goodwill acounting diffrences of the us and uk and their effect on share prices

Another finding was that the post-acquisition relation between goodwill and market values remained significant for only five years for US firms.' This result held for the total amount of

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University of Oklahoma Graduate College

Goodwill Accounting Differences of the US and UK and Their Effect on Share Prices

A Dissertation SUBMITTED TO THE GRADUATE FACULTY

in partial fulfillment of the requirements for the

degree of Doctor of Philosophy

By

Burch Thomas Kealey Norman, Oklahoma

1996

UMI Number: 9700602

UMI Microform 9700602 Copyright 1996, by UMI Company All rights reserved This microform edition is protected against unauthorized copying under Title 17, United States Code

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Goodwill Accounting Differences of the US

and UK and Their Effect on Share Prices

A Dissertation APPROVED FOR THE COLLEGE OF BUSINESS ADMINISTRATION

BY

© Copyright by Burch Thomas Kealey 1996

All Rights Reserved

To my wife, Renee

Acknowledgments

I wish to thank my dissertation committee, Shane Moriarity (Chair), Frances Ayres, Nandkumar Nayar, Gary Meek, and Robert Reed for their encouragement, their support, their guidance and most importantly their assistance in completing this study Their constructive comments provided the foundation for this study I particularly wish to thank Shane Moriarity Professor Moriarity is an educator in the truest sense of the word

Other faculty at the University of Oklahoma have had an important role in helping

me to develop the research skills necessary to complete a dissertation This list is not meant to be exhaustive, but I wish to also say thank-you to: Steven Butler, Elizabeth Cunningham, Louis Ederington, Scott Linn, and G Lee Willinger I do not believe I could have completed this program without their open doors and willingness to help me Sort out and understand various concepts over the last five years

T also have been fortunate to lear about teaching from some excellent classroom educators I particularly want to thank Frances Ayres, Louis Ederington, and Gary

Emery They provide a clear and compelling example of how to be an effective teacher

Shaunna Woollard and Fiona Fink of Extel Financial were instrumental in

providing access to the UK data Without their assistance I could not have completed this study I deeply appreciate their time and assistance

My fellow doctoral students have helped make this journey shorter Michael

Mosebach, in particular, has been an excellent colleague I am grateful for the friendship

we have developed during our years together at the University of Oklahoma I also want

to thank the finance students, particularly Vance Lesseig and his wife Mary and daughter Shelby They provided some light moments when they were needed most

None of this would have been possible without the support, love and

encouragement of my wife, Renee I also wish to thank my mother, Judy, and my fathers Patrick and Randy They have always challenged me to develop to my fullest potential This dissertation was written on a computer my mother purchased for me, and my father’s financial help allowed me to focus on the academic as opposed to the mundane My brother Larry, and my sister Petra, took me fishing often enough to protect my sanity

And of course, Zia Zia is our dog, whose insistence that I take her walking kept helped me keep a perspective during this process

Table of Contents

4.2 ASSOCIATION TESTS AFTER THE FIRST POST-ACQUISTTION FiSCAL YEAR END 32

vii

6.2.2 Analysis oƒ UK Sample near the First Post.Acquisition Balance Sheet Date

6.3.1 Analysis of US Sample for Five Years Afier the Acqwisition Year 5S n2 6.3.2 Analysis of UK Sample for Five Years After the Acquisition Yeqr s5 sx cececeeceexccee

