ORIENT ACADEMIC FORUM

The Goodwill Issue in the Consolidation Accounting

GUO Qin1,YUAN Xueying2
1.School of Economics & Management, Beijing Jiaotong University, P.R.China, 100044
2.School of Economics & Management, Inner Mongolia University, P.R.China, 010021

Abstract: During the 1980’s and 2000’s, a great number of business mergers and acquisitions took place,
especially happened in telecommunications, defense, banking and financial service, health care, and
entertainment. Many companies would like to operate companies they acquired as separate legal entities
rather than a whole company. However, from a financial reporting point of view, statement users want to
see the entire economic entity's financial statement result. Accounting principles require consolidated
financial statements when a parent company owns more than 50% of a Subsidiary company.
Consolidated statements are basically used to present for the benefit of the shareholders, creditors and
other resource providers of the parent. It is first necessary to obtain a conceptual understanding of
goodwill in order to understand its composition, and measurement is then a separate issue. Goodwill is
not simply a residual, the difference between an amount paid and something acquired.
Keywords: Goodwill, Issues, Consolidation, Financial statement, Accounting

1 Introduction

1.1 Background
During the 1980’s and 2000’s a great number of business mergers and acquisitions took place, especially
happened in telecommunications, defense, banking and financial service, health care, and entertainment.
Companies purchase other companies for a variety of reasons. First, in some cases, competing in a given
industry requires significant resources, at present, more and more competitions in the economic market,
only large companies can survive. Second a common goal in these business combinations was to attract
large amounts of investment capital. Third, as a corporate strategy, some companies purchase other
companies in order, to gain access to new customers and markets. They aim to diversify into different
product areas. Like Maytag's example, Maytag's goal is to join the global appliance industry. [1]
Corporate management often is rewarded with higher salaries as increase of the size of the company. In
addition, prestige frequently increases with the expansion of a company and with a reputation for the
successful acquisition of other companies. As a result, corporate management often finds it personally
advantageous to increase company size.

1.2 Forms of M&A

First, a statutory merger is a type of business combination in which only one of the combining
companies survives and the other loses its separate identity. Second, a statutory consolidation is a
business combination in which both the combining companies are dissolved and the assets and liabilities
of both companies are transferred to a newly created corporation. Third, a stock acquisition occurs when
one company acquires the voting shares of another company and the two companies continue to operate
as separate, but related legal entities.
The relationship that is formed in a stock acquisition is referred to as a parent-subsidiary relationship. A
parent company is one that owns a majority of the voting stock of another company, referred to as a
subsidiary. The parent-subsidiary relationship is important because the parent companies have the ability
to control the subsidiary companies. In this dissertation, this will be focus on this kind of relationship
companies' financial statement reporting.

1.3 The reporting entity and consolidated financial statement

Many companies would like to operate companies they acquired as separate legal entities rather than a

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whole company. However, from a financial reporting point of view, statement users want to see the
entire economic entity's financial statement result. For this reason, financial department usually
consolidate or combine the financial result of the separate companies. Therefore, consolidated financial
statements present the financial situation and the results of operations for a parent company and one or
more subsidiary companies as if the individual entities actually were a single company or entity.
Accounting principles require consolidated financial statements when a parent company owns more than
50% of a Subsidiary company. Consolidated statements are basically used to present for the benefit of
the shareholders, creditors and other resource providers of the parent. Even when only a few related
companies are involved, consolidated financial statements often provide the best and the fullest
information regarding the activities and resources of the overall economic entity.[2]

1.4 Form and purpose of consolidated accounts

Consider now the case of a company that acquires a majority (51% or more) of the voting shares of
another. Such a shareholding gives it control of the investee. It may be a short-in terms of share
ownership - for an investor company to move from ‘significant influence’ to ‘control’ but the difference
in accounting is profound. Accountants argue that when one firm acquired control of another, a new
economic entity is created. A group consists of the investor company and the investee company or its
subsidiaries. The parent company prepares accounts for the group: these are known as consolidated
accounts. In addition, the parent and each of the subsidiary companies, being legal entities, continue to
prepare separate accounts.
Consolidated accounts provide financial statement readers with information about all the resources
under one company’s command: what form they take, how they are financed and how successfully they
have been employed in the year. This is the reason of existence of consolidation accounts.

