There is a lot of discussion these days about accounting for goodwill, especially with respect to accounting issues subsequent to its acquisition. This debate is driven by managerial criticisms of goodwill impairment testing, which led to the Financial Accounting Standards Board’s invitation to comment. FASB asked responders to tell them what goodwill is, which is a peculiar question as the board already defines and describes goodwill. I suppose FASB is feeling less confident about its conceptual foundations for goodwill. No wonder there is angst about the accounting issues subsequent to its acquisition!
The more important question — more important because more practical — is whether to continue impairment testing or whether to employ straight-line amortization. The board further asks those who prefer amortization how to implement the process, e.g., asking them about the useful life over which to amortize goodwill.
Goodwill should not be accounted for as an asset or, if it is, it should be immediately be written off to stockholders’ equity. Catlett and Olsen made this recommendation in their 1968 AICPA research study. In their words, “Amounts paid for goodwill in a business combination represent disbursements of a portion of a company’s resources … in anticipation of future earnings. The disbursement of resources reduces the stockholders’ equity in a company’s separable resources … and accounting for purchased goodwill as a reduction in stockholders’ equity evidences the fact.”
Former board member Walter Schuetze was more blunt — in a speech when he was SEC chief accountant, Schuetze claimed that the definition of asset was deficient, and that the definition should include exchangeability as an important element. As goodwill is not exchangeable, it could never be an asset.
While I agree with Catlett and Olsen and with Schuetze, FASB will never move that far. It has too much invested in its conceptual framework and such a move would be revolutionary. The board prefers incrementalism. Let’s be realistic and move to accounting for goodwill subsequent to its acquisition.
The debate seems to be one of relevance versus cost. Those who want to continue the status quo, maybe with some minor tweaks, argue that impairment losses reveal to investors changes in the value of a firm’s goodwill. Of course, they assume that such fair value measurements are useful to the investment community. Some managers, however, grumble that fair value measurements are too costly to obtain.
Some even complain that the measurements are too subjective, thus giving the measurement low reliability. This is an ironic comment since managers usually like subjectivity, as it enables exploitation when it is time to prepare financial reports. More on that later.
The subjectivity comment is also interesting because of the change in the conceptual framework in 2010. Originally, the conceptual framework (May 1980) stated that the two pillars of qualitative characteristics of accounting information are relevance and reliability. The amended conceptual framework (September 2010) replaces reliability with faithful representation with little justification. Indeed, FASB confuses things with the odd comment that it had employed the term reliability “to describe what is now called faithful representation.” This strange remark belies the relatively clear distinction between the terms as defined in the 1980 conceptual framework.
But now, for some reason, the board felt that “faithful representation” was well-defined but “reliability” was ambiguous. I can hypothesize the real reason — the board got sick and tired of investors complaining about the unreliability of fair value measurements. The board, almost religiously, has put fair values on a pedestal and proclaims their relevance and now their faithful representation. It hopes not to address the ebb and flow of fair value vicissitudes.
Which brings us to today’s goodwill issue. The problem is that the fair value of goodwill requires measurements having low trustworthiness, and goodwill measurement initially depends on the fair values of assets and liabilities and previously unrecognized intangibles. Thereafter, it depends on who knows what. It is rife for exploitation because nobody genuinely knows the fair value of goodwill.
The real problem of fair value measurement is that it enables financial statement fraud. Gerald Zack’s book “Fair Value Accounting Fraud” describes myriads of ways to deceive investors with fair value measurements. He looks at many assets and liabilities, including financial instruments and business combination accounting. In this text, wayward managers would find a treasure trove of methods to improve financial statement optics.
If FASB would like to do something really worthwhile, I recommend it revisit the conceptual framework and include as an objective the goal of reducing financial statement fraud. Then the board should adopt standards that give managers little room to exploit financial accounting.
In the meantime, I recommend getting rid of the impairment testing of goodwill; it is a bunch of crock anyway. The profession should adopt goodwill amortization, not because it is more relevant, but because it is less prone to managerial manipulation, especially if we add a relatively low maximum life for goodwill (say five years).
Let’s improve goodwill accounting not by some academic exercise and thereby deceive ourselves that we have improved financial reporting. Instead, let’s improve goodwill accounting by reducing areas of exploitation.
This essay reflects the author’s opinion and not necessarily the opinion of The Pennsylvania State University.