Profit Measurement and UK Accounting Standards: A Case of Increasing Disharmony in Relation to US GAAP and IASs

UK accounting practice differs from International Accounting Standards (IASs) particularly with regard to amortisation of goodwill, provision for deferred taxation and the accounting treatment of pension costs. Under the core standards programme of the IASC the IASs have emerged closer to US practice. This paper evaluates the profit of those UK companies reporting to the Securities and Exchange Commission (SEC) in 1988 and 1994, spanning a period which saw the establishment of the ASB and the implementation of the IASC's comparability project. An increasing gap was found between the reported profit under UK accounting principles and that restated under US GAAP. The difference lay most frequently in accounting for goodwill, provision for deferred tax, and the accounting treatment of pension costs, with accounting for goodwill showing a particularly significant impact in 1994. Notwithstanding the introduction of FRS 10, an overall impression of increasing disharmony could continue to cause reconciliations to be required of UK companies seeking full listing on a US stock exchange, with consequent disadvantage relative to companies in other European countries seeking international capital in the US.     

Goodwill — An Example of Puzzle-Solving in Accounting

The nature of goodwill continues to be misunderstood by most accountants and confusion surrounding the measurement and reporting of goodwill persists. The rejection of official accounting standards on goodwill is a common occurrence. A dynamic open system perspective is used in this paper to re-examine the nature of goodwill. It is found that a meaningful economic interpretation can be developed for internally generated goodwill but not for 'purchased goodwill'. There is an inability to identify the stream of benefits specifically associated with goodwill arising on acquisition.     

Managerial Choices in the Valuation of Acquired Goodwill in the UK

During the 1980s the UK regulations affecting accounting for acquired goodwill allowed managers to make accounting choices affecting recorded goodwill that best served their particular interests. This paper develops and tests the hypothesis that the proportions of purchase price assigned to separable net assets and consequently to goodwill are affected by gearing (leverage) and other considerations.     

Overpaid acquisitions and goodwill impairment losses — Evidence from the US

The purpose of this study is to shed light on the reliability of accounting goodwill numbers by examining whether many goodwill impairment losses arise from overpayment for the target at the time of the acquisition, rather than from a subsequent deterioration of goodwill values. A second related objective is to assess whether the goodwill impairment test introduced by SFAS 142 improved the ability of accounting standards to timely capture situations in which the amount of goodwill is overstated and should thus be written down.     

GOODWILL ACCOUNTING: EVERYTHING HAS CHANGED AND NOTHING HAS CHANGED

In issuing Statements No. 141 and No. 142, the FASB has attempted to make accounting statements better reflect the economics of the exchange of value that takes place in business combinations. At the very least, requiring a single method of accounting reduces the costs of accounting, puts all acquirers on an equal accounting footing, and removes the incentive to incur significant costs to be able to report on a pooling-of-interests basis.
But if the FASB rules have changed significantly, investors' expectations for acquiring companies have not. Therefore, accounting rules should have no impact on acquisition pricing or structuring unless they affect cash flows. Recorded goodwill and return on capital are the artificial result of accounting rules, and largely without economic content. However, understanding the growth value implicit in the price paid is key to helping ensure that acquisitions create value. Boards of directors and executives must understand the minimum annual performance targets they have set for themselves by paying a premium to acquire a company.
The ideal measure of goodwill, which has not been contemplated by the FASB, would capture the premium of the current acquisition price over the value of the target firm's current operating value—that is, the discounted NPV of its current operating cash flows. Using such an economist's definition of goodwill, financial analysts could then come up with the variable that is of greatest interest to investors-namely, the expected improvements in operating performance that are necessary to justify the acquirer's investment in the target company. The economic framework and future growth value analysis based on EVA can be used to answer this question, regardless of the accounting rules du jour.     

A POLITICAL ECONOMY OF SSAP22: ACCOUNTING FOR GOODWILL

In late 19th century Britain it was widely accepted by leading authorities that «goodwill» was simply the purchase of sufficient expected «surplus profits» to persuade the owners of a business to part with its net assets and control, and that this expenditure should be capitalized and amortized against those surplus profits as they are realized. Although this method remains the conventional wisdom, and dominates current international regulation and practice, its conceptual foundation appears lost to modern scholars, for whom the «problem» of accounting for goodwill is «insoluble». In the first part of the paper the concepts of Marx's political economy are employed to elaborate the conventional method, which is argued to be necessary to allow the capital markets to observe the generation and realization of profit and the rate of return on capital. From this perspective, the heavily criticized decision of the UK authorities in SSAP22 to encourage the write-off of goodwill against capital is an anomaly requiring explanation. It is usually explained as either the ASC's acceptance of economic income accounting as the ideal for financial reporting, or its acquiescence to powerful managerial interests. In the second part, these explanations are criticized, and an alternative hypothesis advanced which is consistent with the limited evidence available. That, although the capital markets usually want purchased goodwill to be capitalized and amortized, in the peculiar circumstances of the UK, where unusually large portions of its manufacturing industry were closed or run down in the acquisitions and merger boom of the 1980's, writing-off purchased goodwill against capital was in the collective interest of investors because it helped to hide from public view the fact that dividends were being paid from capital.     

Debating Accounting Principles and Policies: the Case of Goodwill, 1880-1921

Debate surrounding the publication of FRS 10 (ASB, 1997) in the UK displayed support for a variety of accounting policies for goodwill, advocated for a variety of practical and conceptual reasons. An analysis of papers written on goodwill between 1884 and 1921 explores whether this lack of unanimity is a recent phenomenon or not. The paper concludes that during this earlier period there were a number of areas of agreement regarding goodwill but, although a majority of authorities favoured a capitalise/amortise policy, there was a significant difference of opinion relating to its treatment once recorded in the accounts. Analysis also suggests that advocated policies were derived from a desire to promote and operationalise the principle of prudence.     

Did the goodwill accounting standard impose material economic consequences on Australian acquirers?

This research explores the empirical association between takeover bid premium and acquired (purchased) goodwill, and tests whether the strength of the association changes after the passage of approved accounting standard AASB 1013 in Australia in 1988. AASB 1013 mandated capitalization and amortization of acquired goodwill to the income statement over a maximum period of 20 years. We use regressions to assess how the association between bid premium and acquired goodwill varies in the pre‐AASB and post‐AASB 1013 periods after controlling for confounding factors. Our results show that reducing the variety of accounting policy options available to bidder management after an acquisition results in a systematic reduction in the strength of the association between premium and goodwill.     

Peer effect in the initial recognition of goodwill

This study investigates the peer effect in the initial recognition of goodwill. We find that firms imitate their peers in the initial recognition of goodwill. The higher the tendency for imitation, the higher the proportion of goodwill recognized. Imitation behavior in the initial recognition of goodwill cannot be explained by information acquisition or rivalry motivations. Instead, we find evidence that managers’ opportunistic motivations explain the peer effect in the initial recognition of goodwill and the overestimation of goodwill arising from imitation tendencies. Executive overconfidence weakens the peer effect but exacerbates the overestimation of goodwill caused by imitation tendencies. Finally, the higher the imitation tendency, the greater the probability and amount of goodwill impairment in the future. This further confirms that the peer effect leads to overestimation of goodwill. The findings of this study enrich the literature on goodwill and provide insightful empirical evidence for regulating goodwill accounting. The results show that the conservatism principle should be reinforced in the initial recognition of goodwill.     

Public‐Private Partnerships: Form Over Substance?

Public-private partnerships have been devised to avoid treating financing arrangements as government "debt". Governments face incentives to avoid treating these arrangements as giving rise to liabilities. Both the Australian and UK standards boards have avoided a "substance over form" approach in order to accept that PPPs may be kept off-balance-sheet. The analysis supporting their conclusions was based on consideration of whether PPPs led to the acquisition of an asset, using the analogy of accounting for finance leases, rather than addressing whether the substance of commercial arrangements means that contractual commitments may evolve into liabilities.     

