The Entity Theory of Recording Goodwill in Business Combinations: Old Stuff

By Stephen A. Zeff

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.

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