Academic journal article International Advances in Economic Research

Models to Measure Goodwill Impairment

Academic journal article International Advances in Economic Research

Models to Measure Goodwill Impairment

Article excerpt

Abstract

Statement of Accounting Standards No. 142 [2001f superseded the former rules of accounting for amortization of goodwill under Accounting Principles Board Opinion No. 17 [1970]. Entities must now recognize annually impairments in the value of the goodwill associated with purchased firms, rather than amortizing such expenses ratably over 40 years. This better matching of revenues and expenses provides for more valid financial statements, but also mandates accountants to select proper models to measure such impairment losses. The authors highlight some reasons for the issuance of this new standard, compare and contrast the effects of the discounted cash flows and residual income methods to measure such impairments, and suggest how to develop a conceptual model to adhere to the new authoritative provisions. (JEL M41)

Introduction

Since 1970, rather than expensing goodwill immediately, entities have written goodwill off over its useful life (that is, up to a 40-year period), in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 17. But, since goodwill loses much of its value in the earlier years of its existence, the Financial Accounting Standards Board (FASB) recently issued Statement of Financial Accounting Standards (SFAS) No. 142. Briefly, entities must now match such declines in goodwill over their useful lives, by recognizing such declining values much earlier in the acquisitions cycle and, in no case, over more than 20 years. This article outlines some major provisions of this new standard and introduces some methods to help ascertain how to value such goodwill.

Under SFAS No. 142, rather than amortizing goodwill, entities should now at least annually test the impairment of the excess prices they paid for such purchased assets, and write off such declines during those periods. This matching of declines in the excess prices paid for such assets with the periods that the declines occurred should produce more relevant financial statements, as when, say, the neighborhood surrounding a highly valued purchased piece of property declines. The FASB calls the carrying amounts less the fair values of such assets as impairments. Various experts [Valdmanis, 2002] expect that such impairments will cause American companies to write off over a trillion dollars of purchased goodwill.

What is Goodwill?

Entities should record goodwill only when they purchase other entire businesses, since goodwill represents the difference between the price paid for the entire business and all specifically identified assets. For example, a real estate developer may purchase a competitor's properties and customers for more than the fair (market) value price of each individual rental unit, primarily in buying a going (business) concern. This valuation is inseparable from the business' value as a whole. The resultant goodwill equals the purchased price of the acquired business less the fair market value of net tangible and identifiable intangible assets. Thus, this difference, that is, goodwill, is often called a plug, gap filler, or master valuation account. Similarly, entities should not recognize goodwill generated internally, even if they can prove that such assets are worth more than they paid for it, since no objective valuation method arises.

If quoted market prices are unavailable, estimates of fair value should be based on the best available information, usually considering prices for similar assets and liabilities and using appropriate valuation techniques, such as the present value of estimated future cash flows, option-pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis. Firms should use objective valuation techniques to measure such declines in the fair values of their net assets by incorporating assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.