7.2 DISCUSSION OF H2 AND H4 (US AND UK)

67

80

80 85

86

87

89

91 95

List of Tables

1 Summary of US Sample Selection 2 2 0 2.sscccccscesesseesecsesesessecesessesesevecceseeeeeeees 38

2 Summary of UK Sample Selection .0 -.cccccccecescessesessesessesescessseeecevececcececeeesece 4I

3 Descriptive Information for US Targets _ 2 -sscsssessssscscesocsessesesecseseecesecesceceeeeee 43

4 Descriptive Information for US Acquiring Firms .c.cesceccscesessececceccscsceceseeee 46

5 US Sample Industry Representation 0 csccesessessessessscscessessssncesesesecsessececeseoses 47

6 Descriptive Information for UK Targets c.cccscccccsssssssscsessovssessescsenesessessuseseesseee 49

7 Descriptive Information for UK Acquiring Firms .0 ce.ceccecccecscceccecececesceccovoseee 51

8 UK Sample Industry Representation .0 c.ccscecescescescessecsecsesesseseseecesesesceseeeeeees 52

9 Hypotheses Summary cccececcscecccssessessesscscssecsescesossessussuessisecsecercavecsesseresceseeees 56

10 Estimation Results for US Sample Near End of Fiscal Year of Acquisition 58

11 Estimation Results for UK Sample Near End Of Fiscal Year of Acquisition 60

12-Panel P1 Estimation Results for US Sample: First Year After Acquisition 62

12-Panel P2 Estimation Results for US Sample: Second Year After Acquisition 63

12-Panel P3 Estimation Results for US Sample: Third Year After Acquisition 64

12-Panel P4 Estimation Results for US Sample: Fourth Year After Acquisition 65

12-Panel P5 Estimation Results for US Sample: Fifth Year After Acquisition 66

13-Panel P1 Estimation Results for UK Sample: First Year After Acquisition 68

13-Panel P2 Estimation Results for UK Sample: Second Year After Acquisition 69

13-Panel P3 Estimation Results for UK Sample: Third Year After Acquisition 70

13-Panel P4 Estimation Results for UK Sample: Fourth Year After Acquisition 71

13-Panel P5 Estimation Results for UK Sample: Fifth Year After Acquisition 72

14 Estimation of UK Data With NRA Excluded 0 0 0 cceccscccsecsecsssesecscessescesescssoreeeeees 74 15 Alternative Specifications of Estimation Equations to Examine Collinearity Issue in UK Data 0 c cccceeccccccccscsescsesesececsecsesecesesesececececececeeeeeeceees 76 16 Comparison of Changes in Market-To-Book Ratio for US and UK Sample 79

Al Goldfield-Quandt Analysis for US Data 0 0 c.cccccccscesssssecsessescccesseceevsssoseecececeece 96 A2 Goldfield-Quandt Analysis for UK Data .0 0 0.ccccccescsssescessesscsssssesessoscesecceseeceeeees 97

Abstract This study examines the relation between market values and acquired goodwill for

a sample of firms from the United States and the United Kingdom that made acquisitions from 1985-1990 The empirical tests suggest that the differences in the accounting

treatment for goodwill in the two countries led to differences in the post-acquisition association between market values and goodwill Specifically, the post-acquisition

association between the market values of US firms and acquired goodwill remained

positive and significant for the first five years after an acquisition Acquired goodwill did not significantly contribute to explaining the market values of the UK acquiring firms for any of the six years in which the relation between market values and goodwill was

examined This suggests that the accounting disclosure of the goodwill balance in the financial statements is an important factor in market valuation

Chapter One

Introduction

The political world today consists of 197 recognized nations This small number hides an incredible diversity of economic orientations, religious beliefs, cultural values, and legal systems The diversity in national accounting policies should be no surprise since these and other factors have been identified as forces that have helped shape and define accounting practices Differences exist both in measurement practices and in the

disclosures that accompany the primary financial statements of public companies

Accounting diversity has become a contentious issue as world capital markets become more articulated Some security market regulators such as the Securities and Exchange Commission (SEC) in the United States (US) seemed to have adopted the perspective that domestic accounting standards provide investors with adequate

information to allow informed choices about investment alternatives But firms seeking capital in foreign countries face direct and indirect costs when capital market access is conditioned on conforming to another country’s GAAP Officials of the US security exchanges argue that the SEC’s requirement that foreign firms reconcile to US GAAP is such a severe response to accounting diversity that it imposes an unfair competitive hurdle

on stock exchanges seeking the listings and associated transactions of foreign firms For

example, the former Chief Economist of the New York Stock Exchange (NYSE) stated,

“Indeed, if the SEC continues to insist that foreign firms abide by America’s anachronistic accounting standards it will strangle the US markets and do irreversible harm to the US as the world’s dominant financial center” [Freund (1995), Al5]

Efforts to resolve the effects of accounting diversity on the form and content of financial statements have advanced in two related directions One approach is the

development of a single set of accounting principles acceptable internationally According

to Berton (1995), the International Accounting Standards Committee (IASC) and the International Organization of Securities Commissions are working jointly to develop such

a set of international accounting standards If completed, compliance with these standards

is expected to give companies access to a larger number of capital markets, possibly even those of the US Some countries are considering the adoption of these standards to

replace their existing domestic standards Other countries, such as the US, are considering allowing only foreign companies to use these standards for capital market access The related approach has been the move among specific groups of countries to directly

harmonize their national accounting practices For example, the European Community has set accounting standards that member nations must adopt [Mueller, Gernon, and Meek (1994)] The Financial Accounting Standards Board (FASB) is actively involved in

discussions with its counterparts in Canada, Mexico, and Chile about ways that the

standards of these countries can be harmonized [Berton (1995)] Ifa particular set of countries were to harmonize their GAAP, then financial statement numbers would be

comparable within the group This would allow the firms within the group to prepare one set of financial statements to gain access to all the group’s security markets

In the wake of efforts to resolve accounting diversity, there has been greater interest and debate on specific accounting standards One recent area of particular

concern is the diversity in how different countries account for acquired goodwill US firms that make purchase acquisitions typically capitalize the excess of the purchase price over the fair market value of the net assets acquired Post-acquisition, the capitalized goodwill asset is amortized, with an amortization period of forty years or less Other countries, such as the United Kingdom, the Netherlands, Germany, Switzerland, and Italy allow firms to directly charge acquisition goodwill against equity This treatment leaves post-acquisition earnings unaffected by a charge for the amortization of goodwill

Each of these alternative accounting methods has critics The US business press claims that America’s goodwill accounting approach places US firms at a competitive disadvantage in the market for acquisitions [Riley, (1988), Herz and Abahoonie (1990), Linden (1990), Sloan (1994)] This claim is centered on the post-acquisition earnings effect of US GAAP Firms which follow US GAAP report lower post-acquisition

earnings than firms that follow the GAAP of countries where goodwill can be directly charged to equity, ceteris paribus On the other hand, UK managers claim that the write- off of goodwill leads to lower market valuations of their firms [Wechsler (1989)] This argument is based on the fact that writing-off goodwill at acquisition lowers net asset values and increases leverage, ceteris paribus UK managers believe that investors focus

on the reported accounting numbers on the balance sheet and ignore or “forget” the written-off goodwill

This study focuses on the second claim and investigates whether goodwill

accounting policy affects the post-acquisition association between the market values of US and UK firms and acquired goodwill Specifically, this study attempted to determine whether acquired goodwill has to be reported in the financial statements for investors to consider it an asset The measurement of goodwill from acquisitions appears to be similar

in both countries The recent exposure draft from the UK indicates that UK accounting standard setters believe that goodwill is an asset (Financial Accounting Exposure Draft 12) And further, despite the differences in accounting treatments, the financial statements

of US and UK firms provide sufficient disclosures to allow investors to calculate the amount of goodwill from material acquisitions at the end of the fiscal year of the

acquisition

The points detailed above suggest that the post-acquisition relation between

market values and goodwill could be similar for US and UK firms This was not

confirmed by the empirical tests This study supports the claims of UK managers that investors do not consider acquired goodwill when valuing firms post-acquisition The tests are not sufficient to conclude that the difference in accounting policy is the primary cause of the differences in the post-acquisition patterns of association between market values and goodwill Nonetheless, the difference in the association patterns suggests that accounting treatment or disclosures may in fact affect how investors value firms This issue is an important subject for continued research

Another finding was that the post-acquisition relation between goodwill and market values remained significant for only five years for US firms.' This result held for the total amount of goodwill acquired, the book value of goodwill (total goodwill less amortization expense), and for the components of goodwill suggested by Henning (1994) One interpretation of this finding might be that the amortization period that US firms select is too long Japanese and German GAAP only allow goodwill to be amortized for five years This shorter period may better reflect investors beliefs about the service

potential of acquired goodwill

This dissertation is divided into six additional chapters The next chapter identifies the practices approved by US and UK GAAP for the treatment of goodwill Further, based on a recent study, this chapter identifies two distinct components of acquisition goodwill and briefly discusses possible sources for each component Relevant past

research is reviewed and the hypotheses to be tested in this study are developed in Chapter

3 Chapter 4 contains a description of the methodological approach used for the

hypotheses tests The sample selection process is described and a descriptive analysis of the sample is provided in Chapter 5 The results of the hypotheses tests are presented and discussed in Chapter 6 Limitations of the analysis, conclusions indicated by the empirical results, and some directions for future research are discussed in the final chapter

1 The acquisition year and the four subsequent years

Chapter Two Goodwill Accounting Practices in the United States and the United Kingdom and Components of Acquisition Goodwill

2.1 Goodwill Accounting Practices

2.1.1 United States Treatment of Goodwill

Guidance for the accounting treatment of business acquisitions and goodwill in the

US is provided by Accounting Principles Board Opinions No 16 & 17 (APB 16 & APB 17) The APB recommends that the excess of purchase consideration over the market value of the identifiable net assets be debited to a goodwill account Firms should then estimate the expected useful life of goodwill and amortize it against earnings over this period APB 17 specifies an arbitrary upper bound of forty years as the maximum useful life APB 17 recognizes the possibility that unanticipated future events may alter the value

of goodwill For financial reporting purposes the APB recommends that those events which enhance or increase the value of goodwill be ignored However, events which diminish the value of goodwill should be recognized by charging to current earnings an amount equal to the estimated reduction in value

This accounting treatment is consistent with the idea that goodwill acquired in acquisitions has two specific properties First goodwill is an asset That is, goodwill is

expected to provide future economic benefits, arose from some past transaction (the acquisition specifically) and is controlled by the acquiring firm Further, the US

accounting treatment suggests that the benefits provided by goodwill are available only for

a limited time

2.1.2 United Kingdom Treatment of Goodwill

UK GAAP allows two alternative treatments for purchased goodwill (Accounting Standards Committee Statement of Standard Accounting Practice 22 (SSAP 22]) Firms may either capitalize and amortize goodwill over its estimated useful life or directly charge the purchased goodwill against specific equity accounts

The first alternative is similar to the treatment recommended by APB 17

Companies are to first value the acquired identifiable assets and liabilities at fair value The difference between the fair value of the consideration offered and the fair value of the identifiable net assets is then considered goodwill The resulting goodwill is amortized over an expected useful life through a charge to annual earnings Unlike US practice, SSAP-22 provides no limit on the amortization period But similar to US practice

decreases in the value of goodwill are charged to earnings during the accounting period of the decline

The second alternative, and the one that SSAP-22 indicates is preferred, is to immediately write-off goodwill to an equity account Under normal circumstances, SSAP-

22 recommends that the debit be made to a shareholder reserve account When firms have insufficient reserves two alternatives are available Firms may establish a ‘Goodwill Write- off Reserve’ which creates a debit account in shareholders equity The other choice is to

7

petition the British courts to allow the charge to be set against the share premium account

A direct economic interpretation of this accounting policy is that goodwill provides

no measurable benefits to the acquiring firm beyond the acquisition year As Radebaugh and Grey (1991) and others have pointed out, this policy is also consistent with the idea that benefits of acquired goodwill are not necessarily correlated with the costs of

acquisition Rather the realization of the benefits fluctuate across time and are too

uncertain to be reported in the financial statements This economic interpretation is not entirely consistent with the position of UK accounting standard setters when this policy was adopted A previous exposure draft released by the Accounting Standards Committee (ASC) [the predecessor to the current UK standard setting body, the Accounting

Standards Board (ASB)] argued that one important reason for the adoption of the current goodwill accounting standard was to achieve consistency with the treatment of internally developed, or non-purchased, goodwill Further, the Statement of Standard Accounting Practice-Exposure Draft 47 (ED-47) also stated, “It was recognised that this (writing-off goodwill) was an accounting adjustment and did not represent an equivalent loss of

systematic amortization is that they must perform periodic revaluations (or impairment reviews) to determine whether the carrying value approximates the expected future benefits Any decreases in value are expected to be charged to earnings This draft also indicates that firms will be allowed to reverse impairment charges when subsequent events rove that any write-down was excessive, or if subsequent events reverse the previously recognized decreases in value

2.2 Goodwill Components

Although the amount of the purchase price allocated to total goodwill is essentially

a “plug”, Henning (1994) identifies two components of acquisition goodwill The first component, pre-bid goodwill, is defined as the excess of a firm’s pre-acquisition market value (security price times the number of shares outstanding) over the fair value of

identifiable net assets Pre-bid goodwill exists independently of an acquisition and can be considered a measure of investors’ perceptions of the firm’s advantages (disadvantages),

or prospects for future earnings above (below) the normal rate of return on the fair market value of the firm’s net assets Positive pre-bid goodwill may be due to entrenchment in profitable markets, the existence of skilled managers, a strong work force, carefully

maintained customer relationships, or distribution channels which allow the firm a unique advantage Possible causes of negative pre-bid goodwill include perceived incompetent management, and technology changes which threaten to make the firm’s products or manufacturing processes obsolete The accounting focus on transactions can also lead to the imputation of pre-bid goodwill Negative goodwill can occur when contingent

liabilities exist and positive goodwill may occur when a firm has pending opportunities or

projects that have not yet been reflected in the firms’ financial statements An efficient market will impound a value in the share price for these potential events before the actual transactions occur which will lead to accounting recognition

The second component of acquisition goodwill is based on the synergies the bidding firm’s managers expect to gain from an acquisition, and will be referred to as synergistic goodwill When a firm is bought the managers of the acquiring firm may see new opportunities for future cash flows from such things as higher returns to scale for research and development activities, advertising programs, and capital investment The combination may also allow the acquiring firm to eliminate duplicate costs of

manufacturing, administration, and distribution Synergies can also arise because the business combination gives the acquiring firm monopoly power in product or factor markets This monopoly power may lead to gains in price or cost control The excess of the offering price over the pre-acquisition market value of the target (called the bid-premia

in past studies, or premium component of goodwill) is referred to in this study as the synergistic component of acquisition goodwill

An alternative interpretation is that synergistic goodwill may partially or in total represent an overpayment for the target (acquired) firm Roll (1986) provides a synthesis

of the finance literature that has examined the returns to acquiring firms His summary indicates that on average the returns to bidding firms are negative, though not significant Firth (1980) examined the returns to UK bidders and targets concentrated in the brewing industry His findings indicated that bidders on average suffered significant declines in market value Perhaps more direct evidence that goodwill is associated with an

overpayment by the acquiring firm for the target firm is offered by Hethcox (1993) Hethcox studied the market returns to acquiring firms that used purchase accounting and found a negative cross-sectional relation between the returns of acquiring firms and the total amount of goodwill If goodwill is considered an overpayment by investors then its value should not be associated with the post-acquisition market values of acquiring firms

Chapter Three Relevant Past Research and Hypotheses 3.1 Past Research

Prior research on the relation between the accounting treatment of goodwill and market values is limited Much of the past research on goodwill has focused on the relation between goodwill recognition and market returns, not differences in treatments However, five papers with direct implications for the design or hypotheses tested by the current study have been identified The basis, and results of these papers, as well as how they contribute to the present study are discussed in this section

Jennings, Robinson, Thompson, and Duvall (1995) analyzed the relationship between market values and book values to determine whether goodwill as recognized by

US GAAP was impounded in the market values of firms Their sample consisted of all Compustat firms for which goodwill was identifiable, had December 31 fiscal year ends, and were traded on either the New York Stock Exchange (NYSE) or American Stock Exchange (AMEX)

The model proposed and estimated by Jennings, Robinson, Thompson, and Duvall related the market values of the sample firms to 1) the book values of identifiable assets excluding goodwill and property plant and equipment, 2) the book value of goodwill, 3) net property plant and equipment, and 4) the book value of the identifiable liabilities All

variables were deflated by end of period net book value

The model was estimated each year from 1982 to 1988 The signs of the

coefficients on all of the variables were as predicted, with the coefficient on goodwill positive and significant This suggests that investors believe goodwill is an asset and is a source of value to the acquiring firm

Jennings, Robinson, Thompson, and Duvall pointed out that the positive

coefficient on goodwill could be due to the acquiring firms having operating strengths or other unrecorded assets not reflected in book values but which are positively correlated with the book value of goodwill This is consistent with prior research which has found that acquiring firms that make purchase acquisitions have excess market returns in the period before the acquisition even though little association has been found between market returns and acquisition conditioned information [Hong, Kaplan and Mandelker ( 1970), Davis (1990)] If this is the case, then goodwill is significant simply because of its

correlation with a significant omitted variable, the pre-bid or strategic goodwill of the acquiring firm They attempted to control for this possibility by introducing a fixed effects regression to allow the intercept and coefficients to vary by firm In this case the

coefficient on the book value of goodwill declined in absolute magnitude but remained significant This provides further evidence that the market does value goodwill arising from purchase transactions

Jennings, Robinson, Thompson, and Duvall provide the foundation for the current study As discussed earlier, the measurement of goodwill is a fairly mechanical process which is similar in both the US and the UK One of the concerns that has been driving the

debate about the proper accounting treatment for goodwill is the lack of a consensus perspective as to the economic meaning of goodwill This study demonstrates that even when the precise source and meaning of acquired goodwill are not directly controlled, there is an association between this accounting number, when it is reported in the financial statements, and market values The question then follows, does this quantity have to be reported in the financial statements for the goodwill to be incorporated in the value investors assign to firms?

Vincent (1995) studied the post-acquisition relation between the “Accounting Acquisition Premium’ and the market values of selected firms which made acquisitions structured as purchases or poolings over the period from 1979 to 1985 Since pooling transactions avoid goodwill, Vincent used the difference between the book value of the acquired firms and the fair value of the consideration offered as a proxy for goodwill Her study then addressed a question similar to the primary focus of this study, does goodwill have to be disclosed in the financial statements for the market to impute a value Vincent found that when firms made pooling structured acquisitions the premium was significantly associated with the market value of the acquiring firms for the year of the acquisition and the second year after the acquisition On the otherhand, when purchase accounting was used, the premium was significantly associated with the market values of the acquiring firms for the acquisition year and the four subsequent years Her results indicated that the association between goodwill and market values was no longer significant by the fifth year post-acquisition for purchase firms

These results suggest that investors may impute a goodwill amount, even if it is not directly disclosed, immediately after an acquisition But, when firms use pooling, investors may either forget the imputed amount or discount the premium Vincent points out that discounting might occur since as Vincent points out, the premium recognized by purchase firms is subject to auditing, whereas for purchase firms there is no comparable post-acquisition independent valuation of the premium

Vincent’s study indicates that it will be important to test the post-acquisition relation between market values and acquired goodwill for some period of time post- acquisition Otherwise, a finding of a significant association between the market values of acquiring firms and goodwill at the end of the effective year of the acquisition could be misleading That finding would suggest that investors undo the accounting differences and goodwill accounting does not affect the post-acquisition market values of acquiring firms But, as discussed earlier, UK firms predominately write-off acquired goodwill during the fiscal year of the acquisition Even if UK firms do not directly disclose the magnitude of the goodwill write-off, investors can rebalance the equity accounts to identify this quantity

in the year of the acquisition Without supplementary disclosures the post-acquisition balance sheets are silent about the magnitude of acquired goodwill This has caused some

UK managers to worry that their firms’ post-acquisition market values are reduced since investors “forget” about the goodwill [Wechsler (1989)] Thus, if the relation between market values of the acquiring firms and goodwill breaks down when the relation is tested for post-acquisition years other than the effective year of the acquisition then accounting may still play an important role in valuing firms

Amir, Harris, and Venuti (1993) tested for an association between specific

disclosure items in 20-F filings and the market-to-book ratios for a sample of foreign firms cross-listed in the US.* The reconciliation items examined by Amir, Harris and Venuti included both the amortization expense required by US GAAP and any adjustments to goodwill required to reconcile the firms’ foreign GAAP denominated book value to the book value that would be recorded had the firms followed US GAAP Based on their sample of UK and Australian firms, Amir, Harris and Venuti reported that the association between the market-to-book ratio and balance sheet goodwill reconciliation amounts was significantly positive and near one when measured by foreign security exchange market values However, no association between foreign exchange measured market-to-book ratios and US GAAP required goodwill expense was observed for their sample Amir, Harris and Venuti's findings suggest that foreign investors either use the 20-F filing and

“add back’ goodwill amounts that firms have written-off or they have some mechanism to impute an asset value that is highly correlated with the goodwill amount required under

US GAAP

These findings have an important implication for the present study Amir, Harris, and Venuti’s results indicate that the goodwill recognized by UK firms which are cross- listed in the US has some economic substance to investors participating in the UK equity

? The SEC requires foreign firms with a US exchange listing to offer their US investors either US GAAP measured financial reports through standard 10-K filings or to provide foreign GAAP statements with a reconciliation of material differences between US and foreign GAAP through the 20-F filing The idea is to restate the account balances as-if the foreign firm prepared financial statements according to US GAAP

markets This evidence is not sufficient to argue that this relation (between market-to- book ratios and acquired goodwill) should hold for all UK firms that purchase goodwill Arbitrage will assure that the market value of UK firms on UK exchanges should reflect all

of the value relevant information impounded in the firms’ market price on other

exchanges.” However, information not available directly to investors may not be reflected

in the market prices for firms traded only in the UK

Barth and Clinch (1996) extended Amir, Harris and Venuti by studying the relation between share prices of Australian, Canadian, and UK firms and the information contained

in 20-F filing Their goal was to compare the value relevance of specific reconciliation items to the value relevance of the numbers that were reported under the firm’s domestic GAAP Similar to Amir, Harris and Venuti, Barth and Clinch investigated the disclosures associated with the goodwill reconciliation between US and UK GAAP Their study found that the goodwill amount disclosed in the 20-F filing was value relevant to setting prices in the UK

Henning (1994) designed a study to identify the interaction of market values with both the source of purchased goodwill and the length of its amortization period Two sources of goodwill were identified by Henning: 1) the difference between the pre-

acquisition market price of the target and the market value of the net-identifiable assets, or pre-bid goodwill, and 2) the difference between the market value of the acquisition price and the market value of the target firm prior to the acquisition, or premium goodwill

3 This does require that the transactions costs and currency exchange rates allow professionals to take advantage of any arbitrage opportunities that occur

(synergistic goodwill in this study) Henning proposed that these alternative sources of goodwill were likely to have different valuation attributes Further, Henning argued that if these different components have different economic substance then the useful life of the components would also vary Henning’s model tests for the existence of an interaction effect between goodwill source and amortization practices on market values

Model estimation was derived from panel data Firms entered the sample if they made an acquisition between 1985 and 1992, used purchase accounting, and if goodwill was identifiable Firms remained in the sample once entered Models were estimated using market-to-book ratios as one measure of the dependent variable, and twelve month returns deflated by the market value of equity as a second measure The explanatory variables for the market-to-book model version included the book value of acquired

goodwill, and dummy variables chosen to capture whether the sample firm: 1) had a higher relative proportion of premium goodwill to pre-bid goodwill compared to other sample firms, 2) followed strict forty year amortization practices, or 3) used a variety of

amortization patterns The returns model was similar except the goodwill amortization charge was substituted for total goodwill

