Accounting Research Center, Booth School of Business, University of Chicago

Valuation of the Components of Purchased Goodwill

Author(s): Steven L. Henning, Barry L. Lewis and Wayne H. Shaw
Source: Journal of Accounting Research, Vol. 38, No. 2 (Autumn, 2000), pp. 375-386
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
Stable URL: http://www.jstor.org/stable/2672938
Accessed: 29-11-2015 02:53 UTC

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at http://www.jstor.org/page/
info/about/policies/terms.jsp
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content
in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship.
For more information about JSTOR, please contact support@jstor.org.

Accounting Research Center, Booth School of Business, University of Chicago and Wiley are collaborating with
JSTOR to digitize, preserve and extend access to Journal of Accounting Research.

http://www.jstor.org

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

Journal of Accounting Research

Vol. 38 No. 2 Autumn 2000
Printed in US.A.

Valuation of the Components

Purchased Goodwill
STEVEN

L. HENNING,*
AND
WAYNE

H.

BARRY
L.
SHAW*

of

LEWIS,t

1. Introduction
This paper examines whether investors distinguish among identifiable
components of goodwill for valuation purposes, in the year of acquisition.
Similar to Barth, Beaver, and Landsman's [1992] analysis of the value relevance of the components of pension expenses under Statementof Financial Accounting Standards No. 87, we use contemporaneous

stock price

and returns regressions to examine investors' valuation of the components of goodwill and their amortizations. Although current accounting
practice does not require firms to disclose components of goodwillAccounting Principles Board Opinion No. 16: Accountingfor Business Combina-

tions [1970] requires firms to record only the total excess of the purchase
price over the fair value of identifiable assets and to amortize this asset
over a period not to exceed 40 years-market participants can readily
calculate goodwill components from publicly available data.
As detailed in section 2, we decompose the difference between the acquisition price and the preacquisition book value of the target firm's
assets into four components: (1) the write-up of the target firm's assets
to fair market value (WRITEUP), calculated as the difference between

*Southern Methodist University; tUniversity of Colorado at Boulder. Comments from

Randolph Beatty, L. Todd Johnson, Thomas Linsmeier, Robert Lipe, Jody Magliolo, Kimberley Petrone, John Robinson, Toby Stock, Terry Warfield, and workshop participants at
the University of Colorado at Boulder, the University of Notre Dame, the University of
Texas at Austin, Texas Christian University, the University of Waterloo, and the University
of Wisconsin-Madison
Doctoral Alumni Conference
are gratefully acknowledged.
375
Copyright ?, Institute of Professional Accounting, 2000

