A POLITICAL ECONOMY OF SSAP22: ACCOUNTING FOR GOODWILL

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24-11-95 13:47:13

British Accounting Review (1995) 27, 283–310

A POLITICAL ECONOMY OF SSAP22: ACCOUNTING FOR GOODWILL R. A. BRYER University of Warwick In late 19th century Britain it was widely accepted by leading authorities that ‘goodwill’ was simply the purchase of sufficient expected ‘surplus profits’ to persuade the owners of a business to part with its net assets and control, and that this expenditure should be capitalized and amortized against those surplus profits as they are realized. Although this method remains the conventional wisdom, and dominates current international regulation and practice, its conceptual foundation appears lost to modern scholars, for whom the ‘problem’ of accounting for goodwill is ‘insoluble’. In the first part of the paper the concepts of Marx’s political economy are employed to elaborate the conventional method, which is argued to be necessary to allow the capital markets to observe the generation and realization of profit and the rate of return on capital. From this perspective, the heavily criticized decision of the UK authorities in SSAP22 to encourage the write-off of goodwill against capital is an anomaly requiring explanation. It is usually explained as either the ASC’s acceptance of economic income accounting as the ideal for financial reporting, or its acquiescence to powerful managerial interests. In the second part, these explanations are criticized, and an alternative hypothesis advanced which is consistent with the limited evidence available. That, although the capital markets usually want purchased goodwill to be capitalized and amortized, in the peculiar circumstances of the UK, where unusually large portions of its manufacturing industry were closed or run down in the acquisitions and merger boom of the 1980’s, writing-off purchased goodwill against capital was in the collective interest of investors because it helped to hide from public view the fact that dividends were being paid from capital.  1995 Academic Press Limited

INTRODUCTION The current consensus amongst British scholars of accounting is that there is no ‘solution’ to the ‘problem’ of accounting for goodwill. For example, in a recent study for the UK Accounting Standards Board (ASB), Arnold, Egginton, Kirkham, Macve & Peasnell (1992) conclude, ‘Although much has been written on the problem of accounting for goodwill during the past I am grateful to Christopher Napier of the LSE for helpful comments and suggestions, and to my colleagues Stan Brignall and Roger Hulme. Correspondence should be addressed to: R. A. Bryer, Warwick Business School, University of Warwick, Coventry, CV4 7AL, UK Received 5 August 1994; revised 21 March 1995; accepted 16 May 1995 0890–8389/95/040283+28 $12.00

 1995 Academic Press Limited

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century, the solution remains elusive’ (1992, p. vii). The view is questionable on both conceptual and historical grounds. Conceptually, because the origin of the problem for many modern authorities is their uncritical acceptance of the economists’ view that the only measure of ‘value’ of interest to investors is market price based on the present value of expected cash flows, and the dilemma that this notion is obviously far too unreliable for accounting. It has been argued elsewhere that Marx’s political economy, particularly his analysis of the ‘circuits of capital’ based on the labour theory of value, provides a superior conceptual foundation for understanding accounting because it explains its concepts and its functioning within the obviously relevant social, economic and political context of modern capitalism (Bryer, 1993, 1994). In the first part of this paper Marx’s concept of ‘surplus profits’ is used to explain and defend the conventional method of accounting for goodwill as the only justifiable and practical way of meeting the demand of the capital market that published accounts allow it to observe the generation of profit and the rate of return on capital. Historically, the implication in Arnold et al.’s conclusion that any solution has been ‘elusive’ for a century is also open to question. Although this understanding is all but lost to modern students and practitioners, most leading late 19th and early 20th century authorities agreed that goodwill was simply the purchase of sufficient expected ‘surplus profits’ to persuade the owner(s) to part with the net assets and control of a business, and that to reveal the rate of return on capital this cost should be capitalized and amortized against those surplus profits as they are realized. Amortization of purchased goodwill is the required method in all other countries with well-developed capital markets, and is dominant practice by major companies subject to the pressures of the international capital markets, including those from countries until recently dominated by bank finance capital (Tonkin, 1989; Brunovs & Kirsch, 1991; Coopers & Lybrand, 1994).1 Also, the international accounting standard on goodwill accounting (IAS12) has recently been revised to require amortization from 1 January 1995. However, in SSAP22: Accounting for goodwill (ASC, 1984) the UK authorities encouraged its write-off against capital. While, for those who believe there is no solution to the goodwill problem, this widely criticized deviation is understandable, if for some regrettable, from the perspective of Marx’s political economy it is an interesting anomaly requiring explanation. Accounting scholars have explained SSAP22 in two ways. Some explain it as the ASC’s acceptance of the economic income ideal (e.g., Gray, 1988; Ma & Hopkins, 1988; Taylor, 1987). Others believe it is explained by the ASC’s ‘weakness’ in the face of ‘market forces’ dominated by the interests of professional managers in boosting reported profits, and thereby their remuneration (e.g., Grinyer, Russell & Walker, 1990; Hastie, 1990; Nobes, 1992). In the second half of the paper an alternative hypothesis is advanced

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and defended. That UK companies were encouraged to write-off the record amounts of goodwill they purchased in the 1980’s to hide the fact that, for many, dividends were being paid from capital. We proceed as follows. First, the concepts of Marx’s political economy are applied to the ‘problem’ of accounting for goodwill, and are shown to underlie the conventional method. Second, it is shown that, in Marx’s terms, the ‘vulgar economics’ of economic income accounting for goodwill would be anomalous in capitalism. Third, the explanations of SSAP22 given by accounting scholars are considered and rejected as inconsistent with the evidence. Finally, the alternative hypothesis is proposed and defended. MARX’S POLITICAL ECONOMY AND ACCOUNTING FOR GOODWILL Within Marx’s political economy, financial reporting is functional for investors collectively (the capital markets) because it allows them to observe the generation and realization of surplus value and the rate of return on capital (Bryer, 1993, 1994). Information on the realized rate of return on capital is useful to investors in general. Firstly, because it provides them with a collective basis for controlling management, and secondly because it ensures equity between individual investors as ‘fractions of total social capital’. These financial relationships, between investors collectively and management, and between investors themselves, Marx calls the ‘social relations of capital’. Both of them are governed by the collective demand of investors for an ‘equal return for equal capital’, that all capital is required to earn at least the risk-adjusted ‘general rate of profit’, or, in modern terminology, the return on the market portfolio. This ‘required return’ not only provides the basis for ‘disciplining’ management’s decisions, but also for demonstrable and enforceable ‘fairness’ between investors holding fractions of the market portfolio. For example, if all companies are required to publish the realized rate of return on their capital, current investors cannot secretly pay themselves dividends from capital, sell the company, and ‘unfairly’ prejudice the dividends of the incoming investors. For the political economist, therefore, in the context of these relationships, the primary role for accounting is to allow investors in general, the capital markets, to observe the generation and realization of profit and the rate of return on capital. However, it is important to note that although from Marx’s point of view the social relations of capital ‘govern’ accounting, they are not seen as ‘determining’ it, as his critics invariably say they are (e.g., Hoskin, 1994, p. 13). For Marx the economic world is not determined, but is consciously constructed and sustained as a particular system of social relations. Thus, it would have come as no surprise to him that in particular historical contexts the collective interests of investors are better served by ‘creative