Overall the estimation results were consistent with Henning’s predictions

Specifically, the coefficient on the proportion of premium goodwill to total goodwill was negative in the upper quartiles The coefficient on the dummy variable used to identify those firms whose proportion of premium goodwill to total goodwill was in the saniple's lower quartile was significantly positive Henning interpreted these findings as support for his argument that market values are more associated with pre-bid goodwill than premium

goodwill This finding is also consistent with the notion that investors consider premium goodwill to be at least partially an overpayment for the acquisition

Henning’s results suggest that goodwill is not homogenous Therefore, although the accounting policies of both the US and UK treat goodwill as an aggregate amount, investors might consider the components separately when valuing firms which have made acquisitions If, for example, the synergistic (or premium) component of goodwill is a proxy for an excessive purchase price then investors might discount the market values of the acquiring firm by the amount of this goodwill component If the synergistic

component is correlated with the total goodwill then the post-acquisition relation between the market values of acquiring firms and total goodwill will be sensitive to the degree of this correlation.* At the extreme, if all of the goodwill is synergistic goodwill then the post-acquisition relation between market values of the acquiring firms and the total

acquired goodwill might be zero This would occur if investors discounted the market value of the acquiring firms around the announcement dates for the acquisition by the amount of the synergistic component

The use of the components identified by Henning’s will allow the relation between market values and goodwill to vary if investors believe that each of the components has a different economic substance This could be particularly important if the type of goodwill

UK and US firms purchase systematically differs If this is the case, a difference in the association between the market values of the acquiring firms and goodwill in the two

4 Note, while it is true that when an individual acquisition is considered the total goodwill increases with the amount of the synergistic component, it does not follow that given a sample of acquisitions the total goodwill has to be correlated with the synergistic component

countries may be driven by the differences in the components and not the accounting treatment of goodwill Therefore, the association between market values and goodwill is also tested at the component level

In summary, the evidence in this section supports four points which are important for the present study First, Vincent (1995) and Jennings, Robinson, Thompson, and Duvall (1995) provide evidence that goodwill is considered by investors in US companies

to be an asset when it is reported in the post-acquisition financial statements of the

acquiring firms Hennings (1994) shows that aggregate goodwill can be separated into different components which appear to be valued differently by investors Third, the research of Amir, Harris, and Venuti (1993) and Barth and Clinch (1996) indicates that when UK firms reconcile their financial statements to US GAAP, the goodwill from this reconciliation is associated with the variation in their stock prices on their domestic

exchange Finally, Vincent’s results indicate that when sufficient disclosures are available

to allow investors to impute a goodwill balance they appear to do so, thus the post- acquisition market values of pooling firms reflects a proxy for acquired goodwill even though this value is not disclosed in the financial statements

An important issue which remains is whether the market prices of UK firms reflect acquired goodwill when these firms do not reconcile their financial statements to US GAAP This question is addressed directly in the current study to gain insight into

whether the accounting treatment of goodwill impacts firm valuation

3.2 Research Hypotheses

The first question is whether or not goodwill is considered an asset by investors in

US and UK firms near the release of the first post-acquisition financial statements

Prevailing US accounting practice treats goodwill as an asset while the most common UK practice does not Despite the accounting difference, the underlying transaction is similar for firms from both countries, acquiring firms trade some asset for goodwill Further, goodwill is similarly defined in both countries: as the excess of the acquisition price over the fair value of the net assets acquired Finally, the evidence of Barth and Clinch as well

as Amir, Harris and Venuti indicates that goodwill is considered an asset by investors for

UK firms when the amount is disclosed in reconciliations between US and UK GAAP for 20-F filings This suggests that the post-acquisition market value of US and UK firms should reflect this goodwill even if it is not reported in the primary financial statements

The hypothesis is tested by determining whether the post acquisition goodwill balances (book value ir: US, imputed in the UK) provide incremental explanatory power above the other coraponents of book value once for market values The country-specific hypotheses to be tested are:

H1Aus: Acquisition goodwill provides significant incremental explanatory power for explaining the relation between market values and book values of US firms when compared to the relation between market values and book values excluding acquired goodwill at a point in time six months after the first post-acquisition financial statement date

H1 Aux: Imputed acquisition goodwill provides significant incremental explanatory power for explaining the relation between market values and book values of UK firms when compared to the relation between market values and book

values excluding imputed goodwill at a point in time six months after the first post-acquisition financial statement date

Support for these hypotheses will provide evidence that goodwill is considered an asset in both countries soon after the acquisition date At this time the information required to determine the magnitude of goodwill is publicly available, directly to US investors, and indirectly to investors in UK firms

The six month post acquisition measurement date was chosen to insure that investors have sufficient information to identify the acquired goodwill UK firms are allowed approximately six months after the end of the fiscal year before they must release their primary financial statements To insure that the primary financial statements are available to investors the market values of the acquiring firms were collected on the closest trading day to the fifteenth day of the seventh month following their balance sheet date This approach is consistent with past research involving UK firms

The next set of hypotheses examine the association between market values of acquiring firms and the components of acquisition goodwill Since the components arise from different sources, investors may believe the economic substance of the components differs Further, if premium goodwill represents an overpayment then it might be

completely discounted around the acquisition date and not be reflected in the post-

acquisition market values of acquiring firms This, in turn, could camouflage a relation between pre-bid goodwill and market values when tested at the aggregate level The alternative form of the hypotheses to be tested are:

H2Aus: When the market values of US firms are regressed

on the components of acquisition goodwill there is incremental explanatory power above the regression of market values on aggregate goodwill

H2Aux: When the market values of UK firms are regressed

on the components of imputed acquisition goodwill there is incremental explanatory power above the regression of market values on the aggregate imputed goodwill

The next set of hypotheses examines the post-acquisition relation between market values and book values at dates progressively more removed from the acquisition date The UK practice does not continue to remind investors of the purchase of goodwill since

it is excluded from the balance sheet In contrast, the continued presence of goodwill on the balance sheet for US firms will remind investors of its existence The alternative hypotheses to be tested are:

H3Aus: Book value of acquired goodwill provides significant incremental explanatory power for explaining the relation between market values and book values of US firms when compared to the relation between market values and book values excluding acquired goodwill each year for five years after the initial acquisition

H3 Aux: Imputed acquisition goodwill provides significant incremental explanatory power for explaining the relation between market values and book values of UK firms when compared to the relation between market values and book values excluding imputed goodwill each year for five years after the initial acquisition

Once again, the aggregate goodwill amount may conceal differences in the

association between market values and acquired goodwill that would be visible if the association tests were based on the components of goodwill Therefore the next set of hypotheses examine the same question with goodwill components disaggregated Stated

in the alternative form:

H4Auys: Acquired goodwill components provide significant incremental explanatory power for explaining the relation between market values and book values of US firms when compared to the relation between market values and book values of aggregate goodwill each year for five years after the initial acquisition

H4Aux: Imputed acquisition goodwill components provide significant incremental explanatory power for explaining the relation between market values and book values of UK firms when compared to the relation between market values and book values of aggregate imputed goodwill each year for five years after the initial acquisition

The previous hypotheses examine the association between goodwill and market values for US and UK firms independently The final hypothesis involves a direct

comparison between the sample firms from these two countries If similar UK and US firms each made identical acquisitions, the post-acquisition book values of the firms would differ by the amount of unamortized acquisition goodwill, ceteris paribus This could cause the initial market-to-book ratio for a UK firm to be higher than that of the

comparable US firm This follows since the only difference between the US and UK firm

is that the book value of US firms includes goodwill If investors in UK firms

subsequently “forget” about the underlying goodwill then the market value and the

market-to-book ratio value of UK firms should decline If US investors continue to value the goodwill component of their balance sheets then the market values will continue to reflect this goodwill and hold the market-to-book ratio more nearly constant This is a weak test because many other factors which determine the market-to-book ratio are different between these two countries Not the least of which are accounting differences

for issues other than goodwill Nonetheless a finding that UK acquiring firms’ market-to- book value ratio declines faster than the market-to-book ratio of US firms post-acquisition would provide evidence that goodwill accounting policies affect the relation between market values and goodwill The question examined, stated in the alternative form is:

HSA: There is a significant negative difference between the rate of

change in the market-to-book value ratios of UK and US firms during the five year post acquisition period

Chapter Four

Methodology

4.1 Association Tests near the First Post-Acquisition Balance Sheet Date

If an accounting system were designed to perfectly reflect market values, the market value of a firm would be equal to the firm's book value of equity as described by the following equation:

where MV represents the market value, and BVE is the book value of equity The

accounting identity defines BVE as:

accounting practices record values of individual assets and liabilities conditioned on the specific portfolio of the firm Further, for only a few classes of individual assets and liabilities does the recorded balance sheet amount reflect market values With respect to the second assumption, Landsman (1986), Barth (1991), and Shevlin (1991), have

demonstrated that market values reflect some assets and liabilities which are not reported

on the balance sheet, specifically pension plan assets and liabilities and research and

development assets These issues suggest that equation | is incomplete for relating

market values to book values The following modification is required to complete the relation:

as an asset in both the US and the UK, 2) whether only one or another of the components

of goodwill is impounded in market values, and, 3) whether investors in both countries consider goodwill to be an asset for the first five post-acquisition years with a carrying value very near the original acquisition price The examination of these possibilities begins with the recognition that in the US and the UK the accounting for an acquisition allocates the purchase price as follows: