Accounting For Goodwill On The Acquisition Of Corporate Subsidiaries

ACCOUNTING FOR GOODWILL ON THE
ACQUISITION OF CORPORATE SUBSIDIARIES1
Keitha Dunstan
Queensland University of Technology2
ABSTRACT
Despite the existence of regulation, Australian firms retain considerable discretion over the
amount of goodwill recorded on the acquisition of corporate subsidiaries. The acquisition
of a corporate subsidiary is a significant transaction that represents an incremental change
to the investment opportunity set of a firm. This isolation of a subset of the firm's
investment opportunity set provides a unique opportunity to address the endogeneity
problem encountered by other studies that attempt to isolate the incremental importance of
ex ante and ex post explanations for accounting policy choice. The findings support the
conclusion that the proportion of the purchase price allocated to goodwill is ex ante related
to the investment opportunity set of the target company and ex post determined by the firm
wide characteristics, leverage and the investment opportunity set of the acquiring company.
JEL Classification: D23, G32, G34
Key Words: goodwill, corporate acquisitions, efficiency, opportunism
1
This paper is from my PhD thesis completed at the University of Queensland. I am grateful to my
supervisor, Con Anderson and associate supervisor, Julie Walker, for their valuable guidance. Appreciation
is also extended to my colleagues, Majella Percy and Chris Lambert and to participants at workshops at the
University of Queensland, University of Melbourne and University of Auckland.
2
Dr Keitha Dunstan
School of Accountancy email: k.dunstan@qut.edu.au
Queensland University of Technology Phone: (+61 7) 3864 2017
GPO Box 2434 Fax: (+61 7) 3864 1812
Brisbane QLD 4001
AUSTRALIA

2
2
1 Introduction
Accounting for goodwill on the acquisition of corporate subsidiaries involves the determination
of the proportion of the acquisition price to be capitalised as an asset and to be subjected to
subsequent amortisation. In Australia, the accounting treatment of all assets acquired, including
the acquisition of corporate subsidiaries, is stipulated in accounting standard AASB 1015,
"Accounting for the Acquisition of Assets". AASB 1015 requires that all identifiable assets be
recorded at their cost of acquisition, which is measured with reference to fair values. The use of
the pooling-of-interests method is prohibited by AASB 1015. Where the acquisition price
exceeds the fair value of the identifiable assets acquired, the resulting balance is deemed to be
goodwill which must be accounted for in accordance with accounting standard AASB 1013,
"Accounting for Goodwill". AASB 1013 requires goodwill to be capitalised and amortised over
a period not exceeding 20 years. This balance may only be written off if it represents excess
purchase price resulting from a bad buy. Despite the existence of regulation, firms retain
considerable discretion over the determination of the amount of goodwill recorded. Firms are
able to vary the goodwill amount by immediately writing off some or all of the excess purchase
price, by allocating a greater or lesser proportion of the cost of acquisition to identifiable assets
or, where the consideration is other than cash, by varying the deemed fair value of the cost of
acquisition.
Australian companies contend that AASB 1013 impedes the international competitiveness of
Australian corporations1
because the goodwill recognition and amortisation requirements of
AASB 1013 are more stringent than for their counterparts in other jurisdictions2
, (Easton, 1985;
Williams and Carnegie, 1989; Wines and Ferguson, 1993; Pacific Dunlop, 1994; Miller, 1995).
The professional literature in Australia and the United States provides numerous anecdotes
regarding the damaging consequences of different accounting and tax treatments for
goodwill internationally (Corry, 1990; Pacific Dunlop, 1994; McGoldrick, 1997). Empirical
research has addressed this issue by comparing the magnitude of bid premiums, target
shareholder returns and amount of goodwill acquired for takeovers involving acquiring
1
For example, see "Letters" Australian Accountant, November, 1989, "When goodwill creates ill-will"
Pacific Dunlop, August 2, 1994, "Pacific Dunlop digs in over ASC's warning on writing off goodwill"
Financial Review, August 10, 1994 and "PacDun backed in goodwill row", Financial Review, August 11,
1994.
2
For example, the United States of America and the United Kingdom permit the use of the pooling-of-
interests method in limited circumstances, the United States of America permits an amortisation period of
up to 40 years and during the time-frame of this paper, the United Kingdom permitted the immediate write-
off of goodwill against reserves.

2
companies from different jurisdictions. While there are some inconsistent results, these
studies support the general contention that companies from countries with favourable
goodwill accounting and/or tax rules are able to offer more attractive takeover offer terms
than companies from stricter jurisdictions (Cheng, Dunne and Nathan, 1997).
Despite this controversy, evidence regarding the determinants of the accounting treatment of
goodwill is limited3
. An important limitation of the prior Australian research is that it focuses on
the accounting treatment of goodwill balances in general (see Anderson and Zimmer, 1992;
Wines and Ferguson, 1993; Dunstan, Percy and Walker, 1993). The transaction specific factors
of each acquisition, including, the types of assets acquired, the synergies generated by the
combination of the assets of the acquirer and target companies and the contractual arrangements
for the takeover, are ignored. This paper extends the prior research by considering the
determinants of the accounting treatment of goodwill for each corporate subsidiary acquisition
in isolation. This approach recognises the heterogeneous nature of acquired goodwill and
provides the opportunity to investigate the impact of transaction specific factors not previously
considered.
Positive accounting researchers have tended to adopt either ex ante efficiency or ex post
opportunistic explanations for firms' accounting policy choices (Watts and Zimmerman, 1990).
Watts and Zimmerman (1990) assert that, as accounting policy choices are determined jointly by
ex ante restrictions on the accepted set of accounting methods and the ex post exercise of
management discretion, research which uses either explanation in isolation suffers from model
specification error. This paper follows the suggestion of Watts and Zimmerman (1990) by
investigating both ex ante and ex post explanations for the accounting treatment paper of
goodwill arising on the acquisition of corporate subsidiaries, in Australia. The acquisition of a
corporate subsidiary is a significant transaction that represents an incremental change to the
investment opportunity set of a firm. This isolation of a subset of the firm's investment
opportunity set provides a unique opportunity to partially address the endogeneity issues
raised by Watts and Zimmerman (1990). That is, the research will attempt to separate the
3
There is a body of research that investigates the determinants of the choice between purchase and pooling
of interests methods and the wealth effects of the choice (see for example Davis, 1990; Dunne,
1990;Robinson and Shane, 1990). However, this research is not applicable to the Australian setting where
that choice is unavailable.

3
ex ante restrictions on managerial discretion which are related to the expected synergies to
be generated by the combination of the target and acquiring companies, the type of assets
acquired and transaction specific contractual arrangements from the ex post exercise of
discretion (both efficient and opportunistic) determined by the contracting choices of the
firm as a whole.
The remainder of this paper is organised as follows. The next section reviews the limited
research that directly investigates the determinants of the accounting treatment of goodwill
arising on the acquisition of corporate subsidiaries. Section 3 develops hypotheses regarding
the determinants of the amount of goodwill capitalised as an asset on the acquisition of a
corporate subsidiary. Other transaction specific factors, which have the potential to impact on
the accounting treatment of acquired goodwill, are discussed in Section 4. The research design,
sample selection criteria, mode of data collection, specifications for the variables and the testing
procedures are outlined in Section 5. The results of this testing are presented in Section 6. The
paper concludes in Section 7 with a discussion of the contribution and limitations of the paper as
well as possible directions for future research.
2 Prior Research
The determinants of the recognition of goodwill and identifiable assets acquired through the
acquisition of corporate subsidiaries have been investigated by Grinyer, Russell and Walker
(1991) and Wong and Wong (1999) for British and New Zealand firms respectively. Both
studies focus on all acquisitions made by firms in any given year and consider the
determinants of the decision to proportionately allocate the purchase price between
goodwill and identifiable assets. While neither of these studies is set in Australia, their
findings remain useful because evidence as to the corporate motivation for goodwill
accounting policy choices in these jurisdictions provides insight into the likely incentives of
Australian companies.
The implications of the findings of the research by Grinyer, Russell and Walker (1991) to
Australia must be considered with due reference to the inconsistencies between the British
and Australian accounting frameworks. Until recently4
the preferred treatment of acquired
4
Financial Reporting Standard 10 “Goodwill and Intangible Assets”, issued in 1997, prohibits companies
in the United Kingdom from immediately writing off goodwill against reserves.

