How to cite this article:Denis Cormier, Côme Segretain. Acquired Goodwill and Residual Income Components: A Study on the French Market. Ann Soc
Sci Manage Stud. 2019; 3(4): 555616. DOI: 10.19080/ASM.2019.03.555616
To address the question as to whether accounting for goodwill in International Financial Reporting Standards is appropriate, we investigate whether the acquired goodwill of a company is generating future residual earnings. In this paper, we investigate whether the acquired goodwill is generating future results in two components: net and additional income (i.e. other comprehensive income). To do this, we decompose the goodwill as Johnson & Petrone . and formalize, based on the residual income valuation model , a link between acquired goodwill, comprehensive residual income generated by these acquisitions and the premium paid. Results based on regressions conducted on French companies constituting the SBF 120 show a significant association between acquired goodwill and subsequent residual income of acquiring firms, and on the two components of income (net income and other comprehensive income).
Keywords: Goodwill; Residual Income; Ohlson’s Model; Comprehensive Income
The goodwill is the discounted sum of future residual income, i.e. earnings beyond the “normal” return on capital and called abnormal or extraordinary earnings . Under IFRS 3 Business combinations, goodwill arising in a business combination represents a payment made by the acquirer in anticipation of future economic benefits from assets that cannot be separately identified and recognized. Only acquired goodwill is accounted for under IFRS. Internally generated goodwill is not recognized as an asset because it is not an identifiable resource controlled by the entity that can be measured reliably at cost. The rules applicable to the recognition of goodwill in the consolidated accounts of French firms were largely modified by the adoption of IFRS on 2005. Hence, with the removal of systematic depreciation of goodwill and its replacement with impairment testing, return on equity of listed companies instantly increase.
This study focuses on French firms composing the SBF 120 (Société des bourses françaises). It seeks to establish the extent to which goodwill in a given period generates consecutive residual income, according to two components: net income and other comprehensive income - OCI. Moreover, confirming the link between the acquired goodwill and subsequent residual income pave the way for empirical research highlighting the periods or areas where goodwill is justified or otherwise where the price premium is obvious.
Future residual income of the target firm and synergies are the heart of goodwill (core goodwill) and are the only elements that deserve to be capitalized as goodwill. Henning et al. . show a positive and statistically significant association between stock returns and these components, with a greater weight for synergies. However, the premium paid would be negatively valued by the stock markets, seen as an additional cost of the combination.
It is known at least since Preinreich  that it is possible to assess the market value of equity of a firm from its shareholders’ equity and the sum of its residual abnormal or future earnings; the discounted sum of the latter constituting the economic goodwill. This relation is formalized in the Residual Income Valuation model [2,5] obtained using the residual income defined from clean surplus relation (i.e. comprehensive income). Since, there has been debate as to whether transitory or unrealised items constituting OCI are relevant [6,7].
Let’s decompose the price paid for the acquisition of firm i at time t as the market value of equity pi.t over Syni the present value of expected synergies from the transaction plus a premium SPi linked to hubris’ leaders, at a pricing error, at market conditions, negotiating conditions or strategic premium. Starting with residual income valuation:
p = Market price, bv = book value of equity, xa = Residual
(2) Price paidi.t = pi.t + SYNi + SPi where SYN = Synergy, SP =
pi.t is replaced in (2) by expression in (1):
Then replace Price paidi.t in the definition of goodwill (3):
(3) Goodwilli.t = Price paidi.t – FVEi.t where FVE = Fair value of
Upon acquisition, FVE = bv
The goodwill recorded for firm i in t is equal to the price paid,
less the fair value of its equity (FVE).
At the acquiror level, successive acquisitions generate in
times goodwill, and hopefully residual income and synergies, i.e.
residual income for the buyer. We separate residual income into
two components, and control for market value and P/E.
: Market value of equity. These variables are scaled by equity book
value in year t. P/Et: Median Price-Earnings ratio in year t.
