Fair representation of purchased goodwill: An analysis of the underlying nature of acquisition processes

Is purchased goodwill an asset or an overpayment? SFAS No's 141 and 142 consider it an asset, yet recognize the possibility of overpayment. An annual impairment test is thus stipulated, even though the residual nature of purchased goodwill renders impairment measurement difficult.; In the U.S., purchased goodwill arises from a bidding process. Accordingly, to address the possibility of overpayment, the analysis framework is formulated based on research results in the auction literature, to study successful acquisitions in the U.S. from 1990 to 1998.; First, the winner's curse hypothesis states that the winner in a bidding process is likely to be the one who overestimates the target value. The acquisition process in the U.S. embodies all necessary conditions propitious for the occurrence of winners curse, namely, high degree of information asymmetry, high degree of value uncertainty, element of competition, and existence of common-value elements. The winner's curse hypothesis in business combinations is tested empirically.; Second, some event studies inappropriately classify acquisitions as “multiple-bidder” cases and “single-bidder” cases. The difference between these two categories is actually about bidding forms. The auction literature finds that winner's curse exists across bidding forms. An equivalence test is conducted to test the hypothesis that no significant association exists between winner's curse and bidding forms in business combinations.; Third, a Bayesian model is developed based on the concept of affiliation to examine winner's curse across different distributional assumptions about valuation components.; Empirical results support the winner's curse hypothesis and equivalence test results are consistent with the hypothesis that winner's curse exists across bidding forms. The analytical results show: (1) The mean of winner's curse is positive when number of bidders exceeds one, and increases as degree of information uncertainty or number of bidders increases. (2) Winner's curse becomes more deterministic as number of bidders increases.; It is concluded that regardless of bidding forms, on average purchased goodwill includes overpayment. Combining bidding information with proprietary information, acquiror can better assess the possibility and magnitude of overpayment based on the analytical results. In addition, management should adjust value estimates downward when competition intensifies, especially when common-value elements are sizable.