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

376

JOURNAL

OF ACCOUNTING

RESEARCH,

AUTUMN

2000

the fair market value of the target firm's assets and their preacquisition
book value; (2) the value of the target as a going-concern, or standalone, entity (GC), calculated as the difference between the target's preacquisition market value measured six days prior to the acquisition and
the target's fair market value of assets; (3) the market's valuation of the
synergistic value created by the acquisition (SYNERGY), calculated as
the combined cumulative abnormal returns to the target and the acquirer for the 11 days centered on the acquisition announcement; and
(4) any overvaluation of consideration and/or overpayment for the target
(RESID),calculated as the purchase price less the sum of the preacquisition book value of the target's assets, WRITEUP,GC, and SYNERGYCurrent GAAPrecords as purchased goodwill on the acquirer's books only
the aggregate of GC, SYNERGY,and RESID,if their total is positive.
For a sample of 1,576 acquisitions between 1990 and 1994, we find that
investors attach different valuation weights to the components of goodwill. The results show a significant (at the .03 level) positive association
between market values and the amount of going-concern goodwill, with
the magnitude of the coefficient on GCequal to that on nongoodwill assets and on the write-up of the target's net assets to fair market value. We
also document a significant (at the .01 level) positive relation between
market values and the synergy component of goodwill, with the magnitude of this relation suggesting that investors view the acquirer as receiving additional synergy gains (i.e., the coefficient on SYNERGYexceeds
one). Finally, we find no evidence that the market places a continuing
value on the residual component of goodwill; in fact, the results show a
significant negative association between RESID and share price, consistent with the market writing off overpayments in the year of acquisition.
We also examine the relation between stock returns and the amortization of goodwill components in the first year of the combined operation
of the acquirer and target. The results show no association between returns and amortizations of GC and SYNERGY,and a significant negative
relation between returns and the amortization of RESID.The latter result is consistent with the market viewing the residual overpayments as
expenses.
Our study provides evidence that speaks to the Financial Accounting
Standards Board's (FASB)view that a "core" goodwill component is conceptually an asset (under the four criteria in ConceptsStatementNo. 5: Recognitionand Measurementin Financial Statementsof BusinessEnterprises),while
other goodwill components may not be assets. Although the FASBwas not
explicit in its definition of "core" goodwill, Johnson and Petrone [1998]
propose a measure of core goodwill equal to the sum of the going-concern
value of the target and the synergies created by the acquisition. Our finding that investors place positive weights on GCand SYNERGYis consistent
with investors perceiving core goodwill (under Johnson and Petrone's
definition) as an asset. However, the result that investors attach a significantly larger weight to SYNERGYthan to GCsuggests there is incremental

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

VALUATION

OF PURCHASED

GOODWILL

377

information provided by disaggregating core goodwill into its synergy and

going-concern components. Finally, our finding that the market places
a negative weight on RESIDis consistent with the FASB'sview that not all
components of goodwill are assets and that some components-notably
RESID-may overstate the economic value of purchased goodwill.
Section 2 describes the sample and data, section 3 reports the tests
and results, and section 4 concludes.

2. Sample and Data

The initial sample includes 3,097 Compustatfirm-year observations
with a goodwill asset in any fiscal year t = 1990-94, and with dividend and
book value data available on Compustatand market price and returns data
on CRS1We collect information from these firms' annual reports on current additions to, and preexisting carrying values of, purchased goodwill.
Goodwill amortization, if not disclosed, is inferred as the change in the
carrying value of goodwill, adjusted for acquisitions or dispositions of
goodwill other than by systematic amortization. We eliminate 1,356 firmyear observations because no business combination accounted for the
purchase method used during any of the five sample years.' We delete
another 165 firm-year observations because a portion of the purchase
price is allocated to in-process R&D. The final sample consists of 1,576
purchase combinations, ranging from 253 in 1990 to 384 in 1994.
For each of the 1,576 sample observations, we collect data on the current increments to goodwill and the fair value of the assets purchased
from prospectuses and 8K filings, acquirer firms' financial statements,
and information included in the SecuritiesData CompanyUS. Mergersand
Acquisitionsdatabase. The preacquisition book value of the target's assets
is obtained from disclosures in the final annual reports or l0Qs filed by
the target.
Table 1 reports descriptive information about the sample acquisitions.
The average acquirer is about seven times the size of the target based on
total assets, and about three to four times the target size in market value
terms (market values measured six days prior to the acquisition announcement). The average acquisition price of $319 million is substantially higher than the mean book value of the target's assets ($100
million) and the mean fair value of the target's assets ($142 million). On
average, the sample-wide asset write-up is $42 million (16% of purchase
price) and the amount of goodwill is $177 million (57% of purchase

1 We exclude firm-years with no acquisitions because we are interested in how goodwill

is valued in the year of the acquisition. A cross-sectional pooled fixed-effects regression that
includes separate intercepts for each firm and separate intercepts and slope coefficients for
each year, using all firm-years across the five-year period, provides virtually identical results
for both the balance sheet and income statement models.

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

378

S. L. HENNING, B. L. LEWIS, AND W. H. SHAW

TABLE

Descriptive Information on the Sample Acquisitions,

($ Millions)

Ratio of Acquirer to Target Assets

Ratio of Acquirer to Target Market Value
Purchase Price
Book Value of Acquired Assets
Write-Up
Percentage of Purchase Price
FairValue of Assets
Goodwill
Percentage of Purchase Price
Going-Concern Goodwill
Percentage of Goodwill
Synergy Goodwill
Percentage of Goodwill
Residual Goodwill
Percentage of Goodwill
Ratio of Incremental Goodwill Amortization to Net Income

Mean
7.273
3.665
$318.637
$100.259
$ 41.575
16.1%
$141.834
$176.847
56.8%
$ 37.011
20.9%
$ 85.656
48.5%
$ 53.985
30.6%
0.071

1990-94

1st Quartile
4.742
2.184
$87.239
$25.494
$10.216
11.7%
$35.305
$51.173
58.7%
$16.827
32.9%
$34.382
67.1%
$0
0.0%
0.430

Median
6.927
3.576
$221.716
$ 96.962
$ 31.391
14.2%
$127.584
$ 95.862
43.2%
$ 37.635
39.3%
$ 58.194
60.7%
$0
0.0%
0.068

3d Quartile
9.584
4.905
$397.593
$138.572
$ 66.084
16.6%
$204.832
$194.604
48.9%
$ 39.826
20.5%
$ 88.044
45.2%
$ 66.731
34.3%
0.099

Variable definitions: Ratio of Acquirer to Target Assets is the ratio of the acquirer's book value of total assets to
the target's total assets, measured in the last reporting period preceding the acquisition date. Ratio of Acquirer to
Target Market Value is the ratio of the acquirer's market value of common stock to the target's market value of
common stock, where market values are measured six days prior to the first acquisition announcement. Purchase
Price is the amount paid for the target. Book Value of Acquired Assets is the book value of the target firm's assets at
the end of the reporting period preceding the acquisition announcement. Write-Up is the excess of the fair value
of net assets acquired minus their book value. Fair Value of Assets is the fair market value of the net assets acquired.
Goodwill is the excess of the purchase price over the fair value of the net assets acquired. Going-Concern Goodwill
is the excess of the preoffer target market price (market prices measured six trading days prior to the first offer)
over the fair value of the net assets acquired. Synergy Goodwill is the cumulative net increase in market value of
both the target and acquiring firm, using an 11-day window centered on the initial and all subsequent announcements, if any, during the acquisition period. Residual Goodwill is the purchase price minus the preoffer market
value of the target (market value measured six trading days prior to the first announcement) minus synergy goodwill. Incremental Goodwill Amortization is the portion of year t amortization expense associated with the purchase
combination occurring in year t.
aThe sample consists of 1,576 purchase acquisitions occurring during 1990-94 which resulted in purchased
goodwill on the acquirer's books.

price). The amortization expense for the goodwill in the event-year acquisition is approximately 7% of the reported combined income.

3. Empirical Work
Johnson and Petrone [1998] divide the excess of purchase price minus the preacquisition target book value of assets into six components
relating to the target and to the acquisition. The target-related components are: (1) the excess fair value of recognized assets over preacquisition target book values, (2) the fair value of previously unrecognized
assets, and (3) the ability of the enterprise to earn, on a going-concern
or stand-alone basis, a higher return on a collection of net assets than
would be expected if those net assets were acquired separately. The acquisition-related components are: (4) the fair value of synergies from

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

VALUATION

OF PURCHASED

GOODWILL

379

combining the acquirer's and target's businesses and net assets, (5) payments resulting from over- (under-) valuation of the consideration used,
and (6) over- (under-) payment by the acquirer in the course of bidding.2
Under APB OpinionNo. 16, goodwill consists of components 3-6. There
is some question, however, about whether components 5 and 6 should be
included. In particular, in a June 1998 summary of current Board actions, the FASBreaffirmed that goodwill is an asset but expressed concern
that the value of this asset might be overstated by the inclusion of components 5 and 6.
Our tests examine whether market participants place different valuation weights on the components of goodwill by disaggregating the excess of purchase price minus the book value of assets acquired into four
components: WRITEUP,GC, SYNERGY,and RESID.Components 1 and 2
are combined in the variable WRITEUP,equal to the excess of the fair
values of acquired net assets over their net book values.3 Component 3,
going-concern goodwill (GC), is measured as the difference between
the fair value of assets recognized and the preacquisition market value
of the target. We use Bradley, Desai, and Kim's [1988] model to estimate
the magnitude of the synergy gains of the transaction. They argue that
the sum of the changes in the market value of equity of the target firm
and of the acquiring firm to the announcement of the acquisition provides a firm-specific measure of synergy gains.4 We use the combined
cumulative abnormal returns to the target and acquirer in the 11-day
window centered on the acquisition announcement (SYNERGY)to proxy
for component 4.5 Finally, we define RESID as the excess of purchased
goodwill over GC and SYNERGY;RESID proxies for the sum of components 5 and 6.
Our empirical tests follow recent work by Jennings et al. [1996] and
Vincent [1997] which uses balance sheet and income statement models
to assess the value relevance of purchased goodwill and its amortization. The balance sheet model regresses market value on goodwill and
nongoodwill assets and liabilities, while the income statement approach
2Rau and Vermaelen [1998] and Wiedenbaum and Vogt [1987] find support for the
concern that the competitiveness of the acquisition market may result in systematic overpayment for targets.
3We include WRITEUPin our analysis, even though it is not a component of goodwill,
because we expect that investors value WRITEUPsimilarly to GC. Thus, WRITEUPis a control variable in our tests.
4This definition assumes that acquisitions have no effect on the wealth of bondholders
and other claimants. For a sample of firms involved in corporate mergers, Kim and McConnell [1977] and Asquith and Kim [1982] provide evidence consistent with this assumption.
5 In instances where the initial bid is rejected, we aggregate abnormal returns over the
initial announcement and subsequent bids. We calculate abnormal returns using market
model prediction errors. Market model parameters are estimated separately for acquirer
and target using returns on days (-300, -61) relative to the day 0 announcement of the
first bid for the target. The results are robust to using CRSP beta-portfolio excess returns;
results are not sensitive to equal- versus value-weighted market returns.

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

380

S. L. HENNING, B. L. LEWIS, AND W. H. SHAW

examines the contemporaneous relation between long-window (i.e., 12or 15-month) stock returns and goodwill amortization and pregoodwill
amortization earnings. In general, both studies find that goodwill is significantly positively related to share price, with the estimated valuation
weight exceeding 1.0, and that goodwill amortization is not significantly
related to returns. The finding that the coefficient relating goodwill assets to market value exceeds 1.0 leads the authors to conclude that reported goodwill understates the value of this asset to the acquirer.
One explanation for the high coefficient on reported goodwill is that
investors differentially value the components of goodwill. For example,
the coefficient relating market value to purchased goodwill could exceed one if the acquiring firm extracts more synergy benefits from the
transaction than what it paid for these benefits. We expect such benefit
sharing if there is private information about the synergistic gains to the
acquirer which are revealed (fully or partially) after the initial disclosure.6
This argument predicts that the coefficient relating the market value of
equity to SYNERGYexceeds the coefficient relating market value of equity to either GC or RESID.Investors may also value GC, SYNERGY,and
RESID differently if those components have different service lives. In
particular, if excessive payments to the target overstate the value of the
"core" goodwill asset, we expect investors to attach a significantly lower
(than 1.0) weight to RESID.In the extreme case where RESID is not an
asset at all, investors will attach a nonpositive weight to the residual
component. We test whether investors value the components of goodwill
differently using the following regression equation:
MVj t =

lBVJt + 02GW)-W+ 03WRITEUPj t

+ ?4aGCjt + 04bSYNERGY/,t + 04cRESIDt + 05LIABjt

+ ?j

(1)

where MVis the share price at the end of the first quarter of year t + 1,
and t is the fiscal year the acquisition occurred;7 BV*(LIAB) is the book
value of the combined entity's nongoodwill assets (total liabilities) at the
end of year t; GW*is the purchased goodwill from acquisitions prior to
year t; GC, SYNERGY,and RESID are calculated as previously described
and are adjusted for the amortization expense accruing between the acquisition date and the end of year t. All variables are scaled by the number of shares outstanding at the end of year t.
Consistent with Jennings et al. [1996], BVb and GW* are predicted to
have positive coefficients, and LIAB is expected to have a negative coefficient. Given that WRITEUPand GC are included in the preacquisi6A related explanation for the high coefficient on goodwill is that goodwill does not decline in value and, therefore, goodwill amortization increases any understatement due to
benefit sharing.
7 We measure share price at the end of the first quarter of t + 1 to ensure that all year t
accounting variables (such as earnings and book values) are known by investors. Results
using market prices at the end of firm j's fiscal year are similar and are not reported.

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

VALUATION

OF PURCHASED

GOODWILL

381

tion target firm's market value, we expect that the target firm receives
full payment for these components. This reasoning suggests that 03 and
04a, are positive and approximately equal in magnitude to 1. We test
whether and how the market separately values the synergy component
by examining whether 04b > 04a and 04b > 1. Finally, if RESID captures
the transfer of wealth from shareholders of the acquirer to shareholders
of the target, we expect the market to view this component as not an
asset (i.e., 04c,

0).

Before discussing the results of estimating expression (1), we first provide information about the magnitude of the goodwill components of
the sample transactions. Table 1 shows that the average values of GC,
SYNERGY,and RESIDrepresent 21%, 48%, and 31%, respectively, of recognized goodwill.8 In calculating SYNERGY,we note that the average
combined market reaction to the acquirer and target is positive and in
excess of the total goodwill recorded in 879 of the 1,576 transactions.
In these cases, we constrain SYNERGYto the excess of the purchase
price over the preoffer market price six trading days prior to the first
offer. In these 879 cases, we set RESADequal to zero so that the sum of
GC, SYNERGY,and RESADdoes not exceed the amount of goodwill recorded in the financial statements.
The results of estimating equation (1) are shown in table 2, panel A.
We report results using both the Full sample of 1,576 firm-year observations and the Unrestricted sample, consisting of the 697 (1,576 less 879)
firm-year observations where we did not have to constrain SYNERGYor
RESID.Because the results are similar, we discuss only those for the Full
sample. Consistent with prior studies, the coefficients on BV* and on
LIABare significant (at the .01 level) and approximately equal to 1.0 and
-1.0, respectively. Consistent with Jennings et al. [1996], we find the
coefficient on goodwill from prior-year acquisitions (GW") to be significantly greater than zero. Examination of 03 04a' 04b' and 04c reveals that
investors value the asset write-up and goodwill components differently.
Consistent with expectations, the coefficients on WRITEUPand GC are
significantly positive (at the .01 and .03 levels, respectively) and are indistinguishable in magnitude from the coefficient on the book value of
nongoodwill assets.9 In contrast, the coefficient on SYNERGY,04b, is significantly greater than both 04a (the F-statistic, not reported, is significant
at the .01 level) and 1.0 (at the .01 level), suggesting that the acquirer
shares in the synergy gains. Finally, the coefficient on RESIDis negative
(significant at the .03 level), suggesting that investors not only do not
value RESIDas an asset but view RESIDas detracting from firm value.
8In calculating SYNERGY,we find that the combined value of the target and acquiring
firms increases, on average, by 6.31%, with 84% of the sample observations having positive
combined abnormal returns; these proportions are similar to the 7.43% and 75% numbers
reported by Bradley, Desai, and Kim [1988] for a sample of tender offers during 1963-84.
9F-tests of the equality of the coefficients (not reported) are significant at the .02 level.

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

382

S. L. HENNING, B. L. LEWIS, AND W. H. SHAW

~~~~~~~~

Co

-~~~~4
Co,-

o~~~~

~ ~ ~ ~ ~ ~ ~ 403
~ ~ ~ ~ ~~

00

r.
CO

~ ~ ~ ~ ~

m-0
'

0~~~~~~
0

-0
0

C'

~Z

ICO0b

~~ OO~~~~-'~~~--~~~~
+
~~~~-'00O
~~~~~~~oo~Q
~~~
o

:Z o0

0 <
~~~~~~~~~

~ ~

~ ~~~~~~~~~~~~~~~~~~~~~
0U

C) ---q

Cl

~~~C~~~~~QC~~~~~
"~clC
Ct

tcl n

Q0 ~~Ci?
Q
~~~
.

or

,
;Z

&boH~
u
4

.qct

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

VALUATION

OF PURCHASED

GOODWILL

383

In summary, the balance sheet results are consistent with the view that
investors differentially value the components of reported goodwill. We
provide further evidence on the valuation of the components of goodwill by expanding the income statement model used by Jennings et al.
[1996] to consider investors' valuation of the components of goodwill
amortization expense:10
+ 72GWA> +
Y3aGWAGCjt+
+ Y3cGWARESIDjl
+ jt
Y3bGWASYNERGYj,t

Rjt

Yo + yA*

(2)

where R tis the dividend-adjusted return for the 12-month period ending
on the last day of the first quarter of year t + 1;11 At is earnings before
goodwill amortization and extraordinary items for year t;12 GWA*is the
amortization of goodwill existing prior to the event-year acquisition; and
the subscripts GC, SYNERGY, and RESID reflect the amortization of eventyear additions to going-concern,
synergy and residual goodwill, respectively.13 To calculate GWAGc,GWASYNERGy,
and GWApESpwe apportion the
incremental goodwill amortization for each firm using the fraction that
each component represents of the total incremental goodwill asset.14
From table 1, this rule allocates an average 21% of incremental goodwill
amortization to GWAGC,48% to GWASYNERGy' and 31% to GWApESID.This
allocation applies the same firm-specific service life to each goodwill component. About half the sample observations assigned a 40-year life to the
incremental goodwill, another 20% assigned a single period less than 40
years, and the remaining 30% assigned multiple service lives.15

The independent variables in (2) are scaled by beginning-of-the-year market value.

1 Results are similar using stock returns cumulated over the firm's fiscal year.
12 To calculate earnings before goodwill amortization prior to 1993, we add back goodwill amortization since the goodwill from these acquisitions was not deductible for tax purposes. For post-1992 acquisitions, we adjust goodwill amortization to an after-tax basis.
Following Lev and Thiagarajan [1993] and Omer, Molloy, and Ziebart [1991], we estimate
the firm's tax rate as its current federal income tax expense divided by pretax earnings
(minus equity income from unconsolidated subsidiaries plus income from minority interests). Firms having both a negative numerator and denominator are assigned a zero tax
rate, and firms with a positive numerator and a negative denominator are assigned the
statutory tax rate (34%). We draw qualitatively similar conclusions using the statutory rate
for all firm-year observations.
13We do not include a separate variable for the amortization of WRITEUPbecause the
depreciable lives on the purchased identifiable assets are generally not disclosed. The amortization of 4WRTEUP
is, therefore, embedded in A*.
14Incremental goodwill amortization is the portion of year t goodwill amortization from
acquisitions made in year t. Incremental goodwill amortization is calculated using the service life disclosed (1,148 observations) or is inferred as the excess of the current amortization over previous amounts.
15 For firms reporting multiple service lives, we examined the sensitivity of the results
to using the shortest life for calculating the amortization of RESID, and the other lives to
calculate the amortization of GC and SYNERGYResults (not shown) are similar to those
reported.

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

384

S. L. HENNING,

B. L. LEWIS, AND W. H. SHAW

Equation (2) permits direct tests of whether GC, SYNERGY, and RESAD
amortizations capture declines in the values of the goodwill components. If they do, we expect the coefficients to equal -1. If a component
of goodwill is a nonwasting asset, or decays in ways that straight-line
amortization does not capture, the goodwill amortization coefficient will
not be significant.
The results of estimating equation (2) are summarized in table 2,
panel B; again, we present results for both the Full and Unrestricted
samples but discuss results for only the former given the similarity in
conclusions. Consistent with Jennings et al. [1996], the coefficient on
preacquisition year purchased goodwill amortization (GWA*) is indistinguishable from zero. We also find that GWAGCand GWASYNERGY are unrelated to returns in the acquisition year.16 In contrast, the coefficient on
GWARESIDis significantly negative (at the .01 level), suggesting that investors view the amortization of these payments as reducing firm value in
the acquisition year.
by examining the
We probe the results involving RESADand GWARESID
significance of these variables in explaining prices and returns in years
t + 1 and t + 2. These tests (not reported) show insignificant coefficients
on the RESID and GWARESID
variables in both years.17 We interpret the
in year t, and the absence
negative coefficients on RESID and GWARESID
of significant relations for these variables in postacquisition years, as evidence that the market writes off overpayments in the year of acquisition.
We also examine the sensitivity of the results in table 2 to the inclusion
of less than 100% purchases and to industry differences in component
goodwill valuation. Concerning the first issue, our results on the capitalization and amortization of RESIADgoodwill are subject to an errorsin-variables problem because of the allocation of the preoffer market
price to the net assets that the target sells and those it retains. We reestimate equations (1) and (2) separately for the 1,012 (564) transactions in which 100% (less than 100%) of the target is acquired. These
results (not reported) are similar to those documented for the combined
sample. In particular, the coefficients on RESID in the balance sheet
in the income statement model are significantly
model and on GWARESID
negative for both 100% and less-than-100% purchases.
To ensure that our results are not driven by a particular industry, we reestimate equations (1) and (2) for each of the 21 two-digit SIC codes containing at least 30 observations. While the amount of SYNERGY goodwill

16As a sensitivity check, we replaced observations with partial-year amortizations with a

full year's amortization to assess the effect on the results of the timing of acquisitions during the fiscal year. The coefficients on the amortization variables remain insignificant.
17 GC and SYNERGY continue
to show significant positive relations with price in years
returns in years
in explaining
t + 1 and t + 2; GWAGCand GWASYNERGy are insignificant
t + 1 and t + 2.

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

VALUATION

OF PURCHASED

GOODWILL

385

varies across the industries (e.g., synergy goodwill is a higher fraction of

purchase price for high-technology
firms than for heavy manufacturing
firms), the coefficient relating SYNERGY to market value of equity is stable across the 21 industry subsamples. Results for the income statement
model are similar to those reported for the Full sample.

4. Conclusion
We examine whether the market distinguishes
among identifiable
components of goodwill for valuation purposes. The components
approach we use is similar to Barth, Beaver, and Landsman's [1992] analysis
of components of pension expenses. We partition GAAP reported goodwill into the target firm's value as a going concern, the synergy gains of
the business combination, and any overvaluation of consideration and/
or overpayment for the target. Consistent with concerns that some components of goodwill are assets while others are not, our results show that
investors attach positive and negative weights to components
of goodwill. In particular, both the going-concern
component and the synergy
component are significantly positively valued by the market, with the going-concern component valued similarly to nongoodwill assets and the
