Goodwill and Amortization: Are They Value Relevant?

ABSTRACT The Financial Accounting Standards Board (FASB) proposed different methods for the treatment of goodwill after acquisition. Just recently, the FASB issued a new accounting standard requiring no amortization but periodic assessment of goodwill for impairment. This treatment implies that goodwill has an indefinite economic life. An earlier proposal suggested amortization of goodwill over a maximum of 20 years. This treatment implies that the contribution of goodwill to the generation of revenue is finite. This study examines whether the equity markets value goodwill as an economic resource and, if so, whether or not amortization of goodwill is related to the market value of the firm. Such research is vital to the evaluation of the treatment of goodwill in domestic and international accounting standards. An analysis of five consecutive years of financial statement data for 96 firms (480 firm-year observations) indicates that goodwill is positively associated with firm value. Furthermore, goodwill amortization has a significant negative relation with equity values in some individual years and in an analysis with the data pooled across years. Together, these results imply that the market views goodwill as an economic resource that declines in value, and the decline in value is related to the amortization methods used by firms in the sample. (ProQuest: ... denotes formulae omitted.) INTRODUCTION Economic goodwill reflects the ability of a company to earn an excess return on investment. Economic goodwill may be attributed to the company's reputation, superior technology, superior management, or other favorable characteristics that enable the company to earn excess returns. In some cases, these favorable characteristics may be maintained for long periods, but in other cases, they diminish rapidly Accounting standards in the United States specify that a company recognizes goodwill only when the goodwill is acquired through a purchase transaction, e.g., goodwill appears on the consolidated financial statements as a result of a merger of two business entities. Accounting standards define goodwill as the difference between the purchase price and the fair value of the net assets of the acquired company. This accounting treatment implies that goodwill is initially valuable for the purchasing firm: goodwill generates a future stream of earnings and cash flow. The way in which amounts are assigned to goodwill raises the possibility that the goodwill recognized in a purchase may not always represent superior future earnings potential, i.e., economic goodwill. Differences between the purchase price and the fair value of net identifiable assets may result from an excessive price paid for an acquisition or from including in the purchase price the investment banking and legal fees, financing costs, or other costs not related to the future earnings potential of an acquisition. A recent change in U.S. accounting standards, Financial Accounting Standards Board (FASB) Statement No. 142, Goodwill and Other Intangible Assets (FASB, 2001, hereafter referred to as Statement 142), prohibits systematic amortization of goodwill. As suggested by Statement 142, if goodwill produces positive cash flows indefinitely, and there is no apparent decline in value, then greater representational faithfulness might be achieved if goodwill is capitalized and periodically reviewed for impairment rather than systematically amortized. However, if goodwill declines in value without an adjustment through either amortization or a write-down, if impaired, assets and income are overstated, and the financial statements are not representati onally faithful. Under the prior accounting standard, firms amortized goodwill over a period not exceeding 40 years. Similarly, current international accounting standards require amortization over a period not exceeding 20 years. If goodwill does not produce cash flows in perpetuity and a decline in value is apparent, then better representational faithfulness may result from a policy of capitalization and subsequent amortization. …