaysia) Master of Accountancy (United Kingdom) School of Accounting, Banking and Economics University of Wales, Bangor May 1999 0 Cat atan: Pen gajian in! tentunya lebih bermakna Jika dapat melihat senyuman Allah yarham Ayahanda lbrahim bin Awang yang sentiasa berharap kejayaan anak-anaknya. Semoga Allah mencucuri rahmat kepadanya. Thesis in! Juga tanda ingatan buat Wan, Abah, MaIc Kak Yah sekeluarga, Kak Mie sekeluarga. Kak Ma sekeluarga, Shaiful sekeluarga. Haniza sekeluarga, Suhaill sekeluarga, Khamisah, Afzan, Junita. Azlina dan Adik Nor. Juga pada Kak Long sekeluarga. Tuti sekeluarga. Na. An, Ayu dan Razif. Kejayaan mi adalah hasil pen gorbanan semua. iii ACKNOWLEDGEMENT I am greatly indebted to Professor S. J. McLeay whose excellence in supervision and devotion to research has inspired my work. Without his untiring assistance, direction, encouragement, comments, suggestions, and constructive criticism throughout this study, this thesis could have not been completed. He has provided a continuaF source of Intellectual simulation and motivation, which will extend beyond this study. It has been an honourable experience working with him. Special thanks also to Mr. David Neal (my co-supervisor) because without his expertise in theoretical and technical aspects of accounting, my thesis would have been a more difficult journey. His explanation, discussion and comment reflect how good he is in this area. There are several direct and less direct acknowledgements that should be made in connection with this thesis. In particular: I owe Mr. John Goddard thanks because he has been always most gracious in discussing problems in econometrics and in giving me the benefit of his exceptional insight. In addition, I would like to thank Professor William B. Rees and Professor John Grinyer for their comments on the findings of this thesis at British Accounting Association Annual Conference. Likewise I am grateful to Professor Martin Walker and John O'Hanlon who have given some useful suggestions during the BAA-ICAEW Doctoral Colloquium. I have also received help from Gail Hughes who kindly read the entire manuscript and offered many useful comments and suggestions. I am also indebted to my employer, lnstitut Teknologi MARA (ITM) for providing the financial support for this study, in particular to Professor Dr. Ibrahim Abu Shah, the Deputy Reactor of ITM. I wish to express my deepest gratitude to my children - Sara Fateha, Ahmad Hans Azrai and Ahmad Amirul lmran - for their love, patience, encouragement and understanding. Of course, the largest part of my thanks go to my wife Raudzah, who has served as a most patient listener as well as the caretaker of all family affairs that would otherwise intrude upon my work. The constant support and patience of my family has provided me with the motivation for this study. I dedicate this PhD thesis to my parents. Beyond a simple thank you, I want them to know that I love them all very dearly. Last but not least, I would like to thank the members of Malaysian Community in Bangor, members of the School of Accounting, Banking and Economics (SABE) and my fellow students for their friendship and genuine concern regarding my work. May Allah bless us! Muhd Kamil Ibrahim May 1999 iv ABSTRACT This thesis examines the value relevance of goodwill that has been eliminated through reserves in the year of acquisition. Specifically, it investigates the association beiween goodwill reserve write-off and the value placed on the firm by the stock market. In so doing, the thesis describes the relationship between the implied value of purchased goodwill and that of other assets, and we seek to explain the underlying paffern of the amortisation of goodwill over time. The empirical method uses cross-sectional equity valuation models for the period 1994- 6. Based on the modified balance sheet identity, the equity valuation model parameterises purchased goodwill and other assets separately, and a more meaningful interpretation is given of the intercept term than in previous studies relating to purchased goodwill. The results confirm that the market incorporates information on the goodwill reserve write-off in the valuation of a firm, and the results also show that the market: book ratio is similar to tangible assets but its behaviour suggests a relatively higher amortisation rate. Although the present study provides evidence supporting the requirement in FRS 10 (Goodwill and Intangible Assets) to capitalise purchased goodwill, the findings also show that the incremental value of capitalised goodwill declines far more quickly than FRS1O suggests, thus placing particular importance on the impairment test required by FRS 10. V TABLE OF CONTENTS Page Declaration U Acknowledgement iv Abstract V Table of Contents vi List of Tables x List of Figures xiv CHAPTER 1 INTRODUCTION 1.1 Background and Objecilves of the Thesis 1.2 Research Implementation 3 1 .3 Main Empirical Results 4 1.4 Summary Outline of the Thesis 5 CHAPTER 2 THEORETICAL, HISTORICAL and REGULATION ISSUES 2.1 Introduction 7 2.2 Concepts of Goodwill 9 2.3 Factors Creating Goodwill 12 2.4 Accounting Treatment of Goodwill 15 2.5 Goodwill - Matching or Valuation? 