What Generates Goodwill? An Examination of the Relation between Purchased Goodwill and Acquired Firms’ Expenditures on Advertising and Research and Development

March 1, 1996

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Executive Summary Treatment of goodwill from both a tax and a financial accounting perspective is an ongoing problem. The issues stem largely from the fact that the transactions leading to recognition of goodwill (for both tax and financial accounting purposes) are limited to those in which an existing company is purchased in its entirety. From a tax perspective the issues relate to whether the current rules regarding amortization of goodwill achieve an economically efficient result as measured by tax rates on goodwill and other intangibles relative to rates on other assets. Determination of the appropriate tax treatment depends intrinsically upon the tax treatment given to the expenditures that create intangibles. From a financial accounting perspective the issues relate to determination of an appropriate amortization period for goodwill.

This research focuses on the costs to create goodwill. While a number of studies have argued that goodwill is created by expenditures on advertising and research and development, there have been no direct tests of this hypothesis. Using mergers from 1975-1992, this study examines the relation between purchased goodwill and pre-acquisition expenditures on advertising and research and development. Intangible assets generally are ignored during development because the conservatism bias reflected in financial reporting, coupled with a desire to find tax write-offs, provides little incentive for a company to try to value or report in any way self-developed intangibles. This bias causes management to be largely unaware of the level and value of a company’s intangible assets until it becomes involved in a potential business combination. “Goodwill” often is attributed to a variety of factors including location, management quality, proprietary knowledge, and assorted other factors which may or may not relate to costs that are typically expensed for tax purposes. Whether or not purchased goodwill is created by expenditures on tax deductible items is an empirical question. The research hypotheses (stated in the alternative form) follow:

H1: There is a positive relation between an acquired company’s pre-acquisition expenditures on advertising and the amount of goodwill recognized by an acquiring company in a purchase business combination.

H2: There is a positive relation between an acquired company’s pre-acquisition expenditures on research and development and the amount of goodwill recognized by an acquiring company in a purchase business combination.

The results strongly suggest that expenditures on advertising and R&D are a significant source of purchased goodwill. We also found that a number of firms that report no expenditures on either advertising or R&D report significant goodwill. Thus, we can conclude that advertising and R&D expenditures will contribute significantly to goodwill of companies acquired in purchase transactions. However, the source of goodwill remains unknown for acquired firms that do not spend on these items.

From a tax perspective the findings support the assumptions underlying the Gravelle and Taylor analysis for at least some firms. However, Gravelle and Taylor acknowledge that some intangibles may be created by expenditures that are not immediately expensed and that their analysis is predicated on the assumption that the expenditures are expensed as incurred. The results presented here suggest that it may be appropriate to examine the source of purchased goodwill in determining the tax treatment to the purchasing firm. Goodwill generated by expenditures other than R&D and advertising should be evaluated and perhaps treated differently.

The results also indicate that capitalization of advertising and R&D may be theoretically superior to existing accounting practices. The issue then becomes one of determining the appropriate amortization period. A third issue is whether this suggests alternative tax treatments of advertising or R&E.


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