synergy component receiving a higher weight. The latter result suggests
that, on average, acquirers pay less than their reservation price for the
assets and share in the benefits of the acquisition. We also find that investors place a significantly negative value on the residual goodwill component, which captures amounts in excess of the net increase in market
value to the parties to the transaction.
An income statement model examining the relation between stock returns in the year of the acquisition and the component goodwill amortization charges shows no significant relation between returns and the
amortization of the going-concern or synergy components. These results
and synergy components are nonsuggest either that the going-concern
wasting assets or that the assumed amortization rule does a poor job of
capturing the declines in the values of these assets. We document, however, a significant negative relation between returns and the amortization of the residual component in the year of the acquisition.
Overall, these results support the components approach to accounting for goodwill that was considered (and rejected) by the FASB. Consistent with Johnson and Petrone's [1998] measure of core goodwill as the
combined value of going-concern goodwill and synergy goodwill, we find
that both components are significantly positively related to market value.
Further tests show that investors place a significantly larger weight on the
synergy component than on the going-concern
component, suggesting
information is lost from aggregating the two pieces. Finally, the result
that investors do not view the residual component of goodwill as an asset
is consistent with the FASB's view that this component likely overstates

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions

386

S. L. HENNING,

B. L. LEWIS, AND W. H. SHAW

current GAAP recorded goodwill. Our finding of a negative valuation

weight on this component suggests that investors effectively write off this
portion of the goodwill asset in the year of the acquisition.
REFERENCES
ACCOUNTING

PRINCIPLES

BOARD.

Opinion No. 16: Business Combinations. New York: AICPA,

1970.
P., AND E. H. KIM. "The Impact of Merger Bids on the Participating Firms' Security Holders." Journal of Finance (December 1982): 1209-28.
BARTH, M. E.; W. H. BEAVER; AND W. R. LANDSMAN. "The Market Valuation Implications
of Net Periodic Pension Cost Components." Journal of Accounting and Economics (March
1992): 27-62.
BRADLEY, M.; A. DESAI; AND E. KIM. "Synergistic
Gains from Corporate Acquisitions
and Their Division between the Stockholders of Target and Acquiring Firms." Journal of
Financial Economics (May 1988): 3-40.
JENNINGS, R.; J. ROBINSON; R. THOMPSON; AND L. DUVALL. "The Relation between Accounting Goodwill Numbers and Equity Values." Journal of Business, Finance, and Accounting (June 1996): 513-33.
JOHNSON, L. T., AND K. R. PETRONE. "Is Goodwill an Asset?" Accounting Horizons (September 1998): 293-303.
KIM, E. H., AND J. MCCONNELL. "Corporate Merger Activity and the 'Co-Insurance'
of
Corporate Debt." Journal of Finance (May 1977): 349-65.
LEV, B., AND S. R. THIAGARAJAN."Fundamental Information Analysis." Journal of Accounting
Research (Autumn 1993): 190-215.
OMER, K.; K. MOLLOY; AND D. ZIEBART."Measurement of Effective Corporate Tax Rates UsingFinancial Information."JournaloftheAmerican
TaxationAssociation (Spring 1991): 57-72.
Performance of
RAU, P. R., AND T. VERMAELEN. "Glamour, Value and the Post-Acquisition
Acquiring Firms." Journal of Financial Economics (August 1998): 223-53.
VINCENT, L. "Equity Valuation Implications of Purchase versus Pooling Accounting." Journal of Financial Statement Analysis (Summer 1997): 5-19.
WIEDENBAUM, M., AND S. VOGT. "Takeover and Stockholders: Winners and Losers." California Management Review (Summer 1987): 157-68.
Covariance Matrix Estimator and a Direct Test
WHITE, H. "A Heteroskedasticity-Consistent
Econometrica (May 1980): 817-38.
for Heteroskedasticity."
ASQUITH,

This content downloaded from 210.187.26.2 on Sun, 29 Nov 2015 02:53:27 UTC
All use subject to JSTOR Terms and Conditions