4
goodwill in the United Kingdom was to immediately write it off against reserves.5
This
means that, at the time of the Grinyer, Russell and Walker paper, maximising the
recognition of goodwill avoided the annual depreciation charges associated with the
recognition of identifiable assets and was therefore an income increasing accounting policy
choice in the U.K. This is exactly the opposite situation to that which exists in Australia,
where increased recognition of goodwill has a negative earnings effect due to the strict
amortisation requirements.
Grinyer, Russell and Walker (1991) argue that U.K. companies had two conflicting motives
regarding the goodwill accounting policy choice. Firms faced a trade-off between their
incentive to maximise the recognition of tangible assets to strengthen balance sheet ratios
and their incentive to recognise goodwill to improve post acquisition profits. They find that
the proportion of purchase price allocated to goodwill is negatively associated with the
leverage of the acquiring company and the size of the acquisition.
The authors explain the negative relation between the recognition of goodwill and leverage
as being driven by the incentives of highly levered firms to opportunistically improve their
balance sheet position. They contend that management is able to maximise the assets
available to secure future debt by recording a greater proportion of the purchase price as
tangible assets. The explanation offered for their finding that larger acquisitions are more
likely to result in the recognition of lower goodwill balances is based on the premise that,
the more material the acquisition is to the acquiring firm, the greater the exposure to the
risk associated with the acquisition. This provides management with an incentive to
recognise a greater proportion of tangible assets to provide greater assurance to
shareholders of the availability of security, should the target firm fail.
While the trade-off hypothesis does not apply in Australia6
, the evidence provided by
Grinyer, Russell and Walker (1991) that highly levered companies allocate a greater
proportion of the purchase price to tangible assets is relevant. The expected association
between the accounting treatment of goodwill and leverage, in Australia, is discussed
further in Section 3. Interestingly, the authors also note that it is highly unusual for U.K.
5
Russell, Grinyer, Malton and Walker (1989) report that 98% of a sample of U.K. firms immediately
wrote-off their acquired goodwill against reserves.
6
Both the earnings management and leverage explanations would lead to a prediction that Australian firms

5
companies to record intangible assets other than goodwill at the time of acquisition. This is
consistent with the Australian research that contends that acquired identifiable intangible
assets are chiefly recorded by Australian companies as a means of avoiding the requirement
to amortise goodwill (Williams and Carnegie, 1989; Wines and Ferguson, 1993; Dunstan,
Percy and Walker, 1993).
Wong and Wong (1999) examine the accounting treatment of goodwill arising from
corporate acquisitions within a New Zealand context. This research is highly relevant to
Australia because the accounting requirements for accounting for goodwill in New Zealand
and Australia are virtually identical. Consistent with Grinyer, Russell and Walker (1991),
Wong and Wong (1999) also find a negative relation between leverage and the recognition
of goodwill. However, they dispute the contention, made by the prior authors, that this
finding provides evidence that companies are motivated by an incentive to opportunistically
improve leverage. They present an efficiency based explanation instead (pp7-8):
…that the negative relationship between leverage and acquired goodwill is more likely to be a
direct relation with the firm’s investment opportunity set than an indirect relation via the
firm’s debt covenants. That is, because assets-in-place and goodwill are inversely related and
assets-in-place and leverage are positively related, goodwill and leverage would be negatively
related. This relation stems from each variable’s association with assets-in-place and is less
likely to be driven by the existence of debt covenants.
Their finding that goodwill is negatively correlated with the level of assets-in-place held by
a company provides support for this position. The authors conclude that the negative
association found between goodwill and both leverage and assets-in-place is consistent with
an endogenous relation between the firm's investment opportunity set, financing policy and
acquired goodwill. This endogeneity, however, makes it impossible for them to empirically
identify the separate direct and indirect effects.
The underlying premise of this paper is that both the ex ante explanation of Wong and Wong
(1999) and the ex post explanation provided by Grinyer, Russell and Walker (1991) apply.
Further the separation of transaction specific factors from the firm wide characteristics of the
acquiring entity, in this paper, provides the opportunity to separately measure the two
influences. Wong and Wong were impeded from that objective by the fact that their method
focused on all acquisitions made by firms in any given year. This made it necessary for them
to employ the investment opportunity set of the acquiring firm as a proxy for the investment
would avoid the recognition of goodwill.

6
opportunity set of the acquired firm. This paper uses a direct measure of the investment
opportunity set of the acquired company that is not related to the financing policy of the
acquiring company. Therefore, the method employed in this paper enables joint testing to
identify the separate effects of leverage and the acquired investment opportunity set without
suffering an endogeneity problem. The next section applies the costly contracting framework
to develop hypotheses regarding the determinants of the amount of goodwill capitalised as
an asset on the acquisition of corporate subsidiaries.
3 Theoretical Development
Most empirical research testing positive accounting theory has been based on the
opportunistic or so-called ex post perspective. This perspective relies on the assumption of
self-maximisation by contracting parties and the incompleteness of contracts (including
ambiguity and flexibility of the rules) which allow opportunistic divergence7
.The efficient
contracting perspective evolved from the view of Watts (1977) who conjectures that the
context of financial statements is driven by agency cost minimising motives. Efficient ex
ante accounting policy choices minimise agency costs so that the value of the firm is
maximised. This perspective involves the search for accounting policy choices within the
available accepted set which minimise potential conflicts between contracting parties8
.
Holthausen and Leftwich (1983) offer the information perspective as a potential competing
theory to the efficient contracting perspective. The separation of ownership and control
implies that management acquires superior information to that cost effectively available to
other stakeholders. This information asymmetry enables the manager to provide
information regarding the firm’s cash flows, to other contracting parties at a cost that is
7
Researchers using an opportunistic perspective have considered management’s choice of accounting
methods given the existence of bonus plans, debt agreements and the political process. The evidence has
generally found that management of firms with accounting based bonus plans chose accounting policies
which maximise earnings (Watts and Zimmerman, 1990; Christie, 1990). Healy (1985) provides a more
sophisticated test of the bonus plan hypothesis by identifying instances where management may reduce
earnings to maximise their remuneration. More recent research has confirmed the link between earnings
management and remuneration plans (DeAngelo, 1988; Dechow and Sloan, 1991; Gaver, Gaver and
Austin, 1995; Holthausen, Larker and Sloan, 1995).The empirical evidence also supports a relation
between debt agreements and accounting policy choices, with highly levered firms being more likely to
adopt income increasing accounting methods (Christie, 1990; Sweeney, 1994).
8
A number of researchers have identified a relation between accounting policy choice and the firm’s
available investment opportunity set (Zimmer, 1986; Whittred, 1987; Mian and Smith, 1990; Malmquist,
1990; Skinner, 1993; DeFond and Jiambalvo, 1994; Whittred and Zimmer, 1994).

7
lower than they would have incurred had they sought the information themselves. While
recognising that it is difficult to separate efficient contracting and information motivations
empirically, because both perspectives suggest a relation between accounting policy choices
and the investment opportunity set, Holthausen (1990) justifies their separation due to
different cash flow effects. He argues that the efficient contracting perspective focuses on
the potential for accounting choices to increase the value of the firm through a direct cash
flow effect, while the information perspective considers the extent to which accounting
provides information about future cash flows without directly affecting them. This
distinction between the efficiency and information perspectives may be questioned. The
provision of information must ultimately affect firm value if the reduction in information
asymmetry reduces both implicit and explicit contracting costs, including monitoring and
search costs (Godfrey, 1990). While not as thoroughly researched as the other two
perspectives, the information perspective has received some empirical support (Diamond
and Verrecchia, 1991; Bartov and Bodnar, 1996).
For the purposes of this paper, two roles for accounting information are considered within
the ex ante contracting stage. The first relates to the role played by accounting information
in mitigating the information asymmetry between managers and other contracting parties.
This is synonymous with the ‘information perspective’ as outlined by Holthausen (1990).
Beaver (1989) characterises this informational role of accounting data as forming part of
the ‘pre-decision’ process. In this sense, the provision of accounting information to mitigate
information asymmetry is precedent to the formation of an agreement. The agreement on
the accepted set of accounting procedures provides the second role for accounting
information within the ex ante contracting stage. Accounting information, at both of the ex
ante stages, enhances contractual efficiency by minimising contracting costs.9
Accounting information also facilitates the ex post contractual adjudication process. The
accounting outcome applied as the contract benchmark or measure results from
management’s choice of accounting method from within the accepted set. This choice
provides an efficient contractual outcome where the exercised discretion increases the
wealth of all parties. This includes situations where management makes a seemingly self-
maximising choice that was already anticipated and ‘priced’ in the ex ante agreement stage.
Such choices are opportunistic only where management is able to transfer wealth to one
9
Ex ante contracting is efficient because rational contracting parties are assumed to be ‘price protected’