2 Literature Review

2.1 The history of 'combination accounting’

‘Pooling’ or ‘Merger’ accounting
In 1970, the Accounting Principles Board of the American Institute of Certified Public Accountants
issued an Opinion (APB 16) on Business Combinations, which set out in detail the principles on which
the Pooling and Purchase methods should be used.
In 1971 the Accounting Standards Committee, on behalf of the principal accounting bodies in Britain
and Ireland issued an exposure draft (ED 3) of a proposed statement of standard practice on Accounting
for Acquisitions and Mergers. This followed the AICPA statement in outline, but with some differences,
and in much less detail. This proposed statement was allowed to lapse, since it did contravene the two
provisions of the Companies Act 1984, but the accounting bodies did not make any statement
disapproving the merger method.
The Department of Trade did not endorse the method, which it could have done at least partially by
altering the par. 15.5 rules by statutory instrument under s.454 C.A. 1984, but equally it did not take any
action against companies using it [3].
This ambivalence ended with the decision in Shearer v. Bercain Ltd [4]. A holding company which had
acquired two subsidiaries by share exchange used the acquisition method, and credited dividends
received out of the pre-acquisition profits of the subsidiaries to the cost of the investments, rather than to
profit and 10ss account. The Inland Revenue claimed that the company could have used the merger
method, which would have made the pre-amalgamation profits of the subsidiaries distributable to the
members of the holding company, and therefore the basis of a ‘shortfall’ assessment under s.289 Income
and Corporation Taxes Act 1970[5]. The court held that the company was prevented from using the
merger method by the rule in par. 15.5 Sched. 8 C.A. 1948 and the Inland Revenue claim failed [6]. This
was the first judicial ruling on the merger method, and as a result the Department of Trade, at the request
of the accounting bodies, included in the 1981 Companies Act retrospective validation of the merger

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method for companies which had used it before the Act came into force, and a less comprehensive
clearance for its use in the future.
In 1983 the International Accounting Standards Committee issued a statement (IAS22) on Accounting
for Business Combinations, based closely on APB 16. In 1982 the ASC issued ED 31 on Accounting for
Acquisitions and Mergers, followed in 1985 by SSAP 23 under the same title [7].

2.2 The methods of combination accounting

Before IFR 3 there are two methods of accounting for business combinations: purchase and pooling of
interests.
Pooling of interests method accounting is only for the business combination of a continuity of
ownership; that is, the owners of the combing company continue as the owners of the combined
company. For example, if one company acquires another by issuing shares of common stock in
exchange for the common stock of the other company, the stockholders of both combining companies
continue as owners of the combined company. A pooling of interests can occur only when one company
uses its own common stock to acquire the assets or stock of another company [8]. Purchase accounting is
appropriate when an important ownership interest is eliminated in the business combination, which
means, one company acquires another company for cash the stock or assets, the owners of the acquired
company do not continue as owners of the combined company, which having taken cash rather than an
ownership interest. Under pooling of interests accounting, the book value of the assets, liabilities, and
owners’ equities of the combining companies are carded to the combined company as if the companies
had always been combined; that is, the balance sheet items are not adjusted to fair values [9]. Under
purchase accounting, acquired assets and assumed liabilities are reported by the acquiring company at
their fair values at the date of acquisition.
Therefore, the purchased method was the more common method and was used in all cases where one
company was seen as acquiring another. The pooling of interest was used only where the shareholders of
the two companies were seen as coming together to ‘achieve a continuing mutual share in the risks and
benefits attaching to the combined entity such that neither party can be identified as the
acquirer.’[10](IAS 22 Business Combinations, IASC revised 1998, para.8 - now replaced by IFRS 3)
IFRS3 now allows only the purchase method. This will ensure greater and clear comparability of
financial statements for users and remove the incentive to structure combinations in such a way in order
to produce the desired accounting result [11].
In additional, only in the purchased method, the fair value and goodwill are in existence. These should
be assessed correctly and that occur lots of argument between regulators and professionals. If the
investment is greater than the share of net assets then the difference is regarded as the purchase of
goodwill.
Currently, goodwill is one of the most contentious issues in accounting.

3 Analyses

An intangible asset or group of assets that is acquired, other than in a business combination, shall be
initially recognized and measured based on fair value. If a group of assets, the cost will be allocated pro
rata based on fair value, and shall not give rise to goodwill. The SFAS 141 criteria for including in
goodwill intangible assets that are not separable or arises from a contractual right do not apply in SFAS
142.
Costs of internally developing, maintaining or restoring intangible assets that are not specifically
identifiable, that have indeterminate lives are to be expensed when incurred. An intangible asset with a
finite useful life is amortized; one with an indefinite useful life is not amortized [12]. Useful life is to be
determined based on an analysis of all pertinent factors, such as:
1. Expected use of the asset
2. Expected useful life of another asset or group of assets to which the useful life of the intangible may

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relate (such as mineral rights to depleting assets)

3. Legal, regulatory or contractual provisions or available renewals
4. Effects of obsolescence, demand, competition and other economic factors such as the stability of the
industry, known technological advances, legislative action
5. Level of maintenance expenditures needed to obtain the expected future cash flows. If no legal,
regulatory, contractual, competitive, economic or other factors limit the useful life of the asset, its life is
considered to be indefinite. Appendix A of the SFAS gives examples of determining the useful lives of
assets under different circumstances.
Once the useful life is determined, the method of amortization is not necessarily straight line – the
method of amortization shall reflect the pattern in which the economic benefits of the intangible asset
are consumed or otherwise used up [13]. If that pattern cannot be reliably determined, a straight-line
amortization method shall be used. In recording amortization, residual value must be considered as well.
If an intangible asset being amortized is later determined to have an indefinite useful life, the asset will
be tested for, impairment, and shall no longer be amortized. Impairment of an intangible asset that is
being amortized is tested in accordance with the provisions of SFAS 121 - Accounting for the
Impairment of Long-Lived Assets [14].
An intangible asset that is not subject to amortization is to be tested for impairment at least annually in
accordance with SFAS 142. Goodwill is not to be amortized, and it is considered impaired when its
carrying amount exceeds its implied fair value.

4 Reporting Units

Impairment reviews are to occur at least annually, at the “reporting unit” level. A reporting unit is
defined as an operating segment or one level below an operating segment. As defined in SFAS 131,
Disclosures about Segments of an enterprise and Related Information, an operating segment is a
business component that earns revenues and incurs expenses, whose operating results are regularly
reviewed by management to assess performance and allocate resources, and for which discrete financial
information is available [15].
A component of an operating segment is a reporting unit if its assets constitute a “business” in addition
to being an operating segment. SFAS 142 permits the aggregation of economically similar components
for impairment review purposes. The definition of reporting units, and the possible aggregation, could
have significant future impact, as the business changes over time.

4.1 Step one - carrying amount comparison

The first step compares the “fair value” of the reporting unit to its carrying amount (shareholders’ equity
including goodwill) [16]. If the fair value exceeds carrying amount, no further testing is required. If
however, carrying amount exceeds fair value, there is evidence of impairment, meaning the value of
goodwill is less than its carrying value on the balance sheet.
Step one impairment testing must be done at least annually, and can be performed at any time during the
year, provided the test is performed at the same time every year. Different reporting units may be tested
for impairment at different times. Impairment should be tested between the annual tests if circumstances
change that would “more likely than not” reduce the unit's fair value. Such circumstances include:
1) Changes in legal factors or the business climate
2) Adverse action by a regulator
3) Unanticipated competition
4) Loss of key personnel
5) Expectation that a reporting unit may be disposed of

4.2 Step two - impairment measurement

If step one results in the carrying amount of the reporting unit exceeding its fair value, further

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impairment testing must be conducted. Since goodwill cannot be measured directly, its value is
determined as a residual amount after valuing all assets other than goodwill.
If step one reveals an impairment of goodwill, both the tangible and identifiable intangible assets are
valued in order to determine the implied fair value of goodwill. It may be necessary to engage the
services of experts in valuing machinery and equipment and intangibles. SFAS 142 requires valuing a
company’s recorded and unrecorded intangible assets such as internally generated patents.
The implied fair value of goodwill shall be determined the same way as for a business combination [17],
that is, fair value of the reporting unit will be allocated to all the assets and liabilities of the unit,
including unrecognized intangible assets, as if the reporting unit had been acquired, and the fair value of
the unit was the price paid. The allocation is done only for purposes of testing the impairment of
goodwill – no write-up or write-down of a recognized asset or liability is to occur. Nor should a
previously unrecognized intangible asset be recognized as a result of step two impairment testing.

5 Conclusion

In background part of the introduction, the reasons of consolidated companies had been explained,
because at the end of last century, that was the peak time of business combination, it shown that the
importance for researchers to study the consolidated accounting, and to analyze the advantage or
disadvantage of its application in practice. Continuously, the sorts of corporate expansion have been
listed. And then immediately mm the emphasis on one of them: stock acquisition. That is one of the
broadest forms for combination.
Of course, after academic background, the emphasis should be continued to narrow, so that the
consolidation accounting which this study took had been illustrated. At the third part of the introduction,
that is the whole paper form introduction, and presented the novelty of this study for engaging the
readers.
In the literature review part, large number of publications have been read and researched. From the
foundational concepts to the arguments of issues of consolidated accounting, the study had been
deepened step by step. To research the most important issue, goodwill and intangible assets, the best
way is to hear the voice from others, therefore, there is a section listed the goodwill debate fully in the
part of literature review. Then, previous work had been used to inform this study, in terms of developing
a set of research questions, theoretical model and formulating or testing hypotheses.
The associated philosophical paradigms governing my research approach is primary research, which is
positive, realist stance. The method I used to collect the data is qualitative, which came from lots of
journal, periodical and literature.
To be concluded, as business has become more complex and industrial processes more sophisticated, the
amount paid to acquire an intangible asset has become significant in comparison to the fixed asset base
of some companies. Internally generated intangible assets may be capitalized if they have market value,
purchased goodwill and intangibles should be capitalized in the balance sheet. And after discussion, we
knew that once they have been capitalized, these assets either be amortized or subject to a regular
impairment review, depending on their useful economic life.

5.1 Methodology conclusion

Over time, a number of different approaches have been taken to resolve this accounting issue, this study
provided an overview of the more common methods that have been or currently being used.
One of the methods used to solve this issue was the development of descriptive theories based on
observations of accounting practice which was required to deal with such issues as depreciation of plant
and machinery, and the new goodwill and intangibles come out continuously because those who
invested in an entity were no longer involved in the day-to-day running of the business[18]. While all
these news methods and standards this study mentioned, were developed in response to practical needs,
they motivated some accountants to think about the reasons certain practices were more appropriate than

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others. This led to the developments of the goodwill and intangible assets theories involving sets of
conventions or principles. These conventions, such as the principle: SFAS 141, SFAS 142, FRS 10...the
matching principle, the going concern convention and the accounting period convention, were
developed by observing the existing accounting practice. When accounting issues like goodwill and
intangible assets arose, the conventions were used by the accounting profession as the rationale for
choosing between alternative accounting practices.
The other method for solving the problem with goodwill and intangible assets was based decisions on
the findings of empirical research. Since, the 1970s, accounting researchers have focused on the
development of positive theories of accounting that use scientific method to test hypotheses about
accounting practice [19]. It is important that the objective of positive theory is to explain and predict the
choice of methods, rather than to improve accounting practice or to assist in solving this issue in
consolidated accounting. However, some of the findings of the research may be useful in deciding the
most appropriate solution to an issue. So the whole study had used the positive accounting research, one
of the main contributions of positive accounting, research is that it has increased the awareness of the
political nature of accounting choice and the likely reaction of managers to accounting methods.
However, while positive accounting theory may have improved accountants’ understanding of
accounting[20], it is not intended to be a method of solving accounting issues and, it actually had serious
shortcomings.

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