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accounting—that is, the deliberate distortion of published accounts—either overstating or understating the generation and realization of surplus value and the rate of return on capital. Far from offering determinist explanations, it is only from the perspective of Marx’s political economy that the notion of non-determined, creative accounting is meaningful. For most scholars of accounting no meaningful concept of profits exists which could be distorted. Some argue profit is mere ‘epiphenomena’ (e.g., Hoskin & Macve, 1986, p. 121) which, as it does not exist, could not be distorted, and others that there is no ‘substance’ to accounting which could override mere ‘form’ (e.g., Hopwood, 1990). For the majority also, although profit can meaningfully be conceptualized as economic value, as this is inherently ‘creative’, a mere matter of opinion, ‘true’ economic values do not exist, and cannot be ‘distorted’. For Marx on the other hand, underlying economic values is the reality of ‘socially necessary labour’, the human effort required to produce commodities and services, and underlying the reality of ‘profit’ is surplus value, unpaid labour time (1981, p. 119). In the appropriate circumstances, distorting the representation of this reality might well be in capital’s collective interest.2 In the second part of the paper it is argued that SSAP22’s encouragement to write off goodwill against capital was an invitation to just such creative accounting. But the first question is what, from Marx’s point of view, is the reality of ‘goodwill’? All sides of the goodwill debate agree that goodwill is measured as the difference between the market value of an entity at any point in time and the fair value (either the replacement cost, recoverable amount or net realizable value) of its net assets, including any separately identifiable intangible assets (such as trademarks, copyrights, patent rights). And that, if this difference is positive, goodwill exists because the entity is believed, for a variety of reasons (good customer relations, good employee relations, superior technology, superior management, superior location, monopoly power, etc.), to offer a higher return on its capital than alternative investments with the same risk. This excess return was, for Marx, ‘surplus profit’. In his view, the fact that on average companies produce the same risk-adjusted return on their capital is the result of competitive redistribution of the total surplus value generated within the economic system. In the competitive struggle, it happens that particular companies at particular times, for a variety of reasons, secure ‘surplus profits’. As he says, in addition to monopoly power, ‘. . . rates of profit can be very different according to whether raw materials are purchased cheaply or less cheaply, with more or less specialist knowledge; according to whether the machinery employed is productive, suitable and cheap . . . management and supervision is simple and effective, etc. In short, given the surplus value that accrues to a certain variable capital,3 it still depends very much on the business acumen of the individual, either the capitalist himself or his managers and salespeople, whether this same surplus-value is

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expressed in a higher or lower rate of profit and therefore whether it delivers a greater or lesser amount of profit’ (vol. 3, p. 235).

Those entities for which surplus profits are expected would have positive goodwill, their market value would be greater than the fair value of their net assets.4 However, although there is agreement on the measurement and origins of goodwill, there is fundamental disagreement about the implications for accounting. While, as we shall see, economists advocate continuous accounting for the difference between market value and net assets at fair value, from Marx’s point of view any ‘internal’ or ‘inherent’ goodwill, any difference caused by the expected surplus profits from expenditures within the company (e.g. on advertizing, research, employee relations, etc.), would have no place in the balance sheet. The reason is simple. Calculating the present value of expected profits would produce a ‘fictitious capital’. ‘The formation of fictitious capital is known as capitalization. Any regular periodic income can be capitalized by reckoning it up, on the basis of the average rate of interest, as the sum that a capital lent out at this interest rate would yield’ (vol. 3, p. 597).

In other words, can be capitalized to its present value.5 For Marx, any representation of unrealized capital as present value is ‘fictitious’ because the ‘real’ source of value is labour in a production process, the cost of the necessary labour required at a given level of technological development to produce those commodities and services which can be sold to recover both their cost and the value of unpaid labour. It follows that, as inherent goodwill is the present value of expected surplus profits, it should have no place in capitalist accounting designed to allow the capital markets to observe the generation and realization of surplus value. As Marx says, with fictitious capital ‘. . . all connection with the actual process of capital’s valorisation is lost, right down to the last trace, confirming the notion that capital is automatically valorised by its own powers’ (vol. 3, p. 597).6 By ‘valorisation’ Marx means realizing the required return on the capital employed and controlled in the production process. For him, internal expenditure on advertizing, research, employee relations, etc., to generate inherent goodwill, did not create value, did not give control over the value creating labour process, but were necessary unproductive overheads in the competitive struggle to secure the maximum return on capital. While these overheads may bring surplus profits, they are not generated in the production process, but in the market, by one company grabbing a bigger share of the total surplus value available in an economic system than is justified by the size of its capital and the risk of its employment. Thus, if (say) the expenditure on an advertizing campaign were ‘prudently’ deferred as a fixed ‘asset’ in the balance sheet on the grounds that the cash flows expected to result have a present value of at least this amount, to this extent the connection between the accounts and the generation and realization of value in the production

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process, the creation of the commodities or services to be sold and their actual sale, would be lost. Both the capital invested in production and the realized net profit would be overstated by not deducting the expenditure of capital on advertizing and, if written down in future periods, future realized profits would be understated. For Marx, capital is money invested in production for profit. All those expenditures necessary to gain control of the process of production which are expected to be recovered ‘bit by bit’ over more than one turnover cycle of circulating capital, are fixed capital. In the case of purchased goodwill, money is invested by purchasing sufficient of the expected surplus profits of more than 1 year to gain control of another company’s production process, with the intention of making more. Thus, if the surplus profits of one company are purchased by another entity, as this expenditure is necessary to gain control of its production process, to report the rate of return on the purchaser’s capital it is necessary to include the cost of the surplus profits as part of its productive capital, and to set a portion of this expenditure against the surplus profits as they are earned. Unless this is done, the entity’s rate of return on its capital invested in production is overstated. Firstly, the purchasing entity’s total expenditure on productive capital is understated. Secondly, until the capital invested in surplus profits is recovered bit-by-bit as they are realized, there is no return on it. Thus, from Marx’s point of view, unless the amount of capital recovered each period were cancelled out against purchased profits realized, the purchasing entity’s rate of return on its capital employed would be overstated. For Marx, tangible fixed capital is merely a controlled store of use-values for production whose cost is expected to be recovered bit by bit over several accounting periods, through becoming attached to, or embodied in, commodities or services that are realized (Bryer, 1993, 1994). Precisely the same cost, recoverability, and control tests can be applied to recognize and measure intangible fixed capital, which should also be accounted for as the costs of controllable use-values. The only difference is that the use-values are intangible, simply not capable of being touched. For example, a monopoly confers the controllable intangible use-value of no competitors, no other production processes, as does a controlled secret-process. Neither the absence of competitors, nor their ignorance, can be ‘touched’, but these facts are controlled use-values for production nonetheless. However, from Marx’s point of view, while the costs incurred to acquire control of intangible use-values for production should be capitalized if they are expected to be recovered bit-by-bit, as surplus profits are realized, as they do not add socially necessary value (i.e., customers could not be persuaded to pay for cost of establishing the possibility of earning surplus profits, as well as provide the surplus profits), they should not be attached to products or services, but be deducted from total profits as the purchased surplus profits are realized. In other words, intangibles are non-production overheads, and are not inventoried or recapitalized.

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Applying these cost and control tests to goodwill, on both counts inherent goodwill, the expected surplus profits arising from internal expenditure creating the ‘special advantages’ or ‘business acumen’ of the firm, should not be recognized as an intangible fixed asset. Firstly, it has no cost to be recovered from expected profits. It is precisely those expected surplus profits which are not paid for in advance. For example, inherent goodwill may arise from expenditure on advertizing which is expected to produce surplus profits over more than one period. Although creating this expectation has a cost, unlike purchased goodwill the expected profits arising from advertizing expenditures are not themselves purchased. Companies do not spend money on advertizing to purchase expected surplus profits, but to generate them! Secondly, inherent goodwill fails the test of controlability. Unlike, for example, a copyright or patent giving the potential to (ultimately) physically exclude competitors, expenditures on advertizing and training for example, do not give management intangible use-values which they can physically control in the production process. They are non-production overheads. Whereas competitors may be legally coerced, potential customers and current employees cannot. ‘Team-spirit’, ‘business acumen’ or ‘favourable locations’ are certainly intangible use-values, but they are not physically controllable. This is why, although it is often suggested (e.g. FASB, 1985, para. 175) that whether expenditures on intangibles should be capitalized depends on how ‘reasonably’ they are expected to be recovered, from Marx’s point of view they should never be capitalized because they do not create controllable use-values, even though they may create the preconditions for making profits. For example, R&D expense should always immediately be expensed and not deferred as an asset, not because the benefits are too uncertain, but because although this expenditure may create potentially useful knowledge, unless this knowledge is patented or kept secret, it is not physically controllable.7 On the other hand, purchased goodwill is recognized as an intangible fixed asset because in this case the acquiring company’s management has expended capital to gain physical control of an intangible use-value, the power of decision making in the acquired firm, control of its productive capital. Perhaps this is why accounting educators often call purchased goodwill the ‘cost of control’, as this recognizes that the expenditure is to be treated as part of the cost controlling productive capital, for which management is held separately accountable to social capital. Note, however, that although purchasing surplus profits is a necessary cost for gaining control of production, the other ‘incidental’ expenses for lawyers, capital issue expenses, management time, are not. These unproductive overheads merely consume capital, and add nothing to the control that buying the surplus profits has already achieved. The fact that expenditures on surplus profits only purchase control of production, and do not add value to it, may explain why intangibles are generally said to be ‘amortized’ whereas tangibles are ‘depreciated’ (Lee,

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1975, p. 112). The word amortize clearly derives from the Latin mort. In the Italian medieval business world a Morto was a dead or unproductive loan, one which bore no interest (Elder, 1934, p. 189). In England, the word ‘amortization’ originally meant to alienate land in ‘mortmain’, to the ‘dead hand’ of a ‘corporation’, in return for an interest-free loan which would be extinguished by a sinking fund. In other words, amortization meant the periodic repayment of a secured loan to a monastery (the first corporations) which, because of the prohibition of usury, carried no interest. Thus, perhaps, purchased goodwill is still ‘amortized’ and not ‘depreciated’ because earning surplus profits purchased in advance is analogous to repaying an interest-free ‘loan’ from the purchasing firm’s owners for gaining control of production, rather than a cost of productive capital to be embodied as socially necessary value in products or services to be sold for profit. In other words, although conventional accounting treats purchased goodwill as a cost of productive capital, it makes clear it is the price of control by ‘amortizing’ it. If goodwill is the purchase of some or all of a number of years’ surplus profits, this number of years determines its useful life for amortization, and the pattern of amortization is determined by the pattern in which the surplus profits are expected to be realized. If management change their expectations, purchased goodwill should be written-down to its recoverable amount, that part of the cost of the surplus profits now expected to be recovered, and any remainder amortized on the basis of the revised expectations. As for all accounting estimates, to assess the truth and fairness of management’s expectations about the life, amortization method, and recoverability of goodwill, accountants must assess the evidence cost-effectively available, for example, in documentation of the purchase decision, the purchase contract, the achieved rate of return on capital compared to the industry average, competitive developments, etc. Note that writing down goodwill to its recoverable amount has nothing to do with changes in the source of the goodwill, the particular intangible use-values acquired. For example, if a major competitor earning surplus profits is acquired and closed to allow the purchaser to earn even larger monopoly profits, no write-down of acquired goodwill is required. The generation and realization of surplus value is observable, and the rate of return on the total capital invested is correctly stated by capitalizing and amortizing the purchased goodwill in the light of management’s initial expectations. Again, the expenditure is simply the ‘cost of control’. Finally, goodwill as purchased surplus profits is a fixed asset with no meaningful replacement cost, and should not be revalued to ‘current cost’, the current surplus profits it would be ‘necessary’ to purchase to gain control. While this may, perhaps, be estimated, unlike tangible fixed capital, it is not necessary to replace purchased goodwill to continue the process of production, but merely to recover it, and therefore it is not necessary to

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revalue it. It follows as well that any hindsight revaluations of net assets acquired do not affect the value of goodwill. Although apparently lost to modern scholars, the understanding that goodwill was the purchase of surplus profits has been the foundation of conventional accounting thought on the subject since at least the 1880’s.

THE EARLY AUTHORITIES In the first book published on accounting for The Depreciation and Valuation of Factories, Matheson defined goodwill to be the cost of ‘surplus profits’ which, he said, must be written off against profit. His principle for ‘depreciating’ purchased goodwill was that ‘If the amount be small, it may be wiped off at once out of the earnings of the first few years, or it may form the legitimate object to which to apply the surplus profits of a prosperous year’ (1884, p. 24). This statement, repeated by others, is consistent with the principle of writing-off purchased goodwill as the profits are received. A small amount of goodwill implies small profits purchased for a few years. On the other hand, if a firm has a ‘prosperous’ year it presumably earns abnormally large surplus profits, and therefore a large amount should be written off goodwill, whether this level of surplus profit was expected or not. The first paper published on accounting for goodwill was by More in The Accountant in 1891, in which the conventional approach is illustrated by the purchase of a firm with net assets of £100,000, where the ordinary return in its type of business is £8,000 or 8% per annum, and the expected return from the firm is £13,000 or 13% per annum. As More said, if the ‘fair price’ was determined to be £100,000 for the net assets and the purchase of 7-years’ surplus profits of £5,000, the total price would be £126,030, £100,000 plus the present value of £5,000 per annum for 7 years at 8%, or £26,030 which is the value of purchased goodwill.8 In his view, goodwill ‘. . . ought to be regarded merely as an advance by capital, which falls to be replaced out of revenue at the earliest possible date, (1891, p. 286). Thus, he deduced, ‘. . . the period within which the price paid for Goodwill should be replaced out of Revenue ought—to a large extent, at least—be regulated by the number of years’ purchase of the profits which the price represents . . . This present payment of £26,030 represents seven yearly payments of £5,000 (less discount at 8%), and I am disposed to think that in such a case one-seventh of the present payment of £26,030 should be set aside yearly out of Revenue until a reserve of £26,030 was reared up’ (1891, pp. 286–287).

If all went according to management’s expectations, during the first 7 years after the acquisition the shareholders would only get the 8% normal return. ‘Of course, the profits might fall below the amount reckoned on when the

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purchase is made, and in that case the shareholders would have to judge whether they would continue to set aside yearly the amount . . . and be satisfied with smaller dividends’ or, presumably more likely, to write its value down as a loss of capital. As More concluded, if the charge was made when profits had fallen below the expectations that underwrote the price, ‘The shrinkage of the profits would . . . only emphasise the risk which had been run in purchasing the Goodwill’ (1891, p.287), and would, presumably, encourage some or all of its write-off against capital. As Leake later suggested, conceptualizing purchased goodwill as ‘. . . the present value of the right to receive expected super profits . . .’ was ‘. . . useful to apply as a test of the reasonableness or otherwise of the very large sums constantly paid to vendors . . .’, and was necessary to ensure ‘. . . refunding the capital outlay on goodwill’ (1914, pp. 82, 86, 88). What the accountant had to do was ‘. . . determine how much of the annual profits are super-profits . . ., and then the number of years over which the ascertained annuity may fairly be expected to extend’ (1914, p. 86). Then, whenever purchased goodwill ‘. . . remains in the books of an undertaking [i.e., has not previously been written-off against revenue or capital], some provision should be made and charged to Revenue Account in every year in which super-profits have been earned’ (1914, p. 87). As he had earlier put it, copyrights, patent rights, goodwill and trade marks all had in common the fact that they were ‘. . . mere rights to future profit . . . expected to arise in future years’ (1912, p. 161). Where these rights were purchased, he thought, the payment ‘. . . is in effect the carrying out of an agreement under which the purchaser pays in advance to the seller a share of a portion of the profits expected to arise in future years’ (1912, pp. 161–162). In Leake’s view, therefore, unless these rights are purchased ‘. . . there is no capital outlay, and, therefore, there can be no expired capital outlay to be refunded out of future profits . . .’ (1912, p. 162). However, if they are purchased, the capital outlay must be set against them as they are earned so as not to obscure the profits not purchased: ‘The bargain has been made, and the expired capital outlay must be duly refunded out of future profits with the same certainty that the money paid for current expenses must be refunded out of revenue receipts if a correct statement of the owner’s economic profit and loss is required’ (1912, p. 166). By ‘economic profit’ Leake means the rate of return on the total capital invested. Paton and Littleton’s later and widely influential treatment suggests this objective of conventional goodwill accounting continued to represent conventional wisdom well into the 20th century: ‘. . . purchased goodwill represents an advance recognition of a debit for a portion of income that is expected to materialize later. It follows that the amount expended for goodwill should be absorbed by revenue charges—during the period implicit in the computation on which the price paid was based—in order that the income not paid for in advance may be measured’ (Paton & Littleton, 1940, pp. 92–93, emphasis added).

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The income not paid for in advance is the return on the total capital invested. Certainly, there were some in the late 19th century, and a growing number in the later 20th century, who advocated writing off goodwill against capital, and some who advocated its retention at cost or recoverable amount for companies (Hughes, 1982). However, it is important to note that, firstly, the substantial majority of early leading authorities favoured amortization. As Hatfield said, ‘. . . among English accountants, Child, Cooper, Guthrie and Pixley are among those favouring a regular writing off of Goodwill . . .’ (1913, p. 116, emphasis added). In addition to Matheson, More and Leake, considered above, two other well-known names to be added to the list of early authorities in favour of regularly writing off purchased goodwill are Whinney (1898, p. 799) and Payne (1892, p. 145), as well as Hatfield himself.9 Secondly, writing off against capital was only legally available for partnerships and sole traders, and was often advocated for them so that owners could avoid disclosing their purchase price at any future sale, and not on accounting grounds. Thirdly, those advocating the retention of goodwill for companies also often did so for ‘practical’ reasons. A notable leading authority to do this was Dicksee, particularly his influential Goodwill and Its Treatment in Accounts (with Stevens), first published in 1897.10 Dicksee also thought only purchased goodwill should be accounted for, and that it was so many ‘. . . months’ or years’ purchase of the surplus profits . . .’ (1920, p. 82). However, he did not advocate amortization as, in his view, investors had at that time often paid too much for goodwill, and in these cases there were no surplus profits to account for. In these cases, its cost was clearly a loss of capital, which should, in theory, be written off against capital. However, many of the company promotions he had in mind had little or no reserves, and therefore ‘. . . when the value of the Goodwill has been paid for out of capital it is practically impossible for it to be written off except out of profits . . .’, which would be ‘technically incorrect’ because it would create a ‘Secret Reserve’ (1920, p. 98). In other words, if surplus profits were written off against ordinary profits, secret reserves, undisclosed realized profits, would arise because the ordinary profits would be understated. Thus, to avoid the costly and potentially embarrassing necessity of widespread court-sanctioned write-downs of capital, although Dicksee did allow goodwill to be carried at cost so long as it was clearly disclosed, the fact that he stressed it was only where ‘. . . any writing down of Goodwill out of profits, unless it be to correct an actual shrinkage in value since the date when the Goodwill was acquired, is pro tanto the setting aside of a secret reserve’ (1920, p. 106), suggests he accepted that where there was an ‘actual shrinkage in value’, where there was the receipt of purchased surplus profits which reduced the value (cost) of goodwill, it was a necessary charge against profits, and would not create secret reserves.11 While the early accounting authorities had few doubts about the appropriateness and practicality of goodwill amortization, for most modern

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accounting scholars accounting for goodwill is deeply problematic. From Marx’s perspective, the source of their difficulty is their failure to conceptualize goodwill in the context of the social relations of capital. As he said, to understand capitalism, it is important not to confuse the thoughts and desires of the individual capitalist with social reality, because while individual investors and managers think and desire economic value, investors collectively, and managers in practice, see and pursue surplus value (Marx, 1981, p. 134). Thus, from his point of view the difficulty which modern accounting scholars have in understanding goodwill accounting arises from their uncritical acceptance of the thoughts and desires of the individual capitalist as the foundation of accounting. In other words, their uncritical acceptance of the economic income perspective in which the social relations of capital are ignored. ECONOMIC INCOME ACCOUNTING FOR GOODWILL The recommendations of economic theory for goodwill accounting are clear and, for many, are appealing. Firstly, as the objective is to reveal the change in the total present value of the enterprise, both internally-generated and purchased goodwill should be accounted for because it is ‘. . . worse than meaningless to show only the purchased goodwill, which is usually but a fraction of the market’s valuation of the earning power of the whole enterprise’ (Spacek, 1964, p. 331; see also Gynther, 1969, p. 255). Clearly, if the objective is to report changes in value, ‘. . . it seems unreasonable to reduce profits or reserves for something [i.e., anything, including inherent goodwill] which has just been acquired and has not yet diminished in value . . .’ (Arnold et al., 1992, p. 57). Secondly, if goodwill is conceived as a present value it clearly need not necessarily be amortized. Its value may remain constant, it may appreciate, or it may fall. From the economic income perspective the appropriateness of any write-offs depends entirely on the evolving pattern of present value. It may need to be written-off immediately, or it may be carried unamortized and revalued every period (Lee, 1971, p. 324; Arnold et al., 1992, p. x). Although these arguments are logically clear, demanding a periodic economic valuation of goodwill is obviously totally impractical as a foundation for reporting to social capital, as the leading exponents are usually forced to accept (e.g., Gynther, 1969, p. 255; Lee, 1971, p. 327). But, rather than abandon their principles, the economists typically attempt to make them ‘practical’ by arguing that, judged against the ideal of economic valuation, the recognition of only purchased goodwill in the balance sheet is ‘inconsistent’. That if the value of internal goodwill is not recognized, purchased goodwill should not be either, but written-off on acquisition against equity reserves, and not amortized. Only by doing this, they say, will the profitability of two businesses, one which has purchased goodwill, and one which has

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an identical amount of internal goodwill, be ‘comparable’ (e.g. Spacek, 1965; Catlett & Olson, 1968; Solomons, 1989, pp. 68–69). For Marx the hallmark of the ‘vulgar’ economist was an uncritical commitment to the economic income perspective.12 By Marx’s standards, most accounting theorists are decidedly vulgar. For him economic valuation was not simply difficult or impractical. The very idea of allocating ‘revenues’ to commodities such as fixed capital, capitalizing expected future cash flows as as fixed asset, was simply a ‘logical blunder’. Writing off purchased goodwill against capital reserves would simply compound that blunder. It would not make two otherwise identical companies ‘comparable’, one which had purchased goodwill and the other which had internal goodwill. While it would make their reported profits and capital equal, it would mean that the capital of the former company would be understated and its subsequent profits overstated. These two companies are clearly not ‘comparable’, and therefore their reported capital and profits should not be equal. One has purchased profits with capital, the other has earned them! Implicitly at least, in its advocacy of the conventional accounting solution in 1980, the principles of Marx’s political economy were accepted by the UK accounting authorities, and economic income accounting for goodwill rejected.

CONVENTIONAL ACCOUNTING RULES IN BRITAIN OK? The first official statement on accounting for goodwill in the UK was the publication in 1980 of an ASC Discussion Paper. Internal goodwill was not to be accounted for, ‘. . . partly because, under existing cost conventions (historical and current), it is not the function of the accounts of a business to place a value on the overall worth of that business, and also because inherent goodwill may have different values from the stand-point of different parties’ (ASC, 1980, para. 5.1). In other words, it was not the objective of accounting to report subjective economic values. The Discussion Paper carefully considered the accounting options implied by the economic income perspective and rejected them. It supported the conventional view, the ‘. . . alternative argument which is based on the fact that the purchaser of a business, or part of a business, expects that business, including its goodwill, to continue existing as an entity for a number of years and looks forward to, and purchases, the profits of those years’. Thus, it concluded, ‘Under this approach goodwill should be written off over the number of years for which the profits purchased are anticipated’ (ASC, 1980, para. 8.2). Thus, it was ‘wrong in principle’ to write-off purchased goodwill against the share premium account in a share-for-share exchange, ‘. . . since it would imply a reduction of invested capital, which would be unacceptable’, and the same principle was used to reject write-off against

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other equity reserves (ASC, 1980, paras. 7.2, 7.4). In other words, a capital write-off would distort the rate of return on capital. Although the Discussion Paper had clearly recommended a general requirement for the conventional method, the exposure draft which followed (ED30) recommended that companies be allowed the option of either amortizing goodwill over its useful economic life, or writing it off against equity reserves on acquisition. In SSAP22, this option became the preferred ‘treatment’. THE ASC’S PREFERENCE FOR IMMEDIATELY WRITING-OFF GOODWILL AGAINST RESERVES ED30’s ‘theoretical justification’ for the immediate write-off option was the argument from the economic income perspective that ‘. . . as purchased goodwill is of the same nature as non-purchased goodwill, it is inconsistent to recognise the former in financial statements and not the latter . . .’ (ASC, 1982, para. 18). This argument was accepted by SSAP22: the ‘principal reason’ for the immediate write-off option was that it was ‘. . . consistent with the accepted practice of not including non-purchased goodwill in accounts’ (ASC, 1984, para. 6). However, although the ASC accepted some of the arguments of the economic income theorists, it did so selectively. For example, its decision to rule out the retention of purchased goodwill in the accounts indefinitely unless management thought there had been a permanent reduction in its value, even though this was perfectly possible within the economic income view (ASC, 1982, para. 12). This was no principled restriction, but a fiat. ‘ASC considers that purchased goodwill should not be retained as an asset indefinitely . . . as in its view the value of purchased goodwill diminishes through effluxion of time following an acquisition; it may be replaced, to a greater or lesser extent, by non-purchased goodwill, but non-purchased goodwill is not accounted for and its existence should not be used to justify the indefinite retention of purchased goodwill’ (ASC, 1982, para. 15). The ASC provides no empirical or theoretical warrant for their ‘view’ that the ‘value’ of goodwill will diminish through time. On the other hand, neither does it provide any warrant for believing that goodwill vanishes on acquisition. Given ED30’s failure to even attempt to rebut the logic of the conventional view, and the fact, as Holgate says, that ‘. . . the ASC initially asked [!] the panel to prepare an exposure draft on the basis of an immediate write-off of goodwill to reserves’ (1990, p. 12), it is disingenuous of the ASC to say that its arguments show that both immediate write-off and amortization are ‘theoretically’ justified because ‘. . . users of accounts may require different accounting goodwill depending on their particular purpose’ (ASC, 1982, para. 26). As the FASB has stressed, and Marx would have agreed, to be useful financial reports can only ever be ‘general purpose’,

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potentially useful to all investors (e.g., FASB, 1980) as a class, and SSAP22 effectively admitted that the immediate write-off option was simply its preferred accounting policy: ‘The standard requires [sic] that purchased goodwill should normally [sic] be eliminated from accounts by immediate write-off’ (ASC, 1984, para. 6)! And this is what ‘normally’ happened. The policy was almost universally adopted (Russell, Grinyer, Walker & Malton, 1989). THE CONSEQUENCES AND CAUSES OF SSAP22 The consequences were as dramatic as they were predictable. From 1982 the level of merger activity and the goodwill arising grew to unprecedented heights. From an average of less than 5% of bidder’s net assets through most of the 1970’s, by 1987 goodwill represented 44% (Higson, 1989, Figure 2a). In 1988 prices, 1983 sales of independent companies and subsidiaries grew from some £3 billion to an estimated £23 billion in 1988 (Higson, 1989, Table 1). In total from 1972 to 1988 companies and subsidiaries costing £108 billion were acquired, £69 billion being paid between 1984 and 1988. On average over this period some 40% of the target’s value was goodwill. Therefore, crudely, if instead of writing off goodwill against reserves, if it had been written off over (say) 20 years, by 1988 the reported profits of UK companies would have been some £2 billion a year lower [0·4×£108bn/20 years].13 From a random sample of 229 companies from the top 400 UK companies, Russell et al. show that even in 1986, and taking only the previous 4 years’ acquisitions in account, if a 5-year amortization period had been adopted, the average rate of return on equity of these companies would have been 3 percentage points lower (11% rather than 14%), or by nearly 22% (1989, p. 15). Bearing in mind that this average is derived from a sample in which the profitability of about a third of the companies was unaffected, whereas a quarter of them would have reported a fall in profitability of from 5 to 20 percentage points, it is clear that ‘. . . reported company profitability would have been substantially lower in 1986 if companies had been required to adopt the five year amortisation treatment’ (Russell et al., 1989, p. 16). By international standards, UK goodwill accounting clearly allowed and encouraged a large overstatement of both reported profits and the rate of return on capital. How can the regulatory preference for immediate write off and its virtual universal adoption be explained? Although perhaps impossible to determine conclusively, against the background of UK and international accounting standards dominated by conventional accounting, the clear recommendation of the Discussion Paper for compulsory amortization, and the selective way in which the economic income perspective was employed in ED30 and SSAP22, it seems reasonable to rule out a theoretical commitment by the ASC to the perspective itself. A popular alternative explanation is that the