Comprehensive income (CI) is computed as the variation of
equity net of transactions with shareholders. Items are: Ordinary
Share Capital, Preference Capital Reserves, Equity Issued
and Dividends Paid .
The cost of equity rn is computed by applying the CAPM as the
sum of risk-free rate (annual) and the product of an equity risk
premium (fixed) by beta (annual). The financial data - Treasury
bond rate (OAT 5 years) and betas were also collected annually
on Datastream. The equity risk premium has been fixed at 4%.
Goodwill and total intangible assets are collected from annual
An implicit assumption is that the subsequent residual income
is representative of all earnings generated by an acquisition in the
medium to long-term. Statistically, this assumption is realistic for
a large sample, although at the firm level, we can always highlight
growth patterns of nonlinear earnings. In addition, this point is in
line with the assumption of autoregressive process or persistence
of residual income of Ohlson’s model.
We can capture the series of all residual income through market
capitalization divided by shareholders’ equity. Dividing the terms
of the residual income valuation (RIV) by book value of equity, the
Market-to-Book ratio then appears to be equal to 1 plus the sum of
future earnings anticipated by the market and divided by equity.
The Market-to-Book ratio captures earnings generated over a long
period, including goodwill and other capitalized intangible assets.
By using the Market-to-Book ratio as the dependent variable,
Cazavan-Jeny  had already highlighted on pre-IFRS French data
the significant association of goodwill divided by total assets. The
integration in the regression of Market–to-Book is in line with the
assumption of autoregressive process or persistence of residual
income. It is expected that the market to book ratio is strongly
correlated with the residual outcome measures, generating
Concerning the proxy for stock premium, we use the median
ratio on the sample Price-Earnings ratio. As in Gu & Lev , P/E
captures for each year fluctuations in the equity markets affecting
the price of acquisitions. We must also keep in mind that the value
relevance studies show a positive association between goodwill
per share and stock price.
This study focuses on 71 non-financial firms listed in the French
market index SBF 120 for years 2005 and 2008, representing a
sample of 284 firms-years. The sample starts from 111 nonfinancial
firms from which we remove 11 firms with no goodwill
or negative equity. From this sample of 100 firms, we focus on
observations presenting high external growth as expressed by a
ratio of Goodwill/Total intangible assets larger than 50%.
(Table 1) presents descriptive statistics to all the variables.
Other comprehensive residual income component on average
represents 4% of equity against 6% for net residual income
component. Goodwill and total intangible assets represent on
average 69% and 106% of equity respectively.
(Table 2) reports results of hierarchical regressions on the
determinants of goodwill. Since we use panel data to estimate our
models, the problem of heteroscedasticity and autocorrelation
might be an issue. The test of Breusch-Pagan/Cook-Weisberg
shows the presence of heteroscedasticity. Thus, the structure of
errors among the panels is presumed to be heteroscedastic. To this
end, we estimate regressions by the method of feasible generalized
least squares (FGLS) with random effects (based on Hausman
test). To overcome the problems of stability of regressions that
generates the correlation between residual income and Marketto-
Book, we use the natural logarithm of the Market-to-Book
ratio. Results are the following. First, the successive introduction
of variables is done without disruption of coefficients and
progression of Wald test for each coefficient introduced. We
observe that future residual net income has a larger influence on
goodwill than future other components of comprehensive residual
n - x*
n) (coefficient of 0.41 versus 0.19 in the last two
columns). The coefficient carried by the logarithm of the Marketto-
Book is very significant and with a consequent value despite
the use of the logarithm. The coefficient carried by the P/E median
has the expected sign but is not significant at conventional level.
However, the wald test increases with the addition of this variable
in the regression.
Residual income arises not only from acquired goodwill
but also internally generated goodwill. Therefore, as a second
specification, we replace goodwill by total intangible assets as
the dependent variable. The coefficient on the variable xa
n - x*
negative and of low or no significance, whereas the coefficient on
n is positive and significant. It is not surprising since there is no
connection between marks or patