Obtaining high quality financial statements for goodwill accounting:

IFRS, DUTCH GAAP or

US GAAP?

Maaike Ché Thesis supervisor dr. C. Clune

BSc Accountancy and Control

University of Amsterdam

Student number 6128157

Final version 29/6/2013

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Abstract

In this study I want to examine which financial statement under IFRS, DUTCH and US

GAAP has the highest quality for goodwill accounting in the Netherlands and the US. It

seems that local GAAP’s still do not have enough discretion to avoid fraud scandals. This

is why the IFRS was introduced. The goals of the IFRS are to develop global high-quality

and understandable financial reporting standards. The IFRS is expected to present the

highest quality of financial statements for goodwill accounting.

From 2005 onwards, unlisted companies in the Netherlands can value goodwill

under the DUTCH GAAP and the IFRS. In the US, listed companies can value goodwill

under the US GAAP and IFRS. Unlisted companies in the Netherlands and listed

companies in the US can still choose between the local GAAP on the one hand and IFRS

on the other hand. It is relevant for them to determine whether the implementation of

IFRS improved the quality of financial reporting for goodwill accounting. I shall start by

analyzing the quality of financial statements for the US GAAP and the DUTCH GAAP for

goodwill accounting by reviewing the literature. Thereafter, I compare the quality of the

financial statements for local GAAP’s with the IFRS. In other words, a higher quality of

financial statements for goodwill accounting under the IFRS is obtained if the financial

statements for goodwill accounting contain more qualitative characteristics of

accounting information, provided that the obtained qualitative characteristics are

absent in the local GAAP.

Overall, the results show that the financial statements for goodwill accounting in

the Netherlands do not provide comparable and useful financial information for

investors. We do not find high-quality financial statements here. The impairment test in

accordance with the IFRS still shows a lack of qualitative characteristics, but it did

increase the usefulness of the financial statements. Based on these results, there is some

progress, therefore the IFRS is a more favorable goodwill accounting method in the

Netherlands. However, the FASB 142 in accordance with US GAAP, provide all

qualitative characteristics. Since the IFRS only improves the usefulness of the financial

statements, the adoption of these standards will decrease the quality of financial

reporting. Based on the results found, the US GAAP provides the highest quality of

financial statements for goodwill accounting in the US. On the one hand, unlisted

companies in the Netherlands could implement IFRS to assess goodwill. On the other

hand, listed companies in the US could enhance the US GAAP, to obtain the highest

quality of financial statements for goodwill accounting. 2

Dutch Summary

Nederlands beursgenoteerde bedrijven dienen sinds 2005 hun jaarrekening op te stellen

volgens de regels van de Internationale Financial Reporting Standards (IFRS). Niet-

beursgenoteerde bedrijven hebben nog de keuze om hun jaarrekening te waarderen

tegen de Nederlandse Richtlijnen voor de Jaarverslaggeving (RJ) en IFRS. Die nieuwe

standaarden worden ingevoerd omdat er behoefte is aan Europese financiële integratie

om transparante en eenduidige jaarverslagen op te stellen. Amerikaanse

beursgenoteerde bedrijven mogen vanaf 2005 ook hun jaarrekening volgens IFRS op

stellen. Voorgaands, was de US General Accepted Accounting Principles (GAAP) de enige

boekhoudmethode. IFRS wordt ook in de Verenigde Staten (VS) uitgevoerd omdat daar

grote boekhoudschandalen zijn geweest en dit wilt IFRS voorkomen door strengere

maatregelen te nemen.

Er zijn discussies gaande over de waardering van goodwill. De definitie van

goodwill wordt in deze scriptie gedefinieerd als “goodwill ontstaat bij de overname van

een ander bedrijf of deels daarvan, omdat goodwill niet gekocht of verkocht kan worden

als een apart bedrijfsdeel, en heeft toekomstige economische voordelen”. Het gaat

hierbij om positieve en gekochte goodwill, want zelfontwikkelde goodwill wordt niet

geactiveerd in de jaarrekening. Volgens de RJ wordt goodwill gewaardeerd door de

afschrijvingsmethode. Dit houdt in dat goodwill jaarlijks afgeschreven wordt tegen de

resultaten. De afschrijvingduur wordt bepaald door de geschatte economische

levensduur van goodwill, minimaal 10 jaar en maximaal 20 jaar. Voorheen hanteerde de

VS ook een afschrijvingmethode met een maximum van 40 jaar maar de US GAAP

beweert dat goodwill een oneindig levensduur kan hebben en daarom mag deze method

niet meer gehandhaafd worden. Om deze redden werd de Statement of Financial

Accounting Standards (SFAS) 142 ingevoerd om de economische waarde van goodwill

beter te weergeven in de jaarverslagen. Deze standaard introduceert de impairment test.

Een impairment houdt in dat de boekwaarde van de “reporting unit”, inclusief goodwill,

de reële waarde overtreft. Het overschrijvende bedrag, oftewel het verlies van de

waardevermindering, wordt vervolgens van de inkomen afgehaald. De impairment test

wordt in twee stappen geoperationaliseerd.

IAS 36 is een standaard die ingevoerd is door IFRS om bijvoorbeeld goodwill te

waarderen, ook hier wordt een impairment test uitgevoerd. Volgens deze standaard

wordt onder impairment loss verstaan, dat de boekwaarde van goodwill de “recoverable

amount” overschrijdt van de “business unit”. Veelgaands wordt de gebruikswaarde

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gebruikt voor “recoverable amount”.

De onderzoeksvraag van deze scriptie luidt: “in hoeverre is de kwaliteit van de

jaarverslagen voor goodwill verbeterd door de invoering van IFRS in Nederland en de

VS?” Om deze vraag te beantwoorden zijn er drie kwalitatieve kenmerken toegekend om

kwalitatieve jaarverslagen te identificeren. De kenmerken zijn; vergelijkbaarheid,

tijdigheid en verifieerbaarheid. Overigens is de kwaliteit van jaarverslagen ook

verbeterd als het nut toegenomen is. Allereerst worden de locale GAAP’s individueel

bekritiseerd door te stellen of de afschrijvingsmethode/ impairment kwalitatieve

jaarverslagen presenteren. Vervolgens worden deze methodes vergeleken met IFRS

door middel van de kenmerken voor kwalitatieve jaarverslagen. Hieruit kan worden

geconstateerd of de invoering van IFRS heeft gezorgd voor verbeteringen en kwalitatief

betere jaarverslagen. IFRS zorgt voor betere jaarverslagen als de economische waarde

van goodwill beter gereflecteerd wordt in het jaarverslag conform IFRS dan de locale

GAAP’s.