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write-off option was implemented in the interests of management. In what follows we explore this view, and the explanation of political economy that the immediate write-off option was encouraged in the collective interests of investors. THE MANAGERIALIST HYPOTHESIS: A ‘MARKET FOR EXCUSES’? One superficially appealing approach to explaining the ASC’s recourse to the economic income perspective is to argue that we have here an example of Watts & Zimmerman’s (1979) ‘market for excuses’, where accounting theories are supplied in response to demands from vested interests for whom particular accounting regulations have potential benefits. According to Watts & Zimmerman, the demands come from individuals or interest groups who want theories whose application is rationalized to be in the ‘public interest’. They assume accounting standard-setting takes place in a pluralistic political context in which there is a ‘diversity of interest which prevents general agreement on accounting theory’ (1979, p. 275). This view is the foundation of managerialist explanations of SSAP22. For example, Grinyer, Russell & Walker accept their ‘. . . assumption that people select accounting practices ‘‘so as to maximize their own welfare’’ ’ (1991, p. 51). Given this assumption, they believe it ‘. . . reasonable to assume that managers of UK public companies . . . would usually have wished to maximise the level of reported profit over time’ (1991, p. 52). In other words, that the widespread adoption of immediate write-off ‘. . . may well have been motivated by a desire to inflate their [sic] post acquisition profits . . .’ (1989, p. 29). They provide no evidence to support these deductions. Instead, they merely go on to assume that, in addition to the ‘satisfaction’ which they believe managers feel from the approval of the capital market, maximizing reported profits is in the financial interests of management because (a) bonuses are ‘frequently’ linked to accounting profits, and (b) current and future salaries are linked to accounting profits (1991, p. 52). Certainly, ‘if’ management’s pay was linked to reported profits or share values, it might be reasonable to assume that this explains the demand for SSAP22 (and other creative accountings). However, a study by Gregg, Machin & Szymanski (1992) of 288 of the UK’s top 500 companies between 1983 and 1991 shows that the relationship between the salary and bonus of the highest paid directors and both capital market and accounting measures of performance (other than sales growth) was ‘very weak’ (Financial Times, November 28 1992). ‘Another recent analysis by Income Data Services . . . with a sample of 69 of Britain’s top 100 companies, similarly found ‘no discernible relationship’ between performance and pay. Of the 26 companies where profits and/or earnings per share fell substantially, 23 of the most highly paid directors received pay increases’ (Financial Times,

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November 28 1992). In fact, no serious correlations have been found between management pay and profits in any country (Rosen, 1990). Apart from the fact that the evidence does not support the managerialist hypothesis, its real weakness is its unquestioned presupposition that managerial interests dominate UK accounting regulators. As Russell et al. say, according to positive accounting theory ‘. . . corporate managements will take advantage of any discretionary control they have over the financial reporting process to present themselves and/or their company in the best possible light . . .’ (1989, p. 29). This clearly raises the question, why did the regulators give management discretion over goodwill accounting? Why was it, as Nobes says, that ‘. . . given that majority practice and majority argument favoured immediate write off to reserves, the ASC did not try to ban this’ (1992, p. 145)? Implicitly, Russell et al. claim, because they succumbed to management power: ‘During the 1980s the UK regulations affecting accounting for acquired goodwill allowed managers to make accounting choices affecting recorded goodwill that best served their particular interests’ (1991, p. 51). From the managerialist perspective, therefore, SSAP22 was simply the result of the ASC’s ‘failure of nerve’, a lack of ‘authority’ and ‘independence’ (Nobes, 1992, p. 146). However, this essentially psychological explanation takes no account of the broader economic and political context in which SSAP22 was developed and implemented, and the pressures which this may have exerted on the ASC. THE ECONOMIC AND POLITICAL CONTEXT OF SSAP22 A vital part of the context within which UK goodwill accounting must be understood was the large scale divestment from manufacturing industry which began in the early 1980’s, and the central role which mergers and acquisitions have played in this process of ‘industrial restructuring’ (Higson, 1990, p. 11). Earlier work suggests that following the first oil crisis in 1974 it became widely recognized that a large part of UK manufacturing industry had become vulnerable to foreign competition, and preparations began to be made to expose those companies not earning an acceptable return on capital by the implementation of current cost accounting (Bryer & Brignall, 1986; Bryer & Steele, 1990). One consequence would inevitably be a large increase in rationalizing mergers and acquisitions to facilitate divestment. From this perspective it may be no coincidence that the Accounting Standards Steering Committee (ASSC) began work on a goodwill standard in 1974. Although to informed observers they appeared to be ready to allow either the immediate write-off or amortization options, unfortunately no ‘official published material emerged from this exercise’ (Holgate, 1990, p. 10). Nevertheless, an obviously important part of the background to their

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deliberations was the accelerating trend by UK companies towards immediate write-off (Lee, 1973). Following the burst of merger activity from 1972 to 1973, the proportion of companies amortizing purchased goodwill fell from between 10% and 17% over the period 1962–1971, to just 3% in 1973–4 (Holgate, 1990, pp. 9–10). The ASSC considered allowing the immediate write-off option at that time. However, the project was suspended for 3 years, ‘. . . consigned to the ‘‘too difficult’’ drawer’ (Holgate, 1990, p. 10). Holgate implies the ASSC found the problem conceptually too difficult. More plausibly, it may have been dissuaded from doing so for two other reasons. Firstly, immediate write-off was effectively forbidden by the proposed Fourth Directive which required amortization over a maximum of 5 years, or longer if disclosure was provided. Secondly, the expected immediate restructuring of manufacturing industry and associated merger boom was postponed when the US and the governments of other major industrialized economies unexpectedly decided the expand and the UK government decided to subsidize UK manufacturing industry. UK manufacturing industry was on ‘hold’ (Bryer, Brignall & Maunders, 1984). Merger activity dropped sharply in 1974, and during this period the amounts paid for goodwill were relatively small, averaging less than 5% of the bidder’s net worth over the later 1970’s (Higson, 1990, Figure 1; Table 1). Department of Trade Officials negotiated an implicit write-off option in the Fourth Directive, which was published in 1978. Although, as we have seen, the panel which produced the Discussion Paper, which began work following the Directive’s publication, recommended the amortization method, it also left open the option that the immediate write-off option would ultimately be chosen. As it said, one common argument against amortization was that ‘many companies are now carrying large amounts of goodwill; similarly, take-overs occur periodically which give rise to substantial goodwill balances [and] [i]t is unlikely that such companies will wish to reduce their reported profits by charging depreciation on their goodwill’ [1980, Appendix 3, (3)]. It recognized that goodwill accounting was something about which people had ‘deeply-held views’. Although in 1980 the ASC appeared determined to resist pressures for immediate write-off, as the panel was producing its paper profound changes were taking place in Government policy following the election of the Thatcher administration in June 1979 and the second oil shock of that year. As interest rates were increased to an all-time high and Sterling soared, by the time the Discussion Paper was published in June 1980 investors’ attitudes towards UK manufacturing industry had fundamentally changed. From a strategy of ‘hold’, to one of ‘divest’ (Bryer, Brignall & Maunders, 1984, pp. 32– 33). In this peculiarly British context, it is hypothesized that with the imminent prospect of rationalizing mergers and acquisitions and the payment of dividends from capital, the authorities mobilized to provide the necessary

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regulatory freedom for this to occur with the minimum of public alarm. In other words, to both facilitate the distribution of dividends from capital, and to provide ‘excuses’ to justify hiding the fact that this was occurring. Although direct support for this hypothesis is clearly needed,14 it is consistent with evidence available. THE HYPOTHESIS OF POLITICAL ECONOMY: ‘EXCUSES FOR THE MARKET’? If the hypothesis is correct, one plausible basis for preferring immediate write-off during the early 1970’s was the impact which amortizing goodwill would have had on reported dividend payout ratios of those companies badly hit by the first oil shock in 1973–4. Many of these companies were producing current cost accounts showing dramatically reduced profitability, and some at least recognized the ‘difficulty’ of ‘. . . justify[ing] the introduction of a system of inflation accounting which suggests that large numbers of companies are currently paying dividends out of capital’ (Gibbs, Pearcy & Saville, 1976, p. 63). Consistent with the desire of the authorities to allow companies to report ‘justifiable’ payout ratios is the introduction of monetary adjustments to the CCA system implemented in the UK (Bryer & Brignall, 1986; Bryer & Steele, 1990), as is the authorities’ preference for writing off goodwill against reserves after 1980.15 The desire for justifiable payout ratios is also consistent with a demand for ‘excuses’ from economic income theory to justify immediate write off of goodwill in the ‘public interest’. During the recession of the early 1980’s many British companies closed substantial parts of their operations. At the same time, dividends were substantially increased. Although under UK company law the write-off of purchased goodwill against consolidated reserves would not have affected the parent company’s ability to actually pay dividends, for companies with poor current cost results the requirement to amortize purchased goodwill would have meant reporting even worse or negative current cost payout ratios, and high historical cost payout ratios. Even after the benefit of large monetary add-backs, and before any amortization of purchased goodwill, many UK companies were reporting dramatically higher payout ratios, and even on this measure were paying dividends out of capital in 1981 and 1982 (ASC, 1986, Fig. 1). Dividends began to increase rapidly in the early 1980’s, and between 1983 and 1992 they increased at an annual average compound rate of 21·3% (Bank of England Quarterly Bulletin, June 1986, p. 230; August 1993, p. 365). Anticipation of this may explain why compliance with SSAP16, the eventual standard on current cost accounting introduced in 1980, dropped sharply from 1983, and was made non-mandatory in 1985. On a historical cost basis, by the early 1980’s the typical payout ratio of UK companies increased from 16% in the mid-1970’s to around 25% (Bank

