ACCOUNTING FOR GOODWILL: A CRITICAL EVALUATION by MAYNARD JACOBUS VAN DER MERWE Submitted in fulfilment of the requirements for the degree of MASTER OF ACCOUNTING SCIENCE in the Department of APPLIED ACCOUNTANCY at the UNIVERSITY OF SOUTH AFRICA SUPERVISOR: PROF M A FAUL JUNE 1996 The financial assistance of the Centre for Science Development (HSRC, South Africa) towards this research is hereby acknowledged. Opinions expressed and conclusions arrived at, are those of the author and are not necessarily to be attributed to the Centre for Science Development. SUMMARY The principal goal of this research study was to critically evaluate the current accounting treatment of purchased goodwill in terms of a theo­ retical framework established, including an evaluation of the true nature of goodwill. The main conclusion of this study is that goodwill is an intangible asset representing various intangible factors contributing to the enterprise's earning capacity and providing returns in excess of a normal return on assets employed for which an acquiring enterprise is willing to pay an amount in excess of the fair value of the identifiable net assets acquired. The cost of purchased goodwill is measured as the difference between the total purchase price and the fair value of the net assets acquired after ensuring that all assets, tangible and intangible, had been properly identified. Purchased goodwill should be amortised over the estimated period that the enterprise is expected to benefit from the acquisition of the goodwill. Title of dissertation: ACCOUNTING FOR GOODWILL: A CRITICAL EVALUATION Key terms: Accounting for goodwill; goodwill; intangible assets; purchased goodwill; inherent goodwill; negative goodwill; goodwill amortisation; business combinations; goodwill on consolidation; goodwill measurement; goodwill valuation; super profits concept; residuum concept; intangibles concept. ii DECLARATION I declare that ACCOUNTING FOR GOODWILL: A CRITICAL EVALUATION is my own work and that all the sources that I have used or quoted have been indicated and acknowledged by means of complete references. K!c:s 65 7. 7 VAND 1 /'JJ '1V1• '. :I ... ~;.or_..• ...,..~,......... .i..,. 11111111111111111111111 1661985 iii ACKNOWLEDGEMENTS I would like to extend my thanks to the following for help, guidance, patience, interest and understanding during the duration of this study: 1. To the Lord, without whose grace and help I would not have been able to complete this study. 2. To my supervisor, Professor Max Faul, for the professional way in which he led me in this study. 3. To the Technikon Pretoria for giving me the opportunity to com­ plete this study, especially Professor Daan van der Schyf for sub­ stituting for me during my period of study leave. 4. To the Centre for Science Development for financial assistance. 5. To my subject advisor, Yvonne van Stuyvenberg, at the University of South Africa Library for her professional service. 6. To the South African Institute of Chartered Accountants' library, especially Bethany Massyn, for making available copies of articles. 7. To my wife Annatjie and my children Maynard, Boet and Maxie for all their patience during this study. 8. To all my family, friends and colleagues for their motivation and interest in my studies. iv CONTENTS Page Summary Declaration ii Acknowledgements iii CHAPTER 1 INTRODUCTION 1 . 1 Background to the study 1 1.2 Problem definition 2 1.3 Importance of the research 6 1.4 Scope of the research 7 1.5 Research methodology 8 1.6 Formulation of a hypothesis 8 1. 7 Program of the study 9 1.8 Source references 1 1 CHAPTER 2 THEORETICAL FRAMEWORK 2.1 Introduction 13 2.2 Development of accounting theory relating to goodwill 13 2.2.1 Definition of theory 14 2.2.2 Functions of a theory 15 2.2.3 Methodology of theory development 17 2.2.4 Definition of accounting theory 19 2.2.5 Levels of accounting theories 20 2.2.6 Theory approach 21 2.3 A theoretical accounting framework for goodwill 22 2.3.1 The nature of goodwill 23 2.3.1 .1 Introduction 23 2.3.1.2 Major conceptions of goodwill 23 2.3.1.3 Goodwill and the earning capacity of a business 28 v Page Chapter 2 (continued) 2.3.1.4 Characteristics of goodwill 33 2.3.1.5 Critical evaluation of goodwill as an asset 37 2.3.1.6 Conclusion 43 2.3.2 The measurement and valuation of goodwill 44 2.3.2.1 Introduction 44 2.3.2.2 Valuation bases 45 2.3.2.3 Goodwill within the historical cost income model 46 2.3.2.4 Conclusion 48 2.3.3 Goodwill within the conceptual framework for financial reporting 48 2.3.4 Negative goodwill 50 2.4 Inherent goodwill 54 2.5 Summary 58 2.6 Source references 60 CHAPTER 3 DEVELOPMENT OF ACCOUNTING FOR GOODWILL 3.1 Introduction 67 3.2 Historical development of the goodwill concept 68 3.2.1 Early legal definitions of goodwill 69 3.2.2 Customer relations concept of goodwill 72 3.2.3 Super profits concept of goodwill 76 3.2.4 Momentum theory of goodwill 78 3.2.5 Residuum concept of goodwill 79 3.2.6 Intangible resources concept of goodwill 81 3.3 Historical development of accounting treatment of goodwill 82 3.3.1 Phase I : 1 884 to 1 929 82 3.3.2 Phase II : 1930 to 1944 84 3.3.3 Phase Ill : 1945 to 1995 86 vi Page Chapter 3 (continued) 3.4 Summary 87 3.4 Source references 89 CHAPTER 4 CURRENT STATUS OF INTERNATIONAL STANDARDS ON GOODWILL AND ITS DEVELOPMENT 4.1 Introduction 93 4.2 The United States of America 94 4.2.1 Examination of Financial Statements by Independent Public Auditors 95 4.2.2 A Statement of Accounting Principles 95 4.2.3 Accounting Research Bulletin No. 24 - Accounting for Intangible Assets 95 4.2.4 Accounting Research Bulletin No. 40 - Business Combinations 97 4.2.5 Accounting Research Bulletin No. 43 - Restatement and Revision of Accounting Research Bulletins 97 4.2.6 Accounting Research Bulletin No. 48 - Business Combinations 98 4.2.7 Accounting Research Study No. 5 - A critical study of accounting for business combinations 98 4.2.8 Accounting Research Study No. 10 - Accounting for Goodwill 99 4.2.9 APB Opinion No. 16 - Business Combinations 101 4.2.10 APB Opinion No. 17 - Intangible Assets 101 4.3 Canada 102 4.4 United Kingdom 103 4.4.1 Exposure Draft No. 3 - Accounting for Acquisitions and Mergers 104 vii Page Chapter 4 (continued) 4.4.2 Accountants International Study Group Report - Accounting for Goodwill 105 4.4.3 Accounting Standards Steering Committee - Sub Committees 106 4.4.4 European Community's Fourth Directive on Company Accounts 107 4.4.5 Accounting for Goodwill - A Discussion Paper 107 4.4.6 Exposure Draft No. 30 - Accounting for Goodwill 108 4.4.7 Statement of Standard Accounting Practice No. 22 - Accounting for Goodwill 109 4.4.8 Exposure Draft No. 44 - Accounting for Goodwill - Additional Disclosures 112 4.4.9 Statement of Standard Accounting Practice No. 22 - Accounting for Goodwill (Revised) 113 4.4.10 Exposure Draft No. 47 - Accounting for Goodwill 113 4.4.11 Urgent Issues Task Force Abstract 3 - Treatment of Goodwill on Disposal of a Business 114 4.4.12 Discussion Paper - Goodwill and Intangible Assets 115 4.4.13 Goodwill and Intangible Assets - Working paper for discussion at a public hearing 117 4.5 European Community 118 4.5.1 European Community's Fourth Directive on Company Accounts 118 4.5.2 Belgium 119 4.5.3 Ireland 119 4.5.4 France 119 4.5.5 Germany 120 4.5.6 Italy 120 4.5.7 The Netherlands 120 4.6 Australia 121 viii Page Chapter 4 (continued) 4.6.1 Statement of Accounting Standards - Accounting for Goodwill - AAS 1 8 121 4.6.2 Accounting Guidance Release No. 5 - Accounting for Intangible Assets Recognised in Accordance with Statement of Accounting Standards AAS 1 8, Accounting for Goodwill 122 4.6.3 ASRB 1013/AASB 1013 - Accounting for Goodwill 123 4.6.4 Australian Securities Commission Practice Note 39 - Accounting for Goodwill 123 4.7 New Zealand 124 4.7.1 Research Bulletin 11 2 - Accounting for Goodwill 124 4.7.2 Statement of Standard Accounting Practice No. 8 - Accounting for Business Combinations 125 4.7.3 Exposure Draft No. 43 - Accounting for Intangibles 126 4.7.4 Statement of Standard Accounting Practice No. 8 - Accounting for Business Combinations (Revised) 127 4.8 South Africa 128 4.8.1 Discussion Paper No. 3 - Accounting for Goodwill 128 4.8.2 Current practice 129 4.9 International Accounting Standards Committee 129 4.9.1 International Accounting Standard No. 22 - Accounting for Business Combinations 130 4.9.2 International Accounting Standard No. 22 - Business Combinations (Revised) 130 4.10 Summary 132 4.11 Source references 134 CHAPTER 5 ANALYSIS OF CURRENT METHODS OF ACCOUNTING FOR GOODWILL 5.1 Introduction 140 ix Page Chapter 5 (continued) 5.2 Maintain goodwill as an asset unamortised 142 5.3 Write off goodwill to reserves at acquisition 148 5.4 Show goodwill as a deduction off shareholders' equity 151 5.5 Amortise goodwill over its estimated useful life 153 5.6 Write off goodwill to share premium 160 5.7 Summary and conclusions 161 5.8 Source references 163 CHAPTER 6 SUMMARY, CONCLUSIONS AND RECOMMENDATIONS 6.1 Introduction 168 6.2 Summary of the research 168 6.3 Conclusions 169 6.4 Recommendations 172 6.4.1 Accounting treatment of goodwill in South Africa 172 6.4.2 Setting a generally accepted standard in South Africa 173 6.4.3 Areas for further research 174 6.5 Closing remarks 175 BIBLIOGRAPHY 176 CHAPTER 1 INTRODUCTION 1.