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Table of Contents

Chapter Pages

1. Introduction……………………………………………………………………………………………... 6

2. Description of goodwill ………………………………………………………………………......... 8

2.1 Definitions of goodwill…………………………………………………………………………. 8

2.2 List of problems……………………………………………………………………………………8

2.3 Fair value……………………………………………………………………………………………..9

2.4 High quality financial reporting……………………………………………………………. 9

2.5 Positive and negative goodwill……………………………………………………………...10

2.6 Conclusion……………………………………………………………………………………………11

3. Measurement of goodwill in the Netherlands under DUTCH GAAP……………….12

4. Measurement of goodwill in the United States of America under US GAAP…....14

4.1 History background US GAAP………………………………………………………………...14

4.2 Introduction of SFAF 142……………………………………………………………………….14

4.3 Impairment ……………………………………………………………………………………….….15

4.4 Conclusion……………………………………………………………………………………….……16

5. Measurement of goodwill under IFRS………………………………………………….………17

5.1 Introducing IFRS 3 and IAS 36…………………………………………………………….…17

5.2 Impairment IAS 36………………………………………………………………………….…….17

5.3 Conclusion…………………………………………………………………………………………....18

6. Discussion…………………………………………………………………………………………………19

6.1 Financial reporting under DUTCH GAAP………………………………………………..19

6.2 Financial reporting under US GAAP……………………………………………………….20

6.3 Financial reporting under IFRS……………………………………………………………...21

6.4 Alternatives………………………………………………………………………………………….23

6.5 Conclusion……………………………………………………………………………………………24

7. Conclusion…………………………………………………………………………………………………26

8. References…………………………………………………………………………………………………29

9. List of figures and exhibits…………………...……………………………………………………..31

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1. Introduction

Financial reporting in the Netherlands involves many laws and regulations. Sometimes,

these laws and regulations need to be adjusted due to changes in the economy. The

International Financial Reporting Standards (IFRS) were introduced in 2005. Listed

companies in the European Union (EU) have started to report their financial accounts

according to these new standards from this date (IFRS, 2013). The principal objectives

of the IFRS are to develop a single set of high-quality and globally accepted financial

reporting standards. According to Le Blond (2011), the EU decided to adopt the IFRS

because they needed common accounting standards to enhance European financial

integration. Furthermore, listed companies in the United States (US) on the US stock

exchange, could also report their financial statements in accordance with the IFRS from

2005 onwards. The fraud scandals of Enron and Worldcom meant that the quality of US

Generally Accepted Accountancy Principles (GAAP) were considered less reliable.

One of the changes in the IFRS relates to the valuation of goodwill. For the

valuation of purchased goodwill, companies have to carry goodwill on the balance sheet

and then annually analyze the changed value of the goodwill in accordance with the IFRS.

This is described as an impairment. The annual impairment test can be performed at any

time during an annual period. The test has to be performed at the same time every year

thereafter (IAS 36, 2012).

In the Netherlands, unlisted companies can choose between the IFRS and the

DUTCH Generally Accepted Accountancy Principles (GAAP). The valuation of goodwill

according to the DUTCH GAAP can be measured as follows. Goodwill can be deducted

from the equity, deducted from the profit and be entered and then systematically

written off according to its economically useful lifetime (Hoogendoorn, 2002). From

2005 onwards, listed companies in the US also have the option to choose between the US

GAAP and the IFRS. Previously, the US GAAP allowed un(listed) companies amortize

their purchased goodwill over 40 years, but according to Akwasi (2005), this lacked

discretion. The amortization method in the US was replaced by the impairment test in

accordance with the US GAAP in 2001.

Goodwill can be measured in several ways for different companies in many

countries. This thesis will focus on two countries, the Netherlands and the US. These

countries are specifically chosen, because the goal of this thesis is to compare goodwill

accounting in a European country, the US and the worldwide accounting method IFRS. It

is also relevant to investigate the quality of financial reporting with respect to goodwill

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in accordance with the accounting principles in these countries. According to IFRS (2013)

the goal of the implementation of the IFRS is to obtain high-quality, understandable, and

globally accepted financial reporting standards based on certain principles. However,

Sahut et al. (2011) studied the intangible assets of European listed firms, and concluded

that the book value of these assets was valued higher under the IFRS than under the

local GAAP. European investors concluded that the value of goodwill under the local

GAAP was more reliable than under the IFRS. This study concludes that the new

accounting rules for goodwill did not lead to improved financial reporting. Therefore

this thesis will discuss whether the implementation of the IFRS has improved financial

reporting concerning goodwill. The research question will be the following: how did

goodwill accounting under the IFRS improve the quality of financial reporting compared

to the GAAP for goodwill in the Netherlands and the United States of America?

After closely examining the three goodwill accounting methods, it seems that the

US GAAP produces the highest quality financial reporting. For listed companies in the US,

the local GAAP is a better tool to assess goodwill than the IFRS. Furthermore, no

evidence was found that the DUTCH GAAP produced high-quality financial reporting.

Having said that, the usefulness of financial statements for goodwill accounting did

increase under the IFRS in the Netherlands. The IFRS is therefore the optimum choice

for goodwill accounting for unlisted companies in the Netherlands.

The research question will be answered with a review of the literature. Various

authors will explain the valuation methods for goodwill and discuss what the quality of

financial statements is if these methods are followed. The structure of this thesis will be

the following. In chapter two important terms will be discussed. The definition of

goodwill will be discussed and an example of how to calculate goodwill will be provided.

The characteristics to determine high quality reports will be briefly analyzed as well.

Chapter three will discuss how goodwill is measured under the DUTCH GAAP whereby

the write-off method is generally considered to be the most important method. Chapter

four will discuss how goodwill is measured under the US GAAP and the impairment test

will discussed. In chapter five, the valuation of goodwill under IFRS is discussed. Chapter

six will focus on the advantages and disadvantages of the three goodwill accounting

methods. Finally, chapter seven will address the conclusion.

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2. Description of goodwill

This chapter will explain important terms, that are necessary understand the discussion

on the valuation of goodwill. Firstly, three definitions of goodwill will be described. After

this term is defined, I shall explain how goodwill is measured and a list of factors causing

problems for goodwill. Thirdly, the term ‘fair value’ will be explained briefly. The

qualitative characteristics are also described, positive and negative goodwill will be

distinguished and a conclusion to this chapter is presented.

2.1 Definitions of goodwill

Seetharaman et al. (2006) quote previous definitions of goodwill from Bithell’s (1882)

and Spacek (1964). Bithell’s describes goodwill as “a willingness of an owner of a

business to relinquish the expectation of the business by transferring it for a consideration

to someone else, which is known as “selling the goodwill of that business””. Spacek defined

goodwill as “the present value placed on anticipated future earnings in excess of a

reasonable return on producing assets. Thus, it is the cost to the buyer of earnings over and

above the cost of the assets required to produce these earnings”. And in the 20th century,

Wines et al. (2007) define goodwill as the follow: “future economic benefits arising from

assets that are not capable of being individually identified and separately recognised”.

Based on three definitions from three centuries, the term goodwill in this thesis shall be

defined as follows: “goodwill arises when a company has purchased another company or

part thereof, because goodwill cannot be purchased or sold as a separate part, and it can

have future economic benefits”. Goodwill is hard to define because definitions vary from

century to century.

2.2 Problems

Goodwill is measured and recorded as the price paid to acquire a company in excess of

the fair value of its intangible assets. Brunovs and Kirsch (1991) state that goodwill is

difficult to determine, there is not even an unambiguous definition. There are six key

issues that represent the main areas of debate in goodwill accounting: non-recognition

of internally generated goodwill, measurement of purchased goodwill, amortization

guidelines, reassessment of carrying value of goodwill, disclosure requirements in

financial statements and the treatment of excess of assets over the purchase 8

consideration. In other words, the increased value of goodwill for a business is not

recognised. In general, the term “goodwill” in this essay should be understood as the

purchased goodwill. Purchased goodwill can be measured under the local GAAP, IFRS or

other accounting principles. The choice of accounting principles makes it complex, as

does the amortization guidance under these principles. To determine the carrying value

is also complicated, considering this value contains the original cost of an asset minus

the accumulated amount of any depreciation or amortization. Furthermore, the

purchase consideration can be measured differently.

2.3 Fair value

Fair value accounting (FVA) is a method to calculate assets and liabilities that appear on

the balance sheet. Financial Accounting Standard 157 defines fair value as “the price that

would be received to sell an asset or paid to transfer a liability in an orderly transaction

between market participants at the measurement date”. The IFRS‘s definition for fair

value is “the amount for which an asset could be exchanged, or a liability settled, between

knowledgeable, willing parties, in an arm’s length transaction”. Meanwhile, assets and

liabilities can also be reported at their historical cost. Proponents of the FVA state that

fair values for assets or liabilities provide timely information and increase transparency.

Opponents state that fair value is not relevant, unreliable and misleading for long-term

assets. Prices can be disturbed by market inefficiencies and liquidity problems under the

FVA (Laux and Leuz, 2009). The term “fair value” is important in this essay, because the

amount of goodwill consist of the difference between the price paid for the acquired

business and the fair value of the net identifiable assets.

2.4 High- quality financial reporting

IASB (2008) defines relevance and faithful presentation as the most important

qualitative characteristics to control the valuations in the financial statements. Financial

reporting information must be both relevant and faithfully represented if it is to be

useful. The qualitative characteristics to improve decision usefulness are comparability,

verifiability and timeliness. If one or more of these characteristics appear, the quality of

the financial reporting is improved and that means a stronger linkage to a high-quality

report. This thesis assumes that all financial reporting information is useful, the

question is if the financial statement also has the qualitative characteristics to improve 9

the quality of the statements. The characteristics will be analyzed in-depth in the

following.

The first characteristic is comparability. De Franco et al. (2011) developed the

comparability measurement and defined comparability as the ability to compare

economic events and accounting methods of similar firms at the same time. Another

approach is the similarity of the firms’ accounting methods that implement economic

events into accounting data. In this context, financial statements are comparable if the

same goodwill accounting is used for similar firms. Investors and users can compare the

financial information of several firms with the same brand to make useful decisions. The

next characteristic is described by Bull and Watson (2004). The term “verifiability” is

given as “an external enforcer can observe a given aspect of a contractual relationship”.

This implies that the same goodwill accounting approach could arrive at the same

amount by different people. An unverifiable situation occurs if the amount of goodwill

deviates in calculations by different people. The last characteristic “timeliness” is

defined as the option that available financial information can influence the decisions of

users in time (Palepu et al., 2007). If the utility of financial information increases for

users and practitioners for other reasons, the quality of the financial reporting is also

improved.

2.5 Positive and negative goodwill

Positive goodwill will be created if the purchase price of a company exceeds the fair

value of its net identifiable assets.

Example:

Company A’s

balance sheet

Assets 10000

Equity 6000

Liabilities 4000

Total

assets 10000

Total equity and

liabilities 10000

Positive goodwill arises if company A is sold to company B for 15000. The purchase

price of 15000 deducted by the net identifiable assets of 6000 will create a positive

goodwill of 9000. The net identifiable assets have a value of 6000 because the total 10

assets should be deducted by the liabilities. In other words, a purchase- price higher

than 6000 will lead to positive goodwill. On the other hand, negative goodwill will be

created if the purchase price of a company does not exceed the fair value of net

identifiable assets. In this example the purchase price of company A should be lower

than 6000. Lys et al. (2012) argue that negative goodwill is not a common issue. In this

case company A would rather sell his assets for 10000 and pay back the liabilities of

4000 and keep 6000, than sell the company for lower than 6000. Negative goodwill

occurs if a company is on the verge of bankruptcy or if the company is aware of the loss

but would rather sell it than invest more time.

2.6 Conclusion

The term goodwill is difficult to understand because there is no unambiguous definition.

There are factors that complicate determining the definition of goodwill. In this essay

goodwill is defined as “goodwill arises when a company has purchased another

company or part thereof, because goodwill cannot be purchased or sold as a separate

part, and it can have future economic benefits”. Goodwill occurs if the purchase price of

an acquired company or a part thereof differs from the fair value of the net identifiable

assets. If the difference is positive, positive goodwill is created. On the other hand, a

negative amount leads to negative goodwill. In this essay goodwill refers to positive

goodwill and the purchase-price exceeds the fair value of the net identifiable assets. The

qualitative characteristics determine whether high quality financial reporting for

goodwill accounting is obtained.

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3. Goodwill measured in accordance with DUTCH GAAP

There are three methods of the valuation of goodwill under the DUTCH GAAP. Goodwill

can be deducted from the equity, it can be deducted from the profit and it can be

activated and then systematically written-off according to the economic useful lifetime.

Krens (2003) argues that the write-off method is the most relevant one, because the

other two choices can no longer be made from 1 January 2001 onwards. I shall

therefore focus on the write-off method, the other methods will not briefly be described

in this thesis.

The DUTCH GAAP offer companies flexibility in accounting standards, such as in

the treatment of goodwill. Dutch companies usually deducted goodwill against owner’s

equity, as long the profits were not affected in the current and following years. The other

method is to deduct goodwill from the profit and loss account in one time (Roosenboom

et al., 2003). As previously described, the write-off method is implemented from 2001

onwards, according to Krens. Pursuant to Dutch regulations, goodwill is activated on the

balance sheet for the highest expenses deducted by the associated amortizations. The

activated goodwill will be amortized by the expected useful lifetime, to a minimum of 10

years and a maximum of 20 years under Dutch guideline (RJ) 500.221. That implies that

goodwill is to be amortized by a minimum of five percent and a maximum of ten percent

annually. To determine the expected useful lifetime is not simple this is complicated by

several factors. Sometimes an infinite expected useful lifetime can occur which exceeds

the maximum of 20 years. The expected useful lifetime or amortization period is the

period where future economic benefits are being realized. The RJ 500.225 identifies the

factors to determine the amortization period: the nature of the activities, the stability of

the industry, benchmarking, the level of investment and funding to realise the expected

future economic benefits etc.. Another issue is the uncertainty of the economic crisis.

There is a possibility that goodwill has become worthless in the last years due to the

recession. In this case, an opportunity is provided to value goodwill as a recoverable

amount (if there is a sustainable depreciation). This is a faster method to deduct

goodwill from profit but this can only be used if the profit is much lower than expected

(2003, pp 109-111).

This chapter concludes that the write-off method is the most common method to

measure goodwill in accordance with the DUTCH GAAP. The expected useful lifetime of

goodwill is difficult to determine and this refers to the amortization period. The DUTCH

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GAAP provides a limit to the amortization period and there is a list of factors to

determine the amortization period.

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4. Goodwill measured according to the US GAAP

In this chapter the US GAAP method will be introduced. First, the historical background

of US GAAP will be described briefly, which will lead to the introduction of the Statement

of Financial Accounting Standards 142. These standards provide an in-depth

understanding of the impairment test and factors that cause the impairment will be

listed.

4.1 Historical background US GAAP

Davis et al. (2012) also confirm that goodwill can be generated internally and externally.

Internal goodwill can be obtained through superior management, successful advertising

campaigns etc. External goodwill can be generated by a business combination. But only

goodwill resulting from a business acquisition is recorded as goodwill on the balance

sheet. In 1944, the Accounting Research Bullletin (ARB) 24 was the first US guidance for

goodwill. In, accordance with the rules, goodwill was treated as an asset at cost price. If

the useful lifetime of goodwill was relatively short, a company had the option to write off

part of the goodwill by deducting retained earnings, and amortizing the other part of the

goodwill. This exception was implemented because goodwill became worthless in the

long-term, contrary to the book value. Later the ARB applied two methods: the

systematically amortizing goodwill and not amortizing goodwill if there was no evidence

of a loss or limited life. The ARB had doubts about the two methods because it was too

vague and therefore it published opinion 17. Opinion 17 adopts four characteristics to

valuate goodwill: retain goodwill indefinitely as an asset, until the value has diminished,

amortization of goodwill in an arbitrary period, amortization period has a specified

range or an estimated life and deduct the cost of goodwill from the equity at the time of

purchase Considering these characteristics, the ARB decided to amortize goodwill within

40 years.

4.2 Introducing the Statement of Financial Accounting Standards 142

According to the Financial Accounting Standards Board (FASB), goodwill can have an

indefinite life and therefore the amortization period of 40 years in accordance with ARB

is not discrete enough. The FASB is an organization that has the objective to improve US

financial accounting standards for companies in the public interest. The FASB therefore

introduced a new system, the annual impairment test. Actually this was not a brand new

system, the impairment test was already used for the valuation of account receivables,

14

inventories, real estates etc. (Massoud and Raiborn, 2003). Jermane (2002) also argues

that goodwill can be created in accordance with the US GAAP, if a company pays an

additional sum over the fair value of the acquiring company. Amortization of goodwill is

only possible, if goodwill exceeds the fair value of goodwill on the balance sheet.

The FASB introduced the Statement of Financial Accounting Standards (SFAS)

142 in 2001. The board predicted that the statement will improve financial reporting

because it better reflects the underlying economics of those assets. Also, the SFAS 142

helps users to better comprehend the expectations and changes in goodwill over time.

The standards address how goodwill should be accounted for in the financial statements

and represent an important innovation compared to previous practice and standards

that rely on estimates of the current value of goodwill by the management. Amortization

of goodwill should be terminated and a periodic impairment test should be implemented

(Ramanna and Watts,2012).