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of England Quarterly Bulletin, May 1987, p. 262). Through the later 1980’s it rose to around 35% (Bank of England Quarterly Bulletin, November 1990, p. 529), and by the early 1990’s it was running at some 55% (Bank of England Quarterly Bulletin, August 1991, p. 364; Financial Times 26/27 September 1992). If goodwill had been amortized, and had reduced profits by a modest 10%, in 1991 the payout ratio would have been an unprecedented 62% [0·55/0·9]. Thus, there is evidence of a potential need for creative accounting for goodwill, a possible motive. And this adjustment towards the real UK payout ratio takes no account of the many other opportunities for creative accounting that were available in the 1980’s, some of which still exist. Some examples are: allowing the distribution of fixed asset revaluation surpluses (SSAP12); allowing the capitalization of R&D (SSAP13); allowing the proportional elimination of unrealized intercompany profits, and not requiring the recalculation of fair values in every step of step-by-step acquisitions (SSAP14); allowing the ‘partial’ accounting for deferred taxation (SSAP15); allowing the application of the ‘cover’ method, and the selection of exchange rates in foreign currency translation (SSAP20); allowing leased fixed assets not transferring ‘substantially all the risks and rewards of ownership’ to be treated as operating leases and avoid depreciation charges (SSAP21); effectively requiring the ‘amortization’ of pension fund surpluses against pension expense (SSAP24). Space forbids a political economy of these standards, but to round off our political economy of SSAP22 we shall finally briefly consider evidence consistent with the hypothesis that the objective of the authorities was to facilitate as well as hide the rationalizing consequences of acquisitions and mergers. This evidence is their single-minded and urgent focus in the early 1980’s on loosening the legal requirement to use conventional acquisition accounting. This also contributed to hiding the distribution of dividends from capital.

MERGER ACCOUNTING, MERGER RELIEF AND THE DISTRIBUTION OF DIVIDENDS FROM CAPITAL In July 1980, just 1 month after the ASC had published its Discussion Paper, the decision of a high court judge dealing with an apparently routine dispute with the Inspector of Taxes was published. The judge concurred with long-standing accounting opinion, and the clear intent of the Companies Act 1948 section 56 and paragraph 15(5) of Schedule 8, that share premium accounts must be established, and that dividends from pre-acquisition reserves must be used to write-down the carrying value of an investment in a subsidiary, and were not available for distribution by the holding company. In effect, the judge had confirmed that merger accounting was dead, and

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had been since at least 1948. As he said, echoing a formula which had been applied in countless other cases, ‘Shortly put, whatever is purchased with capital in the shape of shares themselves, or an equivalent amount, is itself to be treated as capital’ (Wyld, 1980, p. 50). The case had actually been decided in March 1980. So unremarkable was the decision that the short report which appeared in the Times omitted any mention of paragraph 15(5) of the 1948 Act, and it ‘. . . took some time for the alarm bells to start ringing’ (Wyld, 1981, p. 61). It was not until August 1980 that the CCAB wrote to the Secretary of State for Trade, expressing concern about the ‘damaging consequences’ of the case. The ‘problem’ raised by Shearer v Bercain was, as the CCAB pointed out in a memorandum to the Department of Trade, that it ‘. . . preclude[s] the distribution of profits earned prior to a combination previously thought to be distributable’ (TR401, August 1980). The CCAB neglected to say that this was only ‘thought to be’ the case by a minority of legal opinion, ‘. . . those counsel who were known to interpret the Companies Act 1948 in the way required [who] not unnaturally did a roaring business’, and that ‘Many learned counsel (probably the majority of company counsel) held the opposite view’ (Wyld, 1980, p. 49). ED3’s proposal in 1973 to allow merger accounting had been shelved precisely on the grounds that it might be to recommend something which was illegal, a view which appeared to be fully justified by the Shearer v Bercain decision (Edey, 1985, p. 13; Napier & Noke, 1991). However, once the alarm bells did start ringing, ‘they rang in earnest’. ‘In an unusually swift reaction, in reply to a question asked in the House of Commons, Reginald Eyre, Under-Secretary for Trade, gave notice on 12 November that amendments to the Companies Acts would be proposed in the next Companies Bill to mitigate the effects of Shearer v Bercain’ (Wyld, 1981, p. 61). The Government consulted several interested parties, including a joint working party of the Confederation of British Industry, the CCAB and the Law Society. Its response reveals the cause of the alarm; the nature of the ‘damaging consequences’ envisaged. In the Companies Act 1981 it was provided (sections 36 to 41) that if a company acquired at least 90% of the equity capital another company by the exchange of shares, section 56 would not apply, and the acquiring company would be granted ‘merger relief’. Paragraph 15(5) preventing the distribution of preacquisition reserves was abolished, and rendered harmless for distributions already made where merger accounting had been used. Now the acquisition could either be accounted for using the conventional acquisition method and the share premium account converted into an effectively distributable ‘merger reserve’ in the accounts of the holding company, or the investment in the subsidiary could be accounted for at its nominal value, and the share premium account disregarded. As the fall in the value of a subsidiary following a distribution from pre-acquisition reserves could be set against

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the ‘merger reserve’, even if acquisition accounting was used pre-acquisition reserves could become distributable by the acquiror. As the ASC’s Post Implementation Review put it, ‘The ability to record shares issued at nominal value rather than fair value—which often (but not always) leads to merger accounting in the consolidated financial statements—is more likely to render the pre-combination reserves of the subsidiary available for distribution to the members of the enlarged holding company’ (1988, para. 2.6). In other words, as the exposure draft on accounting for acquisitions and mergers proclaimed, ‘Merger accounting [was] now available’ (ASC, 1982, para. 1.1). This option was introduced by SSAP23, and where it was used, distributable profits were higher and the goodwill problem disappeared. On the other hand, if acquisition accounting was used, merger relief allowed the goodwill arising to be written off against the ‘merger reserve’ and the payout ratio protected against amortization. In a survey of 373 major combinations, Higson found 38% using either merger accounting or acquisition accounting and merger relief, and between 1985 and 1987 where evidence was available, only 6% did not write-off goodwill against reserves (1990, Tables III and IV). In addition, SSAP22 encouraged the wholly novel practice of maximizing the goodwill write-off by suggesting the establishment of ‘provisions’ for reorganization and future losses against the fair value of the net assets acquired and treating them as liabilities in the fair value exercise. Where this method was adopted it entirely relieved the profit and loss account of any of these debits, assuming they actually arose as envisaged (Paterson, 1988). Also, by not explicitly requiring inclusion of purchased goodwill as part of the cost in calculating any profit on the disposal of a subsidiary, the ASC allowed many companies to treat goodwill as distributable profit. CONCLUDING REMARKS The immediate write-off option in SSAP22 cannot be explained as either the acceptance of economic income theory by the ASC, or by pressure from self-interested management. While more research into the motives of the ASC and the pressures to which it was subject is clearly needed to test the hypothesis advanced here, more direct methods will not be easy. These would, for example, require the willingness of government officials, politicians, and past members of the ASC to participate in the research. However, if the hypothesis is correct, those involved are unlikely to cooperate as this could generate political costs for investors. Although the motives of the individuals concerned for encouraging the immediate write-off of goodwill are likely to remain debatable, the motive for wanting to return to amortization seems clear. When the merger boom of the 1980’s subsided, investors began to demand a return to conventional goodwill accounting to allow them to observe the rate of return on capital.