20 2.6 History and Regulation 22 2.7 Conclusion and Discussion 33 vi CHAPTER 3 ACCOUNTING FOR GOODWILL 3.1 Introduction 35 3.2 Valuation and Treatment 35 3.2.1 Stock Market Capitalisation 36 3.2.2 Net Present Value 36 3.2.3 Value as a Function of Current Earnings 37 3.2.4 Value as a Function of Other Variables 37 3.3 The Amortisation of Goodwill 40 3.4 The Capitalisation of Goodwill 45 3.5 Standardisation and Harmonisation 47 3.6 Management Choices and SSAP 22 53 3.7 Value-Relevance of Goodwill 56 3.7 Summary 61 CHAPTER 4 MARKET VALUE AND BOOK VALUE 4.1 Introduction 62 4.2 Pension Fund Property Rights 62 4.3 Markets Valuation of Banking Firms 68 4.4 Research and Development (R&D) 71 4.5 Intangible Assets and Goodwill 73 4.6 Conclusion 87 CHAPTER 5 RESEARCH DESIGN AND METHOD 5.1 Introduction 88 5.2 The Proposed Research 88 5.3 Market Value Test Methodology 91 5.4 The Model and Expected Coefficient Values 94 5.5 Econometric issues 96 vii CHAPTER 6 EMPIRICAL ANALYSIS: OVERVIEW AND DATA 6.1 Introduction 97 6.2 Data and Sample Selection 97 6.3 Definition of Variables 100 6.4 Descriptive Statistics 102 6.5 Exploratory Data Analysis 106 6.5.1 Market Value and Book Value Analysis 106 6.5.2 Market Value and Book Value Analysis (Company without Goodwill) 110 6.5.3 Analysis of Variance 111 6.5.4 Econometric Issues 112 6.5.4.1 Serial Correlation Assumption 112 6.5.4.2 Unearity Assumption 113 6.5.4,3 Heteroscedasticity Assumption 114 6.5.4.4 Multicollinearify Assumption 116 6.5.4.5 Normality Assumption 117 6.6 Summary 118 CHAPTER 7 MARKET VALUE, BOOK VALUE AND GOODWILL Results and Interpretation 7.1 Introduction 119 7.2 The Value Relevance of Goodwill 120 7.2.1 Heteroscedasticity 124 7.2.2 Multicolinearity 127 7.2.3 The Reduced Model 132 7.2.3.1 Dummy Variables Regressions 134 7.2.3.2 The Log-linear Model 136 7.2.3.3 The Balance Sheet Identity Model 140 7.3 The Market Valuation of Goodwill 142 7.4 The Depletion of Goodwill 146 7.5 The Value Relevance of Off-Balance Sheet Items 149 7.6 Summary and Conclusion 150 viii CHAPTER 8 SUMMARY AND CONCLUSIONS 8,1 Summary and Conclusions 15] 8.2 Comparison with Previous Studies 152 8.3 Suggestions for Future Research 156 APPENDIX 1 EFFECT ON EPS, GEARING AND RESERVES Al.] Background 157 A1.2 The issues 158 A1.3 Effects on Earning per Share 158 A].4 Effects on the Gearing Ratio 160 A].5 Effects on Reserves 161 A].o Conclusion 162 APPENDIX2 DUMMY VARIABLE REGRESSIONS - INDUSTRY EFFECTS A2.1 Share Price 3 Months after Year-end 163 A2.2 Share Price at Year-end 171 BIBLIOGRAPHY 179 ix LIST OF TABLES Page Chapter 2 Table 2.1 Suggested Factors Constituting Goodwill 13 Table 2.2 A Summary of Goodwill Accounting Methods 17 Table 2.3 Goodwill Practices of UK Companies (1962 - 1971) 23 Table 2.4 Goodwill Practices of UK Companies (1973 - 1974) 24 Table 2,5 Goodwill Practices of UK Companies (1979 - 1980) 24 Table 2.6 Goodwill Practices of UK Companies (1 982-1986) 26 Table 2.7 Responses to ED 47: Preferred Accounting Methods 29 Chapter 3 Table 3.1 Goodwill Practices of Australian Companies (1985-1989) 40 Table 3.2 Categories of Identifiable Intangible Assets Recognised 40 Table 3.3 Goodwill Amortisation as a Function of Debt, Sales and Ownership 44 Table 3.4 Effect of the Accounting Treatment of Goodwill on Reported Accounting Rates of Return 45 Table 3.5 Financial Consequences of Non-Capitalisation 46 Table 3.6 Goodwill Practices of European Companies (1986-1992) 50 Table 3.7 Goodwill Comparability Indices 51 Table 3.8 Various National Accounting Standards Covering Goodwill 52 Table 3.9 Goodwill Amortisation as a Function of Merger Relief, Acquisition Price and Post-acquisition Geang 54 Table 3.10 Capital Market Values and R&D-in-Process 57 Table 3.11 Goodwill, Agency Costs and Synergy 60 Chapter 4 Table 4.1 Market Value as a Function of Book Assets, Liabilities and Pension Plan Assets and Obligations (Landsman, 1986) 65 Table 4.2 The Effect on Market Value of Neffing Book Assets and Liabilities 66 Table 4.3 Market Value as a Function of Book Assets, Liabilities and Projected Benefits (Gopalakrishnan and Sugrue, 1993) 67 Table 4.4 Modelling the Market-to-Book Patio (Beaver et al.