4.3 Impairment

The SFAS 142 defines that goodwill without an estimated useful lifespan should be

tested for impairment at least annually at the reporting unit level. A reporting unit is an

operating business segment or a rank below this segment. A rank below an operating

business segment, which is referred to as a component, qualifies as a reporting unit if

the component forms a business with discrete financial information and if the

management segment regularly assesses the operating results. In general, goodwill must

be determined and allocated to reporting units. Other assets and liabilities are also

allocated to reporting units, based on the relationship between the other

assets/liabilities and the reporting units. The other assets/liabilities determine the fair

value of those units. Goodwill impairment occurs if the carrying value (book value) of

the reporting unit, including goodwill, exceeds the fair value of the reporting unit.

Factors determining goodwill impairment are: important legal or regulatory changes by

law, unanticipated competitors, unrealized goodwill impairment loss in the financial

statement of a subsidiary, which is also involved in the reporting unit etc. (Hitchner et al.,

2002, pp 76-87).

Hitchner et al. (2002, pp 87-91) describe that goodwill impairment is to

combine the new fair values of the recognized assets and the new fair values of the

unrecognized assets on the valuation date, that may have been occurred between the

purchase date and the valuation date. The fair value of the assets is deducted from the

fair value of the reporting unit to establish the implicit fair value of goodwill. If the 15

implicit value is lower than its carrying value, there is goodwill impairment and goodwill

is written off. Davis et al. (2012) drew up exhibit 1: accounting for goodwill, to better

understand impairment.

Step 1 is the comparison of fair value of the reporting unit to the carrying amount. If the

carrying amount is lower, no further operations are needed. In contrast, step 2 is needed

to process further. In step 2 the implied fair value of goodwill is calculated; the fair value

assets deducted by the fair value of reporting units. If the carrying amount is lower, no

further operations are needed. In contrast, an impairment loss occurs. The authors

describe how macroeconomic conditions, industry and market considerations, cost

factors, overall financial performance etc. are qualitative factors that lead to an

impairment loss.

4.4 Conclusion

After using various methods to valuate goodwill, the FASB eventually introduced the

SFAS 142. Goodwill with an indefinite life should be tested for impairment annually at

the reporting unit level. An impairment loss occurs if the implied fair value of goodwill is

lower than the carrying value. The implicit fair value composes the fair value assets

(recognized and unrecognized) deducted by the fair value of reporting unit.

16

5. Goodwill measured accordance IFRS

This chapter is partially similar to the previous chapter. The US GAAP and IFRS both

implemented the impairment test to valuate goodwill, so this will partially be repeated.

The IFRS introduced the IFRS 3 and IAS 36 in 2003, these standards were published to

provide guidelines for companies to valuate goodwill. This topic will be clarified in the

first paragraph. The impairment under the IFRS and the underlying components will be

explained in next paragraph.

5.1 Introducing IFRS 3 and IAS 36

Many goals of the FASB and IASB are in alignment and both boards high-quality financial

reporting standards. The IASB introduced the IFRS 3 and IAS 36, which concern the

acquisition and goodwill. These standards of the IASB are developing in line with the US

GAAP concerning the valuation date and impairment testing. The IFRS 3 substitutes the

pooling-of-interest method for the purchase method. The assets and liabilities of a

subsidiary should be recognized in the consolidated balance sheet of the parent

company. These assets and liabilities are valued at the purchase date fair values. The

purchasing method refers to identifying all relevant internal and external assets and

estimating their fair values. The IAS 36 is the most relevant standard for the impairment

test. The standard prescribes a complex process for impairment testing, especially for

goodwill, which will be further described in the next paragraph (Glaum et al., 2013).

5.2 Impairment IAS 36

The IAS 36 describes how cash flows and discount value is determined and how

goodwill is assigned to business units. Conforming to these standard, an impairment loss

occurs when the book value of goodwill exceeds the recoverable amount of the cash-

generating/business unit. The impairment test requires an annual valuation of goodwill

and is conducted at the level of business units. Basically, the discounted cash flow

method or other associated methods are implemented to determine the fair value of

these units. The term “recoverable amount” is described in IAS 36.18 as the higher of an

asset’s fair value less the expenses to sell and its value in use. Nevertheless, in practice it

is difficult to measure the exact fair value of the cash-generating/business unit and the

expenses to sell. There are no accurate statements to calculate the exact achieved value 17

from the acquisition. As a result, the IFRS allows companies to apply the value in use as

the recoverable amount because this is less complicated. The value in use is the net

present value (NPV) of a future cash flow that a cash-generating/business unit asset

generates. Furthermore, IAS 36 describes which cash flow components should be

recorded in the valuation (Schultze and Weiler, 2010).

The IAS 36 (2012) also endorses that the objective of IAS 36 is to stipulate that a

company should do an impairment test if its assets are carried more than their

recoverable amount. Furthermore, this article stipulates that is not always necessary to

calculate the fair value of the cash-generating unit less costs or the value in use. If either

of these values exceeds the carrying amount, there is no impairment. Components to

calculate the fair value of assets are: compute the future cash flows the company expects

from the assets, expected fluctuations of these future cash flows, market risk free rate of

interest, uncertainty, non-liquidity, etc.. Moreover, the future cash flows include

projections of cash inflows from the continuing use of the assets, cash outflows to

stimulate cash inflows and net cash flows that are received for the disposal of the asset.

Future cash flows exclude cash inflows or outflows from financing activities and income

taxes.

5.3 Conclusion

The IFRS introduced the IAS 36 to provide specific rules to value goodwill, which would

lead to a better understanding for users of financial reports. The IAS 36 and FASB 142

both state that an impairment test should be conducted annually. If, the book value of

goodwill exceeds the fair value of the goodwill business unit minus the cost or if the

value in use of goodwill occurs, an impairment loss should be recognized in the profit

and loss account in accordance with the IAS 36. There are also specific components to

determine the fair value of assets and future cash flows.

18

6. Discussion

The previous chapters 3, 4 and 5 explained the methods to measure goodwill under the

DUTCH GAAP, US GAAP and IFRS. In this chapter the methods will be compared and as

well as statements from authors concerning the quality of financial reporting. The

discussion distinguishes between the quality of financial reporting for goodwill under

the DUTCH GAAP, US GAAP and IFRS. The quality of financial reporting for the three

methods will be individually criticized. At the end there are alternative explanations of

the findings. After the comparison in this chapter, a conclusion will be submitted for the

research question in chapter 7.