CEO Compensation and Fair Value Accounting: Evidence from Purchase Price Allocation

This study investigates the impact of CEO compensation structure on post‐acquisition purchase price allocation, an accounting procedure that involves fair value estimation of various assets and liabilities. We find that CEOs whose compensation packages rely more on earnings‐based bonuses are more likely to overallocate the purchase price to goodwill, the largest asset recorded post‐acquisition. Because goodwill is not amortized, the overallocation likely increases post‐acquisition earnings and bonuses. We also find that, when the acquirer's CEO bonus plan includes performance measures that are not affected, or are less affected, by the overstatement of goodwill, such as cash flows, sales, or earnings growth, the overallocation to goodwill motivated by bonus plans diminishes.     

Public-Private Partnerships: Form Over Substance?

Public-private partnerships have been devised to avoid treating financing arrangements as government "debt". Governments face incentives to avoid treating these arrangements as giving rise to liabilities. Both the Australian and UK standards boards have avoided a "substance over form" approach in order to accept that PPPs may be kept off-balance-sheet. The analysis supporting their conclusions was based on consideration of whether PPPs led to the acquisition of an asset, using the analogy of accounting for finance leases, rather than addressing whether the substance of commercial arrangements means that contractual commitments may evolve into liabilities.     

Towards Some Principles for Intangible Asset Accounting

This paper examines the conceptual issues of intangible asset accounting in the context of recent controversies over the treatment of brand names and goodwill in company accounts. Issues of definition and recognition and the rationale for balance sheet disclosure are considered for goodwill and other intangibles. The implications of capitalising intangibles under accounting models based on present value, net realisable value, current cost and historical cost are examined, and certain principles are proposed. The problem of testing the validity of asset valuation is explored, and a test is developed on the basis of the ‘recoverable amount’ rule of historical cost. This test is demonstrated for two major UK companies.     

Goodwill or “No-will”: Hubris in the tone at the top

In this study, we examine the effect of hubris in the “tone at the top” on goodwill accounting, specifically the proportion of the purchase price allocated to goodwill following a business combination, and subsequent decisions to write down goodwill. Using a sample of CEO letters to shareholders from firms listed on the Stockholm Stock Exchange, we carry out textual analysis of CEO letters to identify hubristic language markers. Regression analyses show that hubristic tone is positively and significantly associated with the purchase price allocation to goodwill. Furthermore, we predict that hubristic managers are more likely to overestimate future cash inflows related to goodwill and are less likely to perceive the need for a potential write-down. Consistent with this prediction, we find that hubristic tone in the CEO letters is associated with less timely goodwill write-downs. This study contributes to the literature on goodwill accounting, the role of CEO attributes on corporate decision making, and to research on CEO-speak, by providing evidence that a hubristic tone at the top can explain strategic choices by management and accounting outcomes.     

Goodwill impairments and chief executive officer tenure

The purpose of this paper is to examine the tenure of the chief executive officers of publicly held companies and their corresponding goodwill impairment decisions. An opportunity for managers to manage earnings exists via the Financial Accounting Standards Board's (FASB) goodwill accounting rules. It is hypothesized that CEOs will recognize this impairment in the early years of their tenure because blame can be placed on prior management's acquisition decisions, expensing goodwill early will make future earnings look better, or an objective evaluation of the reporting unit increases impairments.     

Towards an understanding of the phases of goodwill accounting in four Western capitalist countries: From stakeholder model to shareholder model

The objective of this paper is to illustrate that the change in shareholders’ attitude towards firms (from stakeholder model to shareholder model) influences the accounting treatments of goodwill. Our study is based on four countries (Great Britain, the United States, Germany, and France) and covers more than a century, starting in 1880. We explain that all these countries have gone through four identified phases of goodwill accounting, classified as (1) “static” (immediate or rapid expensing), (2) “weakened static” (write-off against equity), (3) “dynamic” (recognition with amortization over a long period) and (4) “actuarial” (recognition without amortization but with impairment if necessary). We contribute several new features to the existing literature on goodwill: our study (1) is international and comparative, (2) spans more than a century, (3) uses the stakeholder/shareholder models to explain the evolution in goodwill treatment in the four countries studied. More precisely, it relates a balance sheet theory, which distinguishes four phases in accounting treatment for goodwill, to the shift from a stakeholder model to a shareholder model, which leads to the preference for short-term rather than long-term profit, (4) contributes to the debate on whether accounting rules simply reflect or arguably help to produce the general trend towards the shareholder model, (5) demonstrates a “one-way” evolution of goodwill treatment in the four countries studied, towards the actuarial phase.     

Estimating the Equity Risk Premium Using Accounting Fundamentals

This study uses recent developments in the theoretical modelling of the links between unrecorded accounting goodwill, accounting profitability and the cost of equity, together with Capital Asset Pricing Model (CAPM) betas, to estimate the ex-ante equity risk premium in the UK. The results suggest that, over our sample period from 1968 to 1995, the premium has been in the region of 5%. Our estimate lends support to the view that the ex-ante equity risk premium is substantially less than the historical average of the excess of equity returns over the risk-free rate, and is similar to the rates applied recently by UK competition regulators.     

Harmonisation of Accounting Measurement Practices in the European Community

This study attempts to determine the level of accounting harmonisation in the European Community by examining selected measurement practices from the 1992/93 annual reports of companies from Belgium, Denmark. France, Germany, Ireland, the Netherlands. Portugal and the UK. Harmonisation is tested using the chi-square statistic and measured using the / index. The chi-square statistic tests for the equality of the proportions of accounting measurement methods across countries. The / index measures the extent of concentration around a particular accounting measurement method. The results reveal that accounting for foreign currency translation of assets and liabilities, treatment of translation differences, and inventory valuation are harmonised, while accounting for fixed asset valuation, depreciation, goodwill, research and development costs, inventory costing, and foreign currency translation of revenues and expenses are not harmonised. The results also demonstrate that the extent of harmonisation is greater among fairness oriented countries than among legalistic countries.     

The relative and incremental value relevance of goodwill before and after SFAS No. 142

We explore the value relevance of goodwill against two benchmarks: other accounting information and long-lived tangible assets. Prior research suggests that fair value estimates for goodwill must be inferred from other available information because of the nature of goodwill, including its intangibility. Such inferences are highly discretionary and may limit the usefulness of reported goodwill estimates. Because Statement of Financial Accounting Standards (SFAS) No. 142 relies exclusively on fair value estimates to subsequently measure goodwill, reported values considering management’s increased discretion may be less reliable and less value relevant when presented in conjunction with other accounting information. However, the subsequent accounting measurement for goodwill is not dissimilar from the subsequent measurement for long-lived tangible assets, which are also subject to impairment. In general, impairment measurement is subjective; management may have greater insight, even in the presence of management incentives and other accounting information, that may help confirm or disconfirm investors’ own goodwill estimates. Using other accounting information and long-lived tangible assets as benchmarks for the value relevance of goodwill, we find that reported goodwill provides greater value relevance relative to other accounting information after SFAS 142 and that the difference between the value relevance of goodwill and other long-lived tangible assets is also significantly greater following SFAS 142.     

The Measurement of Harmonisation and the Comparability of Financial Statement Items: Within-Country and Between-Country Effects

This paper reports on an analysis of accounting policy choices made by European companies with an international shareholding. The accounting policies analysed in depth in this paper comprise the treatment of goodwill and accounting for deferred taxation. In the paper, the van der Tas comparability index is developed by separating the index into two components relating to the within-country (intra-national) effects of domestic standardisation and the between-country (inter-national) effects of harmonisation. It is shown in this paper that the value of the index may be interpreted as the probability that two companies selected at random will report financial information that is comparable, and that the lowest level of comparability exists when the accounting methods are assumed to be distributed equiprobably over the companies, the outcome of a random selection of accounting policies. The paper also considers the problems of non-disclosure, and a comprehensive ‘disclosure-adjusted’ comparability index is proposed.