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In February 1990, ‘in response to criticism of the current standard’, in ED47 the ASC recommended a return to amortization (1990, paras. 1.1–1.2). Not surprisingly, the major criticism was that immediate write-off obscured the rate of return on capital: ‘Because purchased goodwill could be written off immediately, it has been difficult for users of financial statements to keep track of the resources that management expended on acquisitions and to calculate whether an adequate return was being earned’ (ASC, 1990, para. 1.2). Marx fully recognized the international nature of capitalism, and would have found it unsurprising that strong pressure for amortization came from the international capital markets, in his view social capital in its most advanced form. As the ASC accepted, ‘With the increasingly global outlook of markets the international comparability of accounting information is of growing importance’, and ‘. . . observe[d] that, in all or most impartial studies of the accounting treatment of goodwill around the world, it has been concluded that amortization of goodwill is the preferred accounting treatment’ (ASC, 1990, Appendix, para. 54). While as a member of the Committee that produced ED47 has said, the international ‘pressure’ to conform was not ‘direct’ (Nobes, 1992, p. 157), in the view of others, it was decisive in producing its amortization requirement (Holgate, 1989; Thomas, 1990). Although controversy over goodwill continued in the UK, and ED47 was set aside and the issue looked at again, from Marx’s perspective the reason is clear. The arguments of both ED47 and its critics were founded in the incorrigible subjectivity of economic value (Bryer, 1990; Grinyer et al., 1990). Given its continued reliance on economic income theory in the Accounting Standards Board’s Discussion Paper: Goodwill and Intangible Assets (December 1993), theoretical controversy seems likely to continue. However, there is again evidence of strong international pressure to return to amortization. For example, as the Discussion Paper points out, although all options are open, ‘Adoption of ‘‘capitalisation and predetermined life amortisation’’ would result in international comparability, which will not be achieved with any of the other methods . . .’, and commentators were encouraged to take into account ‘. . . in particular the extent to which they believe that international comparability is desirable’ (ASB, 1993, paras. 8.2.2 & 8.7.3). This looks like another attempt to secure the preferred outcome by force majeure. As the ASB formally supports the IASC’s aim to harmonize international financial reporting (ASB, 1991, para. 27) it seems unlikely to take any arguments against international comparability very seriously! This ‘pressure’ looks likely to be used to at least eliminate the capital write-off option. However, there is room within its economic income view to move towards international comparability without requiring all companies to employ conventional amortization by, say, banning capital write-offs, but allowing write-offs through the profit and loss account by either amortization and/or periodic revaluations, and requiring disclosure

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of estimated economic life (deemed to be finite). Nevertheless, from within flexible economic income perspective the precise outcome of the ASB’s deliberations are difficult to predict. This, perhaps, is part of the continued allure of economic income theory to the UK authorities, it’s openness to compromise, and the difficulties envisaged in re-writing history if the conventional framework were openly asserted.

N 1. For example, France and Germany (Scheid & Walton, 1991, p. 172; Ordelheide & Pfaff, 1994, pp. 126–127; Simmonds & Azieres, 1989). 2. For some historical examples, see Bryer, 1991, 1993. 3. ‘Variable’ capital is the money advanced for labour which, for Marx, is the source of surplus value, in contrast to ‘constant’ capital advanced for the means of production which is merely transferred to commodities or services, and is not returned with a surplus. 4. Accounting for negative goodwill, where the fair value of the net assets exceeds the market value, is not considered here. Its treatment is analogous to the treatment of positive goodwill. 5. Although Marx refers here only to capitalizing a perpetuity, he elsewhere conceptualized share prices as expected dividends discounted by the required return (Vol. 3, p. 466). 6. Present values are, of course, ‘valorized’, or grow, at the rate of discount through time. 7. Note, however, that the only costs to be capitalized under patents and secret processes are those necessary to establish the patent or the secrecy of the process itself, not the cost of producing the knowledge. 8. Although this assumes the surplus profits have the same risk as the normal profits, More argued that in principle higher rates should be used for successive tranches of surplus profits to reflect the increased risk. 9. Even Garke and Fells, who toy with the ideas of economic income accounting for goodwill [they note an ‘interesting article’ by ‘An American Correspondent’ (1913) which advocated this], accepted that purchased goodwill should be accounted for at cost, and although they thought that it ‘need not’ be written down unless its ‘. . . realisable value as integral parts of a going concern falls below their cost’, they felt it ‘. . . nevertheless desirable to create gradually special reserve funds against such values as a provision against change of conditions’ (1922, p. 163). As the American Correspondent said, very conscious of questioning the generally accepted view, ‘The fundamental difficulty is, accountants in nearly every instance hold to a pretty rigid cost theory of value. Consciously or otherwise, the great majority follow the doctrine that the value of a thing is the money put into it’, whereas in his view, ‘Value is a thing of the mind’ (1913, p. 818)! 10. References are to the Fourth Edition published in 1920 with Tillyard. 11. Guthrie also thought that the goodwill that had arisen in compnay promotions was overvalued—‘goodwills are put down at such fabulous sums . . . nowadays’ (1898, p. 431; see also, Leake, 1914, p. 86). His solution to the practical problem that writing this goodwill off against revenue over the number of years’ purchase of the excess of profits over ‘interest upon capital’ would eliminate distributable profit (and, implicitly, that capital could not be written-down) was to insist on disclosure and to suggest a standard rule of doubling the write-off period (1898, p. 429). 12. By ‘vulgar’ Marx means ordinary, or common. In other words, economists with the views of ‘the woman or man in the street’ who do not ‘expect’ ‘. . . the use of historical

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costs in balance sheets and depreciation figures which do not measure falls in value’ (Arnold et al., 1992, pp. 3–4). 13. An estimate supported by ‘. . . research by Mr Peter Walton of City University Business School and Mr Harold E. Wyman of University of Connecticut [which] confirm [ed] the fears of the many finance directors who have attacked the proposed change . . .’ to requiring amortization of goodwill contained in the ASC’s ED47. It was estimated that the ‘. . . accounting rule change would wipe nearly 10% off the reported profits of the average UK company . . .’ (Financial Times, April 17 1990). 14. For example, evidence that the authorities believed that if the payment of dividends from capital were visible to public gaze during the 1980’s this might be politically ‘unhelpful’ in a context of record unemployment and poverty in ways that might be costly for investors—for example, the increased direct taxes they expected to pay if a Labour government were returned to power in 1986. 15. While, of course, there were, and still are, several alternative views of the role and introduction of CCA, a political economy of CCA and its literature is beyond the scope of this paper. All that is claimed here is that the introduction of CCA and its monetary adjustments are consistent with the introduction of the capital write off option in SSAP22.

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