6.1 Financial reporting under the DUTCH GAAP

From 2001 onwards, the write-off method is the only method to measure goodwill in the

Netherlands. The amortization period for goodwill is calculated with the expected useful

lifetime, at least 10 years and no more than 20 years. Hoogendoorn (2002) states that

the expected useful lifetime of goodwill cannot be determined, as this leads to an

inappropriate amortization amount each year. It is impossible to determine the exact

useful lifetime, which forces companies to use the straight-line method. 50 percent of

the companies in the Netherlands use this method to measure goodwill. On the one hand,

Hoogendoorn suggests that companies should use the amortization method, which save

time and costs. On the other hand, he argues that implementation of the IFRS will lead to

more comparable and transparent information in financial statements. Jennings et al.

(2001) also investigated the quality of the financial statements by examining the

usefulness of financial statement to investors and practitioners without goodwill

amortization. The results show that the elimination of goodwill amortization

requirements will in all likelihood not reduce the usefulness financial statements. The

elimination has no value information for users. However, it is not clear how the research

was conducted. Jennings et al. also mention that the amortization on a straight-line basis

does not provide information value for users and practitioners. Bevers and Thelosen

(2008) describe the disadvantages for some companies in that goodwill has a maximum

amortization period for 20 years. As several companies assess their goodwill

amortization period for more than 20 years, the value of the amortization amount

should be lower in their valuation. Liquidity risks could arise in this situation if liabilities

19

cannot be met when they become due. However, Bevers and Thelosen mention that the

shorter amortization period will reduce the corporation tax.

6.2 Financial reporting under the US GAAP

In the beginning, the amortization period for the US GAAP allowed companies to

amortize goodwill for a maximum of 40 years, while many other countries were

adopting strict limitations on the maximum period. The US however did not agree with

this accounting standard. The US GAAP allows companies to amortize for this maximum

period as long as managers are convinced that the expected economic life is consistent

with this maximum period. Amir et al. (1993) indicate that this long period will lead to

an increase in shareholders’ equity and a slower reduction of earnings. Goodwill

reduces reported earnings in the income statement, so the higher the amortization

period the smaller the amortization amount. This means that the financial report with a

maximum amortization period represents higher reporting earnings compared to a

financial report with a limited amortization period. The higher reporting earnings lead

to a higher shareholders’ equity. Subsequently the SFAS 142 was implemented to

improve the quality of financial reports. Van Hulzen et al. (2011) examined the

influences on financial reporting of this standard by adopting a value relevance model.

This model contains a test on the relevance of impairments and examining the effects of

ignoring goodwill amortization. The outcomes of his model shows that financial

reporting quality has indeed improved by adopting impairments, but financial reporting

quality concerning the effects of ignoring goodwill amortization resulted in a lower

quality. Then Churyk (2005) found that cancelling the amortization of goodwill is

significant. This study is based on comparing market valuations of goodwill by using the

exposure draft. The exposure draft is a document for public commentaries on proposed

new accounting standards, issued by the FASB. The author suggests that the amount of

goodwill is rarely overvalued on the purchase date. This indicates that amortization of

goodwill is not essential. Churyk also noticed that annual impairments reviews need to

be conducted. He also mentions, like previous authors, that an impairment occurs if the

book value of equity exceeds the market value of the business, but Churky adds that an

impairment test should be conducted if the stock price declines. Lapointe et al. (2009)

also studied impairment, but with the retroactive method. The retroactive method

requests companies to adjust retained profits at the beginning of a fiscal period for the

impairment amount. Based on the value relevance and the timeliness of the impairment, 20

Lapointe et al. provided evidence for firms to ameliorate the quality of financial

reporting under the US GAAP. Glaum and Street (2003) agree with Lapointe that the US

GAAP improved the quality of financial statements. They studied the financial statement

of 200 companies. 100 companies used the US GAAP method and the other 100

companies used the IFRS. The results were that the financial statements under the US

GAAP gave a significantly higher compliance level, assuming that the companies were

audited by 4 major firms and operated in the US.

The convergence of new accounting standards with an increase in transparency

will lead to more accurate accounting of goodwill. The transparency will help users to

gain a better understanding of the disclosures on impairments in the financial reporting.

Testing goodwill for impairment is a complex situation where specific understanding of

valuing assets and liabilities is necessary. A quoted market price in an operating market

should be adopted to measure the fair value. Fair values for reporting units are not easy

to obtain since managers use a high amount of discretion in the impairment process. If

quoted market prices cannot be determined, the estimated fair value should be based on

the best available information. This assessment should compare approximately similar

prices for assets and liabilities using valuation methods; present value, option-pricing

models, matrix pricing, option adjusted spread model and fundamental analysis (Lander

and Reinstein, 2003, p 228). Dunse et al. (2004) state that the new accounting standards

lack value-based marketing. This indicates that the goals of the company and the

strategy of the company are not in alignment with the new accounting rules. The

subjectivity is likely to increase because managers make subjective decisions often,

which are based on the subjective assessment in the impairment process. This causes

doubts about the utility of the financial statements. Schultze (2005) also investigated the

impact of impairment for financial reporting. He assumed that an impairment test is

useful if accounting performances were improved. The results proved that there was no

positive correlation generated for a value-based management. Presumably, the

subjectivity of managers was negatively affected and there was an incorrect use of

variables in the valuation model.

6.3 Financial reporting under IFRS

The European Union (EU) decided that listed companies in the EU should adopt the IFRS

from 2005 onwards. From that time, many studies were conducted on the effects of the

IFRS globally. The IAS 36 faced strong criticism from users and others about the

21

complexity of the standards and the heavy reliance on fair value accounting. Van Hulzen

et al. (2011) conducted a study in 2006 to examine the value relevance and the

timeliness of financial reporting by using or not using the IFRS. They focused on the

differences between businesses with high and low amounts of intangible assets, and also

investigated the differences between the impairment and amortization expense. Older

studies showed that there was no statistical relation between the amortization method

and the carried amount of goodwill in the financial statements. The results show that

businesses with high amounts of intangible assets will gain from the change to the

impairment method of accounting, by finding increased value relevance. Value relevance

is defined as the ability of the financial information contained in the financial statement

to capture and recapitulate business value. The findings of their study are not exactly in

alignment with previous studies; the conjecture about the amortization method is true

but the conjecture about the increase value relevance of accounting information is false.

Overall, Van Hulzen et al. state that the impairment method did not improve the

financial information disclosed by financial statements.

The relevance of measuring fair values will also be discussed here. The IFRS

require companies to adopt the quoted prices in active markets to measure fair value as

in the US GAAP. Fair value is needed to implement the impairment test for goodwill. If

the quoted prices are unavailable or goodwill is not traded in active markets, the

estimated fair value should be estimated for the fair value, using market information.

This means that all relevant information is considered in estimating the fair value and

that one of the parties will accept this value in case of an acquisition. This principle is

reflected in the IFRS 2, IFRS 3, IFRS 7, IAS 16, IAS 39, IAS 40 and IAS 41. Cairns (2006)

states that it is difficult to determine the fair value using market information and that

this is often inaccurate and unreliable. Since fair value is an unreliable estimate, financial

statements cannot accurately reflect goodwill. However, goodwill is still estimated in

this manner because otherwise these intangible assets could be overvalued.

Furthermore, Ball (2006) argues that the impairment test under IFRS is not

implemented appropriately in some countries, which cast doubts on the financial

statements. Managers and auditors naturally do not operate the same way in every

country. Some managers and auditors will overlook certain rules and others will strictly

follow the rules to measure goodwill. This leads to a complex situation, because

although goodwill is measured under the IFRS the financial statements are still not

comparable across different countries. Also, auditors, controllers, laws, boards and

others will not provide the same level of supervision in all IFRS-implementing countries, 22

which also leads to uncertainty. For example, if the market takes a downturn and market

prices go down, an impairment test should then be conducted. Ball states that it is

unlikely that all IFRS-adopting countries will conduct the impairment test in the proper

manner. Some countries will condone this to maintain a strong economy. When

managers realize a goodwill impairment, this conveys information about their

assessment of the value of goodwill and the expected return. This mostly implies a

decrease in the stock-market value.

On the other hand, Chalmers et al. (2009) support the IFRS by providing

evidence that impairment better reflects the underlying economic value of goodwill than

amortization. They compared the link between the investment opportunities arising

from synergies before the adoption of the IFRS and the advantages of impairment of

goodwill under the IFRS. An impairment loss is then deducted from the income, giving a

better reflection of the companies’ future investment opportunities, according to

Chalmers et al.. However, it is unclear how the results are measured.

6.4 Alternative explanations

There are several factors that play a role in the enforcement of financial reporting

standards. These factors can influence the results of studies, meaning that part of the

information may be unreliable. One of these factors, according to Francis and Wang

(2008), are auditors. In general, big 4 firms give audits of a higher quality than smaller,

regionally oriented auditors. This may be due to the fact that larger firms can invest

more in better training programs for specific skills and audit systems. Also, big 4 firms

have more incentive to protect their brand-name reputation, therefore mistakes are not

tolerated. However, non-big 4 auditors are less sensitive to the cost of client

misreporting and the company’s reputation. This means that the financial reporting of a

company with services from big 4 firms are often of a higher quality than non-big 4 audit

firms, regardless of the accounting method. Furthermore, several studies have shown

that the results of other studies, conducted just after the implementation of the IFRS, are

mostly unreliable. Many companies and auditors were not familiar with the enforcement

and implementation of the IFRS, therefore not all financial statements were reported

appropriately. During that period, it was difficult to compare financial statements. Van

Hulzen et al. (2011) argue that an extension with additional years would improve the

reliability of the results of the studies. The results of studies conducted in and around

23

2005 cannot determine whether the IFRS or the local GAAP provide a better financial

statement.

Another important factor is the size of a company. The larger the number of

resources and the larger the scope of those resources (in comparison) to acquired

goodwill, the greater the flexibility in allocating goodwill. Larger amounts of resources

lead to a higher quality of financial reporting, according to Lang and Lundholm (1993).

The government puts more pressure on larger firms than smaller firms. Larger firms

have stronger incentives to enforce the guidelines for accounting. Managers have more

flexibility to allocate goodwill to low and high growth units, assuming a large firm. A

low-growth unit can accelerate the impairment process and a high-growth unit can

delay the impairment process with internally generated growth options.

The last factor addressed is the tax system. First, a close associative relationship

between financial accounting standards and tax regulations decreases the quality of

financial reporting, according to Guenther and Young (2000). Political purposes such as

collecting taxes for the government are examples, which influence the quality of

financial reporting. Secondly, the higher the rate of tax liability, the higher the incentive

to reduce taxable income. High tax rates increase the incentive to conceal profits in

financial statements.

The previously discussed factors influence the quality of the financial statements,

which influences the ability to properly reflect the underlying economic value of

goodwill. Regardless of which goodwill accounting companies enforce and implement,

the quality of financial reporting already increases by the choice of big 4 firm’s auditors,

to operate a large company (except for the DUTCH GAAP) and to work in a country with

a low sensitivity for tax systems. Furthermore, the results of studies that investigated

the quality of the financial statement in and around 2005 are mostly unreliable. The

authors’ statements in those studies should not be compared with outcome of other

studies.

6.5 Conclusion

In this chapter the advantages and disadvantages are listed for goodwill accounting

according to the DUTCH GAAP, US GAAP and IFRS. High-quality financial reporting for

goodwill accounting is obtained if this complies with the qualitative characteristics. The

advantage of an amortization period under the DUTCH GAAP is a reduction in tax

payments. A disadvantage is the liquidity risk. Overall, the valuation for goodwill under 24

the DUTCH GAAP does not provide high quality financial reporting, because the financial

information does not contain any qualitative characteristics. The disadvantage of

impairment test under the US GAAP and the IFRS is the determination of the fair value.

The advantage is a better underlying economic value of goodwill and financial reporting.

Overall, the valuation for goodwill under the US GAAP leads to high-quality financial

reporting, because it complies with most of the qualitative characteristics. On the other

hand, not all IFRS goals are achieved: the implementation of the IFRS only improved the

usefulness of financial reporting and does not contain the other qualitative

characteristics. Overall, the various goodwill accounting methods are supported by some

and not by others. Based on the results, the US GAAP is the best goodwill accounting

method in the US for listed companies and the IFRS is the best goodwill accounting

method in the Netherlands for unlisted companies, to obtain the best quality financial

reporting in those countries. Also, several factors play a role in the underlying economic

value of goodwill in the financial statements, such as auditors, the size of the company

and the tax system.

25

7. Summary and Conclusion

The EU decided to adopt the IFRS because they needed a new set of common accounting

standards to increase the quality of financial statements. One of the changes of the IFRS

relates to the valuation of goodwill. This thesis investigates whether the IFRS improves

the quality of financial statements for goodwill accounting in the Netherlands and the US.

Some companies still have the option to choose between the local GAAP and IFRS. To

these companies it is important to study which method leads to the best quality of

financial statements for goodwill accounting. The results show that the adoption of IFRS

did lead to a little improvement in the financial statements in the Netherland and no

improvements in the US at all. The qualitative characteristics of high quality financial

reporting were all absent, only the usefulness increased.

In the Netherlands, unlisted companies can choose between the write-off method

according to the DUTCH GAAP or the IAS 36 according to the IFRS. In the US, listed

companies can value their goodwill under the US GAAP and also the IAS 36. However,

Sahut et al. (2011) studied intangible assets of European listed firms, and they

concluded that the amount of goodwill under the local GAAP was more reliable than

under the IFRS. The new standard did not enhance the quality of financial statements,

which caused some debate. This thesis therefore focuses on the improvements of the

quality of financial reporting for goodwill accounting under the IFRS in the Netherlands

and in the US. Qualitative characteristics are required to determine high-quality

financial statements. If one or more of the qualitative characteristics; comparability,

verifiability or timeliness occurs, or the usefulness is increased, high-quality financial

reporting is obtained. A higher quality of financial reporting under IFRS is achieved if

qualitative characteristics were lacking in the local GAAP’s but appeared in the IFRS.

Firstly, the quality of the DUTCH GAAP and the US GAAP has to be studied. Then the

goodwill accounting for GAAP’s can be compared with the IFRS. This comparison can

determine whether the quality of the financial reporting is improved with the qualitative

characteristics. The study will be conducted with a review of the literature.

Overall, the amortization method under the DUTCH GAAP is an inappropriate

method to reflect the economic value of goodwill. Hoogendoorn (2002) and Bevers and

Thelosen (2008) state that the expected economic useful lifetime cannot be determined

accurately. The value of goodwill in the financial statement does not represent the

economic value of goodwill, which leads to a misleading report for users. It makes no

sense to compare the financial statements in a branch if the financial information is not 26

reliable. Jennings et al. (2001) prove that the amortization of goodwill does not increase

the usefulness of financial information. The straight-line method does not provide value

information about goodwill either. Cairns (2006) shows that the quality of financial

statements under IFRS did not improve the financial statements in the Netherlands. Fair

value is an unreliable estimate and financial statements possibly do not accurately

reflect goodwill. The IAS 36 does not solve the problem in the Netherlands, financial

information can still not be compared between companies in the same industry. On the

other hand, Chalmers et al. (2009) argue that the IAS 36 did improve the quality of

goodwill accounting. An impairment loss gives a better reflection for the companies’

future investment opportunities compared to the amortization method. This increases

its usefulness for decision-makers.

The goodwill accounting methods in the US show mixed evidence of increased

accounting quality. Van Hulzen et al. (2011) state that impairment test increases the

usefulness of the financial information. However, the elimination of goodwill

amortization decreased the usefulness of the financial information. In other words, Van

Hulzen et al. believe that both goodwill accounting methods improve the quality of the

financial statements. Meantime, Churyk (2005), a proponent of the FASB 142, argues

that the impairment test is justified. The impairment loss results in an accurate

economic value of goodwill allowing companies to compare their financial statements.

On the other hand, Lander and Reinstein (2003) oppose the FASB 142. The estimated

fair values are not reliable since the value is based on “best available” information.

According to these authors, comparability is not possible. Likewise, Cairns (2006)

provides evidence that the IAS 36 did not improve the quality of financial reporting and

that financial information still cannot be compared between firms in the same branch.

The next important quality characteristic is timeliness. On the one hand, Lapointe

et al. (2009) state that timeliness is identified as one of the characteristics of information

in the financial reporting under US GAAP. On the other hand, Van Hulzen et al. (2011)

did not find evidence that timeliness is a characteristic of the IAS 36. Glaum and Street

(2003) investigated the verifiability of goodwill accounting under the US GAAP and IFRS.

The results were that financial statements under the US GAAP gave a significantly higher

verifiable level. At the same time, Ball (2006) argues that it is not conceivable that

managers and auditors operate the IAS 36 the same way. This leads to a complex

situation, because although goodwill is measured under one accounting method,

financial statements are still not comparable and verifiable across countries.

Based on the literature review and the examined accounting quality 27

characteristics, the results show mixed evidence of increased accounting quality. In the

Netherlands, the quality of financial information was not comparable and useful. After

the implementation of the IFRS, financial statements were still not comparable but the

utility was improved. Some progress occurs in the Netherlands under the IFRS. In the US,

the quality of financial statements was verifiable and in time, overall, the statements

were not always comparable and useful. The adoption of the IFRS did not lead to major

improvements in the financial statements either. The qualitative characteristics of high-

quality financial reporting were all absent under the IFRS, although the usefulness did

increase. Based on the results, the IFRS is recommended for unlisted companies in the

Netherlands and not recommended for listed companies in the US. The US GAAP

contains more qualitative characteristics than IFRS, therefore the US GAAP obtains a

higher quality of financial reporting.

Finally, the literature reviews show that the IFRS improved the quality of

financial statements for goodwill accounting in the Netherlands and did not improve the

quality of financial statements for goodwill accounting in the US. Future research could

also use studies that exclude goodwill accounting from big 4 firms and extremely large

companies. Furthermore, these studies should not be compared to other studies

conducted immediately after the implementation of the IFRS in 2005.

28

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9. List of figures and exhibits

Exhibit 1: Accounting for goodwill p 16

31