8
contracting party at the expense of another party (Watts and Zimmerman, 1990).
Opportunism is possible even under the assumption of rationality if not all contracting
outcomes are foreseen and there is a absence of ex post settling up due to positive search
and monitoring costs (Fama, 1980). The relation between the contracting stage, the role of
accounting and the promotion of contractual efficiency or opportunism is depicted in
Figure 1.
Figure 1 here
This paper tests hypotheses that are based on the different contracting stages and the
associated role of accounting.
3.1 Ex ante Explanations
3.1.1 Information Hypotheses
Information asymmetry exists where management has superior information that is not cost
effectively available to other contracting parties. Managers will voluntarily publicise this
information if they are able to minimise the search and monitoring costs that stakeholders
will ultimately bear (Bartov and Bodnar, 1996). However, such disclosure will not be made
if it puts the firm at a competitive disadvantage (Verrecchia, 1990).
In the case of the acquisition of a corporate subsidiary management may have superior
information about the wealth to be created through the generation of synergies. Evidence
supports the contention that target company shareholders benefit from the expected
synergies in the form of a higher offer price (Dodd and Ruback, 1977). However, empirical
evidence questions whether similar gains are afforded to the shareholders of the acquiring
company (Kennedy and Limmack, 1996). Where the expected value of synergies generated
by a combination is high, management will be willing to offer target shareholders a greater
bid premium to entice their acceptance of the offer. If management has information about
the expected magnitude of the synergies, that is not available to stakeholders, they may
have incentive to disclose information about the wealth created to justify why a high
purchase price was paid. Otherwise, the stakeholders of the acquiring company may
conclude that the takeover was motivated to maximise the self-interest of management.
from any anticipated ex post opportunism (Alchian and Woodward, 1987).

9
Managers could make a media announcement regarding the wealth generated by the
corporate combination, however, a more credible signal of this information is to capitalise
the increased excess purchase price as goodwill, the balance which is then attested to in
audited financial statements. An alternative credible means of identifying this wealth
creation would be to recognise greater amounts of identifiable assets. However, restrictions
on the accepted set of accounting procedures limit management’s discretion in adopting
this alternative. This argument is developed in section 3.1.2. Further, the recognition of
identifiable intangible assets will disclose more specific information about the source of the
wealth than the recognition of goodwill. The excess purchase price, whether or not it is
recorded as goodwill, is already a required disclosure. The identification of individual assets
provides extra discretionary disclosure that may be more likely to reveal proprietary
information to competitors.
Empirical and theoretical work in financial economics and strategic management has
addressed the sources of wealth creation in takeovers (Dodd and Ruback, 1977; Dodd,
1980; Bradley, Desai and Kim, 1988; Berkovitch and Narayanan, 1993; Jensen, 1986).
Writers such as Chatterjee and Lubatkin (1990) and Seth (1990) contend that where the
acquiring and target companies operate in related industries wealth is generated through the
combination of their resources at an operational level.10
Such operational gains include
economies of scale (e.g. marketing and distribution), economies of scope, technological
transfers and increased market power (Trautwein, 1990; Simmonds, 1990; Seth, 1990).
A further closely related synergy that might be created through the combination of related
companies is managerial synergy. Researchers contend that the market for corporate
control provides a powerful mechanism for the discipline of management (Fama, 1980;
Jensen, 1986; Groff and Wright, 1989; Wong, 1992). If the management team of a firm is
inefficient it is likely to become a takeover target because an acquirer would be able to
create wealth by replacing the incumbent management. If an acquiring firm operates in a
related industry they would be in a strong position to generate such managerial gains
because their existing management team would already have the necessary expertise in the
area (Trautwein, 1990; Simmonds, 1990; Seth, 1990).
10
Examples of related takeovers include: vertical integration, where a firm acquires successive processes
within the same industry; horizontal integration where a firm acquirers another within the same industry
sector, and; concentric acquisitions such as acquiring another company which has new technologies which

10
Where the magnitude of ‘operational and managerial synergy’ is an increasing function of
the extent of relatedness between the acquirer and the target company, and where the
recognition of goodwill provides a credible indication of the value of that synergy, the
amount of goodwill recognised is expected to be a function of acquirer and target company
relatedness.
HYPOTHESIS ONE
The more closely related the acquirer and target company, the greater the
proportion of the ‘notional’ purchase price recorded as goodwill.
Researchers have investigated the ‘financial synergy’ generated by corporate combinations
through a coinsurance effect. Coinsurance occurs where bankruptcy costs are decreased
due to less than perfect correlation between the cash flows of the combining firms,
increased size of the firm and/or a decrease in systematic risk (Amit and Livnat, 1988;
Asquith and Kim, 1982; Choi and Philippatos, 1983). A more specific source of ‘financial
synergy’ exists where the combination of the target and acquiring firms mitigates
contracting problems related to inadequate financial slack and/or free cash flow (Smith and
Kim, 1994).
Myers and Majiluf (1984) argue that information asymmetry provides management with the
opportunity to transfer wealth from new investors to existing shareholders by issuing equity
or risky debt, when the firm is overvalued. Information asymmetry impedes the capital
market’s ability to assess management actions, so the market recognises the potential for
wealth transfers by responding negatively to new issues. This creates an incentive for firms
to maintain financial slack to enable the pursuit of positive net present value (NPV)
investments as they become available without having to resort to the issue of risky
securities.11
Myers and Majiluf (1984) suggest that a corporate combination provides the
means for transferring slack between firms without having to bear the cost of an adverse
market response to a new issue.
will be useful in improving the existing company’s processes.
11
Myers and Majiluf (1984) define financial slack as liquid assets and riskless borrowing capacity beyond
what it needed to meet current operating and debt servicing needs.

11
The opposite problem to holding insufficient financial slack is having excess free cash flow.
Jensen (1986) describes the agency problems associated with free cash flow.12
Growth in
corporate resources creates demand for new management positions, opportunities for
managerial promotion and is positively related to management compensation (Jensen,
1986). This provides management with incentives, in the absence of appropriate investment
opportunities, to invest in sub-optimal projects (negative NPV) to maintain corporate
growth. Under the assumption of bounded rationality, shareholders will recognise the
potential for managers to take this divergent action and will discount their valuation of the
managers services on the basis of reduced expected quasi rents arising from investment in
the firm. Jensen (1986) states that growth through corporate acquisitions will mitigate the
agency costs of free cash flow if the acquisition provides growth opportunities sufficient to
absorb free cash flows.
Smith and Kim (1994) argue that the concepts of financial slack and free cash flow are
indistinguishable as they both involve comparisons between a firm’s cash generating ability
and its available investment opportunities. The relation between liquidity and the availability
of investment opportunities is depicted in Figure 2.
Figure 2 here
Where liquidity is low but the availability of investment opportunities is high, the firm has
inadequate financial slack and is likely to under-invest (forgo positive NPV projects).
Conversely, where liquidity is high and the firm has few investment opportunities, the firm
has high free cash flow and the manager has incentive to over-invest (undertake negative
NPV projects). Therefore, the combination of a ‘slack poor’ firm with a ‘high free cash
flow’ firm reduces the potential for both under-investment and over-investment and will be
reflected in a higher market value for the combined firm. In the presence of information
asymmetry regarding the expected value of financial synergy generated by the combination,
management will have incentive to disclose information about the wealth created by
capitalising a greater amount of goodwill.
12
‘Free cash flow’ is the cash flow in excess of that required to fund all positive net present value projects
(Jensen, 1986).

12
HYPOTHESIS TWO
Where an acquisition generates ‘financial synergy’, by combining a
company which is slack-poor with a company having free cash flow, the
proportion of the ‘notional’ purchase price recorded as goodwill will be
greater than where a combination of firms does not generate ‘financial
synergy’.
3.1.2 Restrictions on the Accepted Set
Ex ante restrictions on the accepted set of accounting methods limit the ambit of
management’s discretion by setting recognition criteria and/or measurement rules for the
assets acquired. These restrictions on management’s discretion would be encompassed in
the firm’s explicit and implicit contracts and would include legislative requirements13
,
generally accepted accounting principles (GAAP)14
and specific contractual requirements.
Research investigating the stipulation of accounting calculations in debt covenants and
executive bonus plans has found that accounting numbers are generally stated in terms of
GAAP with some specific modifications (Whittred and Zimmer, 1986; Smith and Warner,
1979). For example, intangible assets may be deducted from total assets in the calculation
of leverage in debt agreements or certain accruals may be adjusted before the calculation of
earnings in management remuneration contracts. The purpose of any specific GAAP
adjustments would be the promotion of ex ante contractual efficiency through the
minimisation of ex post opportunism.
Accounting for the acquisition of corporate subsidiaries involves the separate recognition of
identifiable assets (both tangible and intangible) and goodwill. The restrictions on the
accepted set would provide an acceptable range of proportional allocations of the cost of
acquisition for the assets that would vary depending on the actual types of assets acquired
in the transaction. Skinner (1993) contends that the value of assets already in place is more
verifiable/observable. This suggests that the recognition of identifiable assets, both tangible
13
The relevant legislative limitations (for the time period of this paper) are encompassed within the
Corporations Law (1991).
14
GAAP represent a ‘specialised form of case law’ which sets precedent that may be used by the
contracting parties. Ball (1989) draws an analogy with the legal precedent provided in common law.
"Contract law provides that a substantial body of precedent, too costly to explicitly write into individual
contracts, is ‘read into’ and is thus implicit in all contracts" (Ball, 1989, p.8).

13
and intangible would be less costly in terms of measurement and audit costs where a firm
has high levels of assets in place.
Some identifiable assets encompass growth options requiring further discretionary
investment (eg. brand names) and components of goodwill might be considered as assets in
place (eg. firm reputation). In general, however, the ‘identifiability’ of intangible assets
would improve as they become closer in form to assets-in-place and are therefore more
observable and verifiable. Where an identifiable asset consists primarily of assets in place
the measurement, book-keeping and audit costs will be low. However, the magnitude of
these costs will increase as growth options become a larger component of an intangible
asset. At high levels of growth options these increased costs provide a deterrent to the
recognition of identifiable intangibles. Given the ex ante restrictions on management’s
discretion considered earlier, it is hypothesised that the proportion of purchase price left
unidentified and therefore allocated to goodwill will be positively associated with the level
of growth options being acquired.15
HYPOTHESIS THREE
The higher the proportion of assets acquired which are growth options
the higher the proportion of the ‘notional’ purchase price recorded as
goodwill.
3.2 Ex post Explanations
The acquisition of a corporate subsidiary is a significant transaction that has an impact on
the consolidated financial statements of the reporting entity subsequent to the acquisition. It
is therefore expected that ex post exercise of management discretion, within the accepted
set, will vary depending on the impact of this transaction on the contracts already in place
in the firm. Efficiency or opportunism may motivate the ex post exercise of managerial
discretion within the accepted set. Watts and Zimmerman (1990) acknowledge that the
exercise of ex post discretion will be efficient where the outcome was anticipated during the
ex ante contracting process and the parties to the contract have been price protected.
15
Anderson and Pavletich (1995) applied the Myers (1977) model and reasoned that the level of growth
options held by a firm provides an approximate measure of its ‘economic goodwill’.

14
The empirical distinction between ex post efficiency and ex post opportunism is only
possible where the ex ante contracting process can be observed. Therefore, this research
does not attempt to distinguish between the two states. This lack of distinction does not
affect the predictions of the hypotheses, as the discretionary choices of management remain
the same in both instances. If the potential for management to adopt contractually
favourable accounting procedures is anticipated ex ante then management will be forced to
adopt those procedures to ensure they receive their fair pay-off because the agreed pay-off
would have been discounted in anticipation of opportunism. Alternatively, if management’s
actions were not anticipated and there is the possibility of incomplete ex post settling up,
management will have an opportunistic incentive to adopt the same policies.
3.2.1 Debt Covenants
Whittred and Zimmer (1986) find evidence that Australian debt agreements frequently
contain leverage constraints measured as the ratio of total liabilities to total tangible assets.
Cotter (1998) confirms this finding and also finds that prior charges covenants, that restrict
the amount of secured debt owed to other lenders, typically require the deduction of
intangible assets from the denominator in Australian private debt agreements. This may
provide firms that are close to their leverage constraints in their debt agreements with
incentive to maximise the allocation of the purchase price to tangible assets and therefore
minimise the recognition of goodwill when accounting for corporate acquisitions.16
Further,
it may be cost effective for these firms to negotiate for the inclusion of identifiable
intangible assets in the denominator of leverage constraints.17
In which case, management
would have incentive to increase the allocation of the purchase price to both tangible and
identifiable intangible assets and further decrease the amount of goodwill recorded. The net
benefits of the recognition of identifiable intangible assets is subject to the increased
proprietary, measurement, bookkeeping, audit and loan renegotiation costs that would be
incurred.
Similar to prior opportunistic based research, this paper assumes that more highly levered
firms are more likely to have debt agreements containing leverage constraints and that they
would be closer to violation of borrowing constraints imposed by their debt covenants than
16
Grinyer, Russell and Walker 1992 conclude that the negative association between leverage and the
recognition of goodwill, that they find, is consistent with this explanation.
17
An article entitled "Murdoch values mastheads at $500 million" Australian Financial Review September
15, 1989 stated that News Corporation had revalued its identifiable intangible to avoid breaching a debt
equity ratio commitment.

15
other firms. Press and Weintrop (1990) offer empirical support for a positive association
between leverage, the existence of debt covenants and closeness to the constraints
contained in debt covenants. This paper predicts that there is a positive association between
leverage and the allocation of the purchase price to tangible and perhaps identifiable
intangible assets. This implies that there is a negative relation between leverage and the
recognition of goodwill.
HYPOTHESIS FOUR
There is a negative association between the leverage of the acquiring
entity and the proportion of the ‘notional’ purchase price recorded as
goodwill.
Highly levered firms may also have earnings management related reasons to avoid the
recognition of goodwill. These are discussed in the next section.
3.2.2 Accounting Rate of Return
A substantive body of literature addresses management’s incentive to manage the level of
accounting earnings. Much of this research adopts the view that management has incentive
to manipulate earnings to opportunistically maximise their ex post contractual pay-offs.
Management compensation schemes commonly use accounting earnings as the basis for
managerial performance evaluation (Lambert and Larker, 1987). Researchers have
provided extensive evidence that accounting policy choices are linked to the existence of
bonus schemes (Healy, 1985; Dechow and Sloan, 1991; Gaver, Gaver and Austin, 1995;
Holthausen, Larker and Sloan, 1995). There is also evidence that managers facing violation
of debt covenants, such as interest coverage and dividend constraints, adopt income
increasing procedures (Sweeney, 1994).
The capitalisation of goodwill is an income decreasing accounting policy choice because of
the requirement for subsequent amortisation. This suggests that where a firm is close to
technical default of debt covenants18
or there is a bonus plan based on accounting earnings
in place, management may be more likely to avoid the recognition of goodwill.19
18
Cotter (1998) reports that most private debt agreements include an interest coverage requirement that is

16
Consistent with prior research, hypothesis four uses leverage as a proxy for the effect of
leverage constraints. It could be argued that leverage will also be associated with the
existence of profit based constraints. This being the case, the earnings management
incentives associated with the accounting treatment of goodwill will be captured by tests
for hypothesis four. No similar proxy for the existence of bonus plans exists. However,
Smith and Watts (1992) argue that firms with a greater proportion of assets-in-place are
more likely to have accounting based compensation packages than high growth option
firms because alternative measures of performance are more appropriate for the latter
group. This indirect association between the investment opportunity set and the accounting
treatment of goodwill is addressed in hypothesis six.
A direct test for the relation between bonus schemes and the accounting policy choice
would necessitate access to details about each firm’s management remuneration packages.
This information is not publicly available for the time frame covered by this paper. In the
absence of the direct observation of the debt or bonus plan agreements, a crude earnings
management hypothesis is developed. That is, it is proposed that firms with a lower
accounting rate of return would be more likely to opportunistically manage profits upwards
as they would be more likely to be in an unfavourable position for any existing contracts
than other more profitable firms. Therefore, firms with a low accounting rate of return are
more likely to avoid the recognition/amortisation of goodwill.
The major flaw with a hypothesis using low accounting rate of return as a proxy for a
firm’s contractual discomfort is that accounting rate of return itself is likely to be driven by
the investment opportunity set. For instance, Gaver and Gaver (1993) contend that firms
with a high proportion of assets-in-place will generate higher accounting profits than high
growth option firms. However, it is argued that this endogeneity problem is controlled for
in this paper because the investment opportunity set of the firm is also included in the
model (hypothesis six). In addition, any bias in the results would be conservative and make
a significant relation less likely.
defined in terms of the ratio operating profit before interest and taxes to interest expense. She finds no
evidence to suggest that the amortisation of goodwill is added back into the numerator.
19
There is evidence that managerial remuneration is positively related with the level of accounting profits
even in the absence of explicit bonus schemes linked to earnings (Smith and Watts, 1992).

17
Another weakness of this hypothesis is that any relation found cannot be tied back to the
specific contractual arrangements, be they debt agreements or bonus plans. There may also
be alternative explanations motivating the management of earnings. Researchers provide
evidence that firms manage earnings, to avoid political costs (Wong, 1988; Jones, 1991;
Gerhardy, 1991; Cahan, 1992; Guenther, 1994), to mask financial distress (Murphy and
Zimmerman, 1992; Pourciau, 1993; Houghton et al.., 1993; DeAngelo, DeAngelo and
Skinner, 1994) or to avoid hostile takeover/proxy contests (DeAngelo, 1988; Groff and
Wright, 1989; Christie and Zimmerman, 1994). This means that if tests of this hypothesis
identify earnings management in the form of avoiding the recognition of goodwill no
conclusion can be made as to the motivation for the earnings management. This problem
notwithstanding, the hypothesis is included in the interest of improving the explanatory
power of the model and to avoid the potential for model specification error.
HYPOTHESIS FIVE
There is a positive association between the rate of accounting return for
the acquiring entity and the proportion of the ‘notional’ purchase price
recorded as goodwill.
3.2.3 Indirect Association with the IOS of the Acquiring Entity
Skinner (1993) finds accounting policy choices to be directly related to bonus plan, debt,
political cost proxies and the investment opportunity set and indirectly related to the
association between the investment opportunity set and the bonus plan, debt and political
cost proxies. Gaver and Gaver (1993) applied the Myers (1977) model of the firm to
hypothesise a relation between the levels of growth options held by the firm and the
financing and compensation policies selected. They predict that firms having high levels of
growth options will have low leverage because equity financing mitigates the potential
under-investment problem associated with risky debt. They further predict that market
based compensation schemes for management will provide a better contracting solution for
high growth option firms where accounting based performance measures do not reflect
managerial growth enhancing activities. Using this reasoning, the contracting choices of the

18
merged entity are expected to be endogenous with the investment opportunity set of the
merged entity as a whole. Their findings are consistent with this proposition.20
Hypotheses four and five have already dealt with the direct relation between contractual
arrangements and the recognition of goodwill. Hypothesis six addresses the indirect
association between the investment opportunity set of the firm and the accounting policy
choice. Using the reasoning of Skinner (1993), high growth option firms will have lower
leverage and are less likely to use accounting based performance measures for management
remuneration. This means that high growth option firms have less incentive to minimise the
recognition of goodwill due to the impact on contractual arrangements. As such, it would
be expected that there would be a positive association between the level of growth options
held by the acquiring entity and the amount of goodwill recognised.
HYPOTHESIS SIX
There is a positive association between the proportion of assets of the acquiring
entity which are growth options and the proportion of the ‘notional’ purchase price
recorded as goodwill.
4 Control Variables
The previous section developed both ex ante and ex post explanations for the accounting
treatment of goodwill on the acquisition of corporate subsidiaries. This section identifies
five additional factors, which have the potential to impact on the discretion available to
management and ultimately the accounting policy choice made. While these factors fall
outside the theoretical domain of the paper their omission from any testing would lead to
misinterpretation of the main effects being studied.
4.1 Materiality
Australian accounting standards exempt companies from compliance where their application has no material
effect. Firms can argue that goodwill need not be recorded where the amount is immaterial. While there will be
cross-sectional variation in the amount of goodwill for each transaction, it might be expected that more material
transactions have the potential to have more material goodwill balances. Where goodwill is more material,
management has less discretion within the accepted accounting policy set, as it will be more costly to avoid its
20
Smith and Watts (1992) also provide evidence that the investment opportunity set is linked to financial,
dividend and compensation policies.

19
recognition. The potential relation between materiality, the accepted accounting policy set and opportunism
suggests that the inclusion of this control provides the opportunity for a cleaner test of the ex post hypotheses.
4.2 Type of Consideration
A takeover may be financed by cash (internally generated or borrowed) or by the issue of shares in the acquiring
company, to the target shareholders. There are two factors that will affect the choice of the type of consideration,
first, the contractual arrangements of the acquiring and target companies and second, the likely impact of any
goodwill recognition on the post-acquisition firm.
Management may intentionally choose to finance the acquisition through the issue of shares to minimise the
recognition of goodwill21
. Where the consideration takes the form of assets other than cash, management retains
discretion over the measurement of the purchase price and ultimately the measurement of any residual goodwill.
The valuation practices employed by companies in the determination of fair values of shares offered as purchase
consideration have been criticised by accounting standard setters (Coopers & Lybrand, 1993). It is argued that
companies minimise the recognition of goodwill and therefore the impact of any subsequent amortisation of
goodwill by making conservative valuations of shares provided as consideration for the acquisition of
subsidiaries. Where the source consideration is cash (from the raising of debt or internal funds) management has
less discretion to minimise the recognition of goodwill resulting in the recognition of higher goodwill balances.
While beyond the scope of this paper, it might be expected that the amount of goodwill recorded would be
negatively associated with the issue of shares as consideration for the acquisition.
4.3 Magnitude of Bid Premium
Where a firm is acquired in a takeover, the cost of acquisition usually exceeds the market value of the firm prior to
the announcement of the takeover bid. This bid premium represents the target ‘holders share of the expected
wealth to be generated by the combination of the target and the acquiring company (Walkling and Edminster,
1985). The higher the bid premium paid the greater the difference between the cost of acquisition and the book
value of the assets of the subsidiary and the less managerial discretion about the measurement of this excess. As
mentioned earlier, the identification of assets involves increased measurement and monitoring costs. Therefore,
the more material the bid premium, the more costly it is for firms to avoid the recognition of goodwill.
4.4 Industry Effects
The amount of ‘economic goodwill’ acquired in a transaction is likely to vary cross-
sectionally across industries. Prior literature and conceptual debate suggests that two
industry groupings have relevance to the likely amount of goodwill acquired, target
21
Overseas research provides evidence that firms choose shares over cash to finance acquisitions to enable
the use of the pooling of interests method to avoid the recognition of goodwill (Hong, Kaplan and
Mandelker, 1978; Davis, 1990).

20
company membership of the mining industry or of a service industry. The potential affect of
target company membership of these two industries is discussed in sections 4.4.1 and 4.4.2.
4.4.1 Mining Industry
A recent Australian court case has brought into question whether the acquisition of a
mining target, in particular a gold miner, is likely to give rise to an acquired goodwill asset
(Soloman Pacific Resources NL v Acacia Resources Ltd, 1996). In November 1996, the
Urgent Issues Group (UIG) issued Abstract 10 Accounting for Acquisitions – Gold Mining
Companies, which states that the acquisition of a gold mining target is unlikely to result in
a material amount of goodwill, unless it involves the acquisition of specialised access, skills
or knowledge or results in the generation of synergies. The basis for the contention that
goodwill does not arise on the acquisition of gold miners, is that the product gold is
homogeneous and that the value of a gold mining company is primarily the value of gold
reserves less the expected cost of recovery. The absence of any firm specific expertise
means that there should be no goodwill. While less persuasive than for the gold industry,
similar arguments hold for other mining companies especially producers for which mineral
assets are their major assets. If mining companies have less goodwill than industrial
companies then this variable would be expected to affect management’s discretion and
ultimately have a negative association with the recognition of goodwill.
4.4.2 Service Industry
Many companies that lobbied against the existing regulation of goodwill accounting have
argued that the standard unfairly penalises firms operating in service industries22.
These
types of companies typically have larger goodwill balances and are therefore more affected
by the requirement to amortise goodwill. The major assets of service industry companies
are usually intangibles such as human capital or loyal customers. Given the measurement
and monitoring costs associated with the identification of intangible assets the value of
these assets is more likely to be left in the goodwill balance. If companies in the service
industry do have larger amounts of these assets then management ability to avoid the
recognition of goodwill is limited. Accordingly, this variable is also included as a control.
22
For example see “Letters”, Australian Accountant November, 1989.

21
5 Data and Research Design
5.1 Data
The sample for the paper comprises all successful acquisitions of listed public companies by
listed public companies, in Australia, which were first recorded in the consolidated financial
statements of the acquiring company during a financial period ended between June 30,
1988 and June 30, 1994. The financial year ending June 1988 is the earliest appropriate
year because the mandatory accounting standard AASB 1013 Accounting for Goodwill first
applied to this period. Prior to 1988, it is well documented that many Australian companies
failed to account for goodwill in accordance with the then professional regulation AAS18
(Miller, 1995). Evidence supports the contention that non-compliance was virtually
eliminated after the imposition of ASRB 1013 (Miller, 1995). A major problem with
selecting such a long time frame is that other institutional and economic factors are unlikely
to have remained stable during the entire period.23
However, it is necessary to include the
years 1988 and 1989 to obtain sufficient data for statistical analysis.24
Further, it is asserted
that any bias caused by such institutional shifts will have a conservative impact on the
results.25
A list of Australian companies which were delisted during the period, July 1, 1987 until
June 30, 1994 was compiled from publications by the Australian Stock Exchange (ASX,
1988; 1989; 1990; 1991; 1992; 1993 and 1994) and other sources (Notham, 1994).
Companies that were delisted for reasons other than a successful takeover, where the
acquiring company was a listed Australian public, were excluded. Also, several of the
acquisitions were recorded as subsidiaries by the acquiring company prior to the year
ending 30 June 1988.26
These acquisitions were also excluded. This provided a potential
sample of 229 successful takeovers of Australian listed public companies by another, during
the relevant time period.
23
An example of non-static regulation is the issue of AAS 24 Consolidated Financial Reports (which had
application from June 1991) and AASB 1024 Consolidated Accounts had application from December
1991). Prior to this regulation companies were entitled to not prepare consolidated accounts or record
consolidated goodwill. However, all companies included in the sample for this paper did voluntarily
provide consolidated accounts and were therefore subject to the mandatory regulation of AASB1013.
24
Takeover activity was more fervent in the 1980’s than in the 1990’s. The peak year being 1988 with 280
bids being made (Corporate Adviser, 1996).
25
The sample period ends in 1994 because extension into 1995 and 1996 would have exacerbated the
problem of the long data window while adding less than twenty extra observations.
26
This might occur if the takeover involved increasing the parent company’s shareholding from say 60% to
100%.

22
To facilitate testing, it was necessary to survey the annual reports of the acquiring company
for the two years prior and the first year subsequent to the acquisition and the annual
reports of target company for the two years prior to the acquisition. It was also necessary
that share price information be available for all acquiring and target companies for three
years prior to the takeover offer. Takeovers involving companies where this information
was unavailable, due to missing records or the acquirer or target company being less than
three years old, were excluded from the sample. This resulted in a final sample of 163
acquisitions.
Table 1 provides a summary of the final sample by year and by industry of the target firm.
The sample is predominated by acquisitions in the 1988 and 1989 years and where the
target company operates in the gold or investment and financial services industries. While
this reflects the general patterns of takeover activity during this period, this does have
implications for the generalisability of the results of this paper.
Table 1 here
Information relating to the terms of the acquisitions was gathered from a number of
sources. These include: the “Takeovers” section of The Australian Financial Review 1987
to 1994; publications by the ASX (ASX,1988; 1989; 1990; 1991; 1992; 1993 and 1994) ;
publications by Financial Analysis Publications (Notham, 1994a and 1994b); and all
lodgements made with the ASX by the acquirer and target companies, including the Part A,
B, C and D documents. Share price information for the target and acquiring companies was
extracted from the Australian Graduate School of Management (AGSM) Share Price Files.
Where possible, Annual Reports were obtained from the AGSM Annual Report File. For
companies not included on the AGSM Annual Report File, the only accessible source of
annual reports for 1986, 1987 and 1988 was the University of Sydney which acts as a
repository of early records of the ASX. A number of annual reports of target mining
companies and companies listed on the second board were missing due to poor record
keeping procedures throughout the years. More recent annual reports were retrieved from
the microfiche records of the ASX.

23
5.2 Specification of Variables
5.2.1 Dependent Variable
The dependent variable is the proportion of the ‘notional’ purchase price that is recorded as
goodwill for each individual acquisition transaction (GOODWILL). Where the
consideration provided for the acquisition was entirely cash the cost of acquisition is
determinate. However, where shares were issued as consideration, the cost of acquisition
must be recorded at the fair value. While fair value is defined, AASB 1015 does not
stipulate the basis for the valuation of the shares. This means that management retains
significant discretion over the measurement of the cost of acquisition. In an attempt to
overcome the subjectivity of the recorded cost of acquisition, this paper will focus on a
‘notional purchase price’ which is measured as the market price of the shares one month
prior to the takeover offer multiplied by the number of shares issued as consideration. This
provides an objective, though arbitrary basis for estimating the fair value of the purchase
consideration.
5.2.2 Independent Variables
Hypothesis One
The underlying premise of Hypothesis One is that ‘operational and managerial synergy’ is
generated where two companies with closely related operations are combined. The
determination of whether the acquiring company and the target operations are related is based
on observation of the movement in share prices of the two companies. Firms with related
operations should experience similar share price reactions to industry specific and economy wide
information. This is measured using the Kendall-Tau Correlation between the monthly price
relatives (adjusted for capitalisation changes) of the two firms during the three year period
ending one month prior to the announcement of the takeover bid (CORRIND). A potential
problem with this measure is that infrequent trading of the smaller target firms means that the
last traded share price is often a poor reflection of current market trends. However, any bias is
likely to be conservative because misclassification would mitigate against finding a significant
result.27
27
To check the robustness of this measure it was compared to an alternative proxy for relatedness. The
second proxy was represented as a dichotomous variable taking the value of 1 where the two companies
have the same two digit ASX industry code and 0 if they did not. The two measures were significantly
correlated (Kendal-Tau prob.<0.05). The use of this alternate specification of the variable did not
significantly alter the results.

24
Hypothesis Two
To test Hypothesis Two, it is necessary to identify acquisitions that generate ‘financial synergy’
through the combination of a slack-poor firm and one having free cash flows. The identification
of these firms involves the measurement of both investment opportunities and liquidity.
The measure employed for the level of investment opportunities is FACTOR. This measure was
extracted, using factor analysis, from four popular measures of growth options employed in
prior literature. The derivation of this measure is explained fully under the specification of the
independent variables for Hypotheses Three and Six.
The measure for liquidity (LIQUID) is adapted from Lehn and Poulsen (1989) who use an
accounting rate of return measured as: operating profit before depreciation, tax and interest, less
dividends paid, divided by total assets. A liquidity measure based on accounting returns is
preferred to one based on just cash flows because traditional cash flow measures ignore the fact
that some cash flows are already committed to claimants as dividends (Lang, Stulz and
Walkling, 1989). The present paper employs the same rate of return measure as Lehn and
Poulsen except that it is averaged over the two years prior to the takeover announcement to
smooth the impact of temporary factors affecting any single year.
Each of the sample companies was categorised as having either high or low levels of liquidity
(LIQUID) and investment opportunities (FACTOR), depending on whether they were above or
below the median observation for all companies in the sample. Firms were then classified into
one of the four cells as represented in Figure 2. Relatively fewer firms fall into cells 1 and 4 than
cells 2 and 3 for both acquirer and target firms. High ‘financial synergy’ acquisitions would be
those, which combine a firm from cell 1 with a firm from, cell 4. This classification only applied
to 12 acquisitions, which was insufficient to enable testing. When this classification is changed to
any acquisition which includes the combination of a firm from cell 1 or 4 with any firm not from
the same cell, 78 acquisitions are identified. While this provides a less clear measure of ‘financial
synergy’ is does provide the basis for a distinction between low and high ‘financial synergy’
combinations. Any bias caused by misclassification would be conservative as it would mitigate
against finding a result. The variable FINSYN is coded 1 for those fitting this definition of high
‘financial synergy’ takeovers and zero if not.

25
Hypotheses Three and Six
The independent variable, proportion of assets as growth options, is a relative rather than an
absolute measure of the investment opportunity sets. The construct is based on Myers (1977)
notion of growth options vs assets-in-place. Researchers have employed numerous measures of
this construct, however, all of the measures used to date suffer weaknesses. Often researchers
include numerous alternative measures within regression models which introduces a
multicollinearity problem and reduces the power of testing (Gaver and Gaver, 1993).28
Gaver and Gaver (1993) recognise that the investment opportunity set is inherently
unobservable so any individual measure will suffer error. They develop a composite measure
comprising six alternative measures suggested by researchers. Gaver and Gaver reason that a
composite measure would capture the explanatory power of the variables without assuming the
bias associated with the measurement error for any individual measure. They use factor analysis
was to identify one factor that parsimoniously explained the intercorrelations among the
individual measures. This research replicates the procedures adopted by Gaver and Gaver by
including as many appropriate measures as possible and then decomposing them into one (or
more) common factor for testing. This paper employs four alternative measures in the factor
analysis. These are specified as follows.
MKTBK
The market value of the firm (as proxied by the market value of ordinary shares at balance
date plus the book value of partly paid shares and the book value of preference shares
plus the book value of debt) divided by the book value of total assets.
MKTBE
The market value of the ordinary shares at balance date divided by the book value
ordinary equity.
28
Skinner (1993) includes four alternative measures for the investment opportunity set within his model,
asset beta, property plant and equipment to market value, research and development intensity and Tobin’s
q.

26
MKTPPE
The market value of the firm (as proxied by market value of ordinary shares at balance
date, plus the book value of partly paid shares and the book value of preference shares
plus the book value of debt) divided by the book value of property plant and equipment.
MKTTA
The market value of the firm (as proxied by market value of ordinary shares at balance
date, plus the book value of partly paid shares and the book value of preference shares
plus the book value of debt) divided by the book value of tangible assets.
Two of the measures used, MKTBK and MKTBE, were included in the six variables selected by
Gaver and Gaver (1993)29
as proxies for growth options. The market to book value of the firm
(MKTBK) is a common measure for growth options in the literature. This measure is based on
the premise that where the book value of assets provides a proxy for the value of assets-in-place,
the difference between the market value of the firm and the book value of assets is an
appropriate measure of growth options. MKTBK is similar to Tobin’s q, as used by Skinner
(1993) except that he uses an estimate of the replacement value of the assets of the firm as
the denominator. Gaver and Gaver include MKTBKE as it adjusts for the measurement error
of MKTBK experienced for highly levered firms and represents expected excess return on
equity.
The third measure used in this paper, MKTPPE is the inverse of a measure specified by Skinner.
Property, plant and equipment (P,P&E) can be argued to represent the essential revenue
generating assets-in-place of a firm. A comparison between the book value of P,P&E and the
market value of the firm is argued to provide insight into the market’s valuation of the
investment opportunities of the firm. MKTTA is included as an additional measure in this paper
using a similar rationale. It is argued that intangible assets contain a greater growth option
29
Two important variables excluded from the factor analysis for this paper are the P/E ratio (E/P ratio or
other variations comparing earnings to price) and research and development intensity which are common
proxies for growth options in prior studies, including Gaver and Gaver (1993) and Skinner (1993). The P/E
ratio was not an appropriate measure of growth options for the sample in this paper due to the
predominance of loss generating companies, particularly for gold mining targets. Where growth options
are considered to be positive function of the P/E ratio, a negative P/E ratio is not interpretable. The
rationale for exclusion of R & D intensity was that less than ten percent of the sample invested in any
research and development and, for those that did, the amount was usually immaterial. Other variables
included by Gaver and Gaver (1993) and Skinner (1993) not included here were the variance of total return
on the firms over four years, the inclusion of the firm in growth oriented mutual funds and asset beta.

27
component than other assets then a ratio focusing on tangible assets will add a further dimension
to the measurement of growth options.
Selected statistics from the factor analysis, using the principal components method of extraction,
are reported in Table 2. The first step in conducting factor analysis is to check whether the
variables are sufficiently correlated to provide a sensible factor extraction (Norusis, 1994). Panel
A of Table 2 shows that the pairwise correlations between the variables are all significant except
for between the variables MKTPPE and MKTTA. Despite one insignificant correlation, the four
measures are retained based on a rule of thumb that a variable must be significantly correlated
with at least one half of the other variables to preserve parsimony (Norusis, 1994).30
The factor
analysis identified four components common to the four measures. The minimum number of
factors needed to adequately represent the original correlations between the underlying
measures is determined by the requirement that the sum of the eigenvalues of the extracted
factors must exceed the sum of the communialities of the underlying measures (Gaver and
Gaver, 1993; Cattrell, 1966; Harman, 1976). In this case, the first component extracted had an
eigenvalue of 2.065 which exceeded the sum of the communialities of the variables.
Accordingly, the factor score of this first component is employed as the measure for growth
options employed in this research. The common factor for the target firms has been coded as
GWTHTARGET (tested in Hypothesis Three) while the common factor for the acquiring
companies has been coded as GWTHACQUIRER (tested in Hypothesis Six).
Table 2 here
Hypothesis Four
The ratio of non-current liabilities (excluding provision for deferred income tax) plus the current
component of long-term liabilities plus short-term borrowings to total tangible assets as at the
These measures were excluded because the information was unavailable.
30
Several other tests confirmed that the use of factor analysis was appropriate, as follows.
Ÿ Bartlett’s test of spherisity resulted in a chi-square of 515.323 at a probability of 0 which enabled
rejection of the null hypothesis that the pair-wise correlations were insignificant.
Ÿ The negative of the partial correlation coefficients were all less than 0.04 indicating that the
partial correlations between variables were low once the linear effects of all other variables are removed.
Ÿ The Kaiser-Meyer-Olkin measure of sampling adequacy should be at least 0.5 for each variable for
it contribute to a parsimonious component extraction (Norusis, 1994). This requirement was satisfied for all
four measures.

28
balance date immediately prior to the year of acquisition is used as the indicator for the leverage
of the acquiring entity (LEV).31
Hypothesis Five
The rate of accounting returns of the acquiring entity (ROR) is measured as the average of the
accounting profit after tax divided by total assets for the two years prior to the acquisition.
Hypothesis Six
The specification of the measure for hypothesis six is explained with hypothesis three.
31
Several other measures of leverage were tested but there was no effect on the results obtained.

29
5.2.3 Control Variables
♦ Materiality
The measure of the materiality (MATER) for an acquisition is the total cost of acquisition
divided by the book value of total assets of the acquiring entity.
♦ Type of Consideration
The type of consideration (FINTYPE) is coded as a dichotomous variable taking the value of 0
where the financing is entirely cash and 1 where shares form some part of the consideration.
♦ Magnitude of Bid Premium
The share premium paid (BIDPREM) is measured as the difference between the offer price and
the pre-bid market price of the target shares as a percentage of the pre-bid market price. The
target market price is the share price one month prior to the announcement of the intention to
instigate a takeover to the ASX. Where the consideration consisted of shares in the acquiring
company the value of acquiring shares is also based on the share price one month prior to the
announcement.
♦ Mining Industry Target
The variable ASXMIN is coded 1 where an acquisition involves a mining industry
target, or 0 if it does not.
♦ Service Industry Target
The variable ASXSERV is coded 1 if the target company operates in a service
industry or 0 if it does not.
5.3.1 Summary Statistics
The summary statistics for each of the variables are presented in Tables 4 and 5. The coefficients
of skewness and kurtosis for all of the continuous variables, except CORRIND, departed
significantly from a normal distribution.32
.
Table 3 and Table 4 here
The five hypotheses and the six control variables are jointly tested using multivariate
ordinary least squares (OLS)) regression. The OLS regression relies on an assumption that the
relation between the dependent and independent variables is linear. The non-normality of the
distribution of the dependent and independent variables, particularly high levels of skewness
32
Foster (1986) states that benchmarks for suspicion of non-normal distributions are a skewness coefficient
of >0.5 or <-0.5 or a kurtosis coefficient of >1 or < -1. One-sample Kolmogorov-Smirnov goodness of fit tests
confirmed that the distribution of each of these variables departed significantly from a normal distribution.

30
suggests that their relation may not be linear (Glasnapp and Poggio, 1985). A further
assumption of the OLS regression is homoscedasticty, that is, that the variance of the error of
prediction remains constant (Gujarati, 1988). Highly skewed distributions are also likely to
violate this assumption (Glasnapp and Poggio, 1985). Breaches of the assumptions of linearity
and homscedasticity will result in biased or inefficient although consistent estimators (Breen,
1996). An appropriate statistical tool to improve the linearity and normality of a variable is
to transform the variables (Atkinson, 1988). Numerous types of transformations were trialed.
The transformed variables are approximately normally distributed33 34
and are described in
the Key to Table 5.
6 Results
The results of the multivariate OLS regression are reported in Table 5. The overall
regression was statistically significant with an adjusted R square of 8.5%. While the overall
model is significant, the results for the individual hypotheses are mixed. The first three
hypotheses deal with the ex ante explanation for the accounting policy choice. The only one
of these hypotheses which is supported is hypothesis three which predicts that the amount
of goodwill recognised will be positively associated with the level of growth options
acquired from the target company. The importance of this finding lies in the fact that the
research design employed in this paper has been able to isolate the investment opportunity
set acquired in the individual transaction and its direct relation with goodwill from the
indirect affects of the investment opportunity set of the firm as a whole.
Table 5 here
Hypotheses one and two find no support in any of the tests. Further, the testing indicates
that CORRIND has a statistically significant association in a direction the opposite to that
predicted. These two hypotheses address the incentive of management to recognise
goodwill as a means of mitigating the information asymmetry about the wealth created from
the synergistic combination of the companies. Hypothesis one is based on the contention
that the combination of closely related companies is more likely to generate operational and
33
The chi-square goodness of fit test and a Kolmogorov-smirnov one sample test for goodness of fit
confirmed that the transformed variables had a good fit with a normal distribution (p<0.1).
34
A further assumption is that the error terms all have the same variance. A visual inspection of the plots of
the Studentised residuals against the predicted values of the dependent variable shows that while the
assumptions of linearity and normality are approximately met, some heteroscedasticity remains.

31
management synergies and that management would be more likely to recognise goodwill in
such cases. Using the logic of this hypothesis, one explanation for the negative association
identified is that there is less information asymmetry about the synergistic affects of related
acquisitions because market participants can observe this relatedness and predict the
potential synergy directly and need not rely on management disclosure. Hypothesis two
contends that the combination of a slack-poor with a high free cash flow firm will result in
the generation of financial synergy and that management will recognise goodwill to ex ante
reflect this information. The explanation for the anomalous result for hypothesis one can be
reapplied here. If the market independently is able to assess such synergies then there will
be little information asymmetry about their value.
The argument that the capital market would be able to assess these types of synergy gains
support from the fact that the measure adopted in this paper for these synergies are based
on publicly available information. Fama (1970) firmly asserts that capital markets are at
least semi-strong form efficient so that all publicly available information is reflected in share
prices. Information asymmetry about the synergies associated with an acquisition will only
exist where management has special information about their value. This means that
hypotheses one and two can only be tested if the actual information asymmetry about the
wealth to be created by the synergies is controlled for.
The ex post explanations for the accounting treatment of goodwill are postulated in
hypotheses four (LEV), five (ROR) and six (GWTHACQUIRER). Only hypotheses four
and six find support. The negative association between leverage and the recognition of
goodwill is consistent with the findings of Grinyer Russell and Walker (1991) and Wong
and Wong (1999). Wong and Wong (1999) also find a positive relation between the
investment opportunity set of the acquirer and goodwill. However, unlike Wong and Wong
(1999), the research design of this paper has enabled the separation of the explanatory
power of leverage and the investment opportunity set of the acquirer from the ex ante
association between the recognition of goodwill and the investment opportunity set
acquired.

32
An overall significant regression with few individual signifcant variables may be evidence of
multicollinearity. The existence of multicollinearity does not affect the results of the overall
regression, but it does create difficulties in interpreting the significance of the incremental
contribution of individual variables. A common means of diagnosing multicollinearity is to
examine the pair-wise correlations between the variables (Tabachnick and Fidell, 1989).
Gujarati (1988) suggests that a better test is to regress each of the independent variables
against each other independent variable to identify any significant relations. Table 6
presents the results of pair-wise correlations and results for individual univariate OLS
regressions between each combination of two independent variables.
Table 6 here
Parametric and non-parametric correlation tests and OLS regressions revealed that 23 of
the 55 pair-wise combinations have statistically significant associations. The high number of
significant pair-wise correlations suggests the presence of mutilcollinearity.35
Other
diagnostic tests confirm that low to moderate collinearity is present in the data set.36
While
an examination of the tolerances and variance inflation factors did not indicate a collinearity
problem, the calculated eigenvalues and condition indexes indicate that there are at least
two near linear dependencies in the data. Gujarati (1988) proposes that the simplest
solution to this problem is to drop the collinear variables. However, he acknowledges that
ad hoc modification to a theoretically supported model is likely to result in specification
bias. Specification bias is a potentially more serious problem for the OLS regression
because it results in biased and inconsistent estimators, whereas multicollinearity only
creates problems for the interpretation of the separate contribution of each explanatory
variable.
7 Summary and Conclusions
This paper is motivated by the controversy surrounding the regulation of accounting for
goodwill and the limited evidence regarding the determinants of the discretionary
accounting treatment of goodwill. The basic premise of the paper is that both ex ante and
35
Despite this high number of significant associations between the independent variables, the correlation
coefficients are relatively low with the highest correlation being –0.567. Not all authors agree that these
levels of correlation evidence a problem. Tabachnick and Fidell (1989) do not consider multicollinearity to
be a severe problem until bivariate correlations are in the vicinity of 0.70.
36
Four diagnostic tests were performed: the tolerance test; the variance inflation factor; the eigenvalue test;
the condition index test.

33
ex post factors play a role in the determination of the goodwill accounting policy choice.
This contention is generally supported by the finding that the overall model, including the
six hypothesised independent variables and five control variables, had significant
explanatory power.
The most significant contribution of this paper is that it provides an opportunity to address
this endogeneity problem identified by Watts and Zimmerman (1990) by delineating ex ante
and ex post factors. The accounting treatment of goodwill is found to be ex ante directly
related to the investment opportunity set acquired being the assets already held by the
target. The ex post exercise of discretion is determined by the contracting choices of the
firm as a whole including an indirect association with the investment opportunity set of the
acquiring entity. This paper extends the work of Skinner (1993), Pincus and Wasley
(1994), Gupta (1995) and Wong and Wong (1999) who investigate the indirect and/or
direct relation between the investment opportunity set and accounting policy choices. The
tests in this paper provide a refinement of the tests of Skinner (1993) who addresses the
endogeneity problem by including both an investment opportunity set measure and
contracting variables in a model of accounting policy choice. Wong and Wong (1999) do
refocus Skinner’s work in an empirical investigation of the accounting treatment, however,
this paper provides a more precise measure of the acquired investment opportunity set and
also controls for other transaction specific factors.
The second contribution of the paper is that it provides insight into the factors that
motivate management’s discretionary accounting policy choices for goodwill. Much of the
professional/theoretical debate has focused on the opportunistic motives to avoid the
recognition of goodwill through means such as recognising greater amounts of identifiable
intangible assets or by manipulating the cost of acquisition. By taking a transaction specific
approach this paper has been able to determine that efficiency factors remain relevant even
in the presence of such opportunistic motives.
The most important limitation of the paper is that it focuses on a specific accounting policy
choice, being the accounting treatment of corporate subsidiaries in the year of acquisition.
If management evaluate their accounting policy choices in light of their entire accounting
portfolio then focusing on one choice provides only a partial examination of management
incentives (Zmijewski and Hagerman, 1981; Press and Weintrop, 1990). It is a contention

34
of this paper that while management is likely to make accounting choices within an
accounting portfolio, the acquisition of a corporate subsidiary represents a significant
enough transaction that it is possible to identify managerial motives within this one context.
Pincus and Wasley (1994) and Gupta (1995) suggest that progress of the paradigm is
dependent on investigations of accounting policy choices within specific contexts and
specialised samples. The results of this paper support that suggestion by providing evidence
that the isolation of one aspect of a firm’s investment opportunity set enables a clearer
distinction between efficiency and opportunistic factors within one model. This opportunity
could be further pursued in future research.
The paper also faces several design issues that limit the internal validity and generalisability
of the results. First, the sample selection methods introduce both a size and a survivorship
bias. Second, the tests were conducted using data pooled over a long time period, making it
possible that institutional changes might have affected the results. Finally, interpretation of
the results of tests of the OLS regressions must be qualified by the presence of moderate
collinearity between the independent variables and some heteroscedasticity of the error
terms.
An significant boundary to the scope of the paper is that it does not investigate the
economic determinants of the decision to acquire investment opportunities through
corporate acquisitions. Future research could address whether these factors are associated
with the accounting treatment of goodwill. It is probable that the goodwill accounting
policy choice for a corporate acquisition is endogenous with such transaction specific
characteristics.This paper did attempt to indirectly address the motives underlying an
acquisition by identifying the potential for the generation of synergies. However, the results
of tests for the relation between the generation of synergies and the accounting treatment of
goodwill fail to control for cross-sectional variation in the magnitude of information
asymmetry. A more in-depth study of the motives underlying an acquisition may enable a
better specification of the incentives of management to mitigate information asymmetry
through the recognition of acquired goodwill.

35
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