| The
Entity Theory of Recording Goodwill in Business Combinations:
Old Stuff
By
Stephen A. Zeff
OCTOBER 2005 - The
proposal by FASB and the IASB to adopt the “entity
theory” for recognizing the amount of goodwill in
a business combination is hardly new to the U.S. accounting
literature. This literature has dealt with the preparation
of the consolidated statements, but the principle is the
same for the journal entry on the acquiring company’s
books that records the goodwill arising out of the business
combination.
To
be sure, FASB’s September 1991 discussion memorandum,
Consolidation Policy and Procedures, treats the
entity theory and its consequences for the amount at which
goodwill should be recognized when a minority interest exists,
but it provides no citations to previous literature. My
purpose in this editorial is to bring out the antecedents.
Henry
Rand Hatfield, in his highly acclaimed textbook, Accounting:
Its Principles and Problems (Appleton, 1927), argued
for recognition of 100% of consolidated goodwill even if
less than 100% of the shares had been acquired. He wrote:
“Inasmuch as in the consolidated balance sheet the
full value of each of the assets is shown, although the
holding company has only a fractional interest therein,
it seems needlessly inconsistent in regard to the single
asset goodwill to show only part of its value and to neglect
entirely that portion representing the equity of the outstanding
stockholders” (page 448).
Maurice
Moonitz, a student of Hatfield’s, made a similar argument
in “The Entity Approach to Consolidated Statements”
(The Accounting Review, July 1942) because, according
to him, the practice of recognizing only the purchased share
of goodwill when there is a minority interest “makes
goodwill a function of the number of shares acquired, not
a function of any attribute such as superior earning power
of either a legal or an economic entity” (page 241).
Moonitz expanded on this argument in his monograph The
Entity Theory of Consolidated Statements (American
Accounting Association, 1944). Both Hatfield and Moonitz
were renowned accounting academics at the University of
California, Berkeley, from 1910–1940 and 1940–1980,
respectively.
No
less an authority than William A. Paton, at the University
of Michigan, advocated recognizing the goodwill associated
with the minority interest. He wrote, “In general,
it is reasonable to assume [that] the market value of the
minority slice is consistent with the demonstrated value
of the majority interest.” By not recognizing the
minority share of the excess of the purchase price of the
shares over the acquired company’s book value, including
the goodwill, “the consolidated statement is a hodgepodge
rather than a clear-cut, consistent presentation from the
point of view of the dominant interest—the point of
view which should be emphasized in consolidated reporting”
(Corporation Accounts and Statements; Macmillan,
1955). Even though Paton did not embrace the entity theory
in principle, he nonetheless argued for grossing up the
goodwill to 100%.
In
the third edition of the Accountants’ Handbook
(Ronald Press, 1943, edited by Paton), the chapter
on consolidated statements written by Paton disciple Perry
Mason stated a preference for recognizing the goodwill equivalent
to the minority interest. This preference was carried forward
into the Handbook’s fourth edition (Ronald
Press, 1956).
In
the 1950s, the authors of the two leading advanced-accounting
textbooks evinced sympathy with Moonitz’s entity theory
and its implication for the amount to be assigned to consolidated
goodwill. In their leading textbook, Principles of Accounting,
Advanced (Prentice-Hall, 1952), H.A. Finney and Herbert
E. Miller explained the theory and showed in a numerical
example how it would affect the amount that should be attributed
to consolidated goodwill. Wilbert E. Karrenbrock and Harry
Simons (Advanced Accounting, Comprehensive Volume;
South-Western, 1955) did likewise.
Louis
H. Jordan, in the Handbook of Modern Accounting
(McGraw-Hill, 1970, edited by Sidney Davidson), discussed
the entity theory and pointed out that one of its implications
was that the minority share of goodwill should be recognized
in the consolidated balance sheet.
The
entity theory has also been discussed in several accounting
theory textbooks, most notably in Vernon Kam’s Accounting
Theory (Wiley, 1990). Kam, a student of Moonitz’s,
wrote: “The entity theory has the advantage of having
been formulated rationally.”
As
I have demonstrated above, FASB and the IASB’s joint
proposal has received considerable favorable attention in
the U.S. accounting literature since the 1920s. As a consequence,
the proposal is hardly a radical one.
Stephen
A. Zeff, PhD, is Herbert S. Autrey Professor of Accounting
at the Jesse H. Jones Graduate School of Management, Rice
University, Houston, Texas. His two-part article, “The
Evolution of U.S. GAAP: The Political Forces Behind Professional
Standards,” was published in The CPA Journal in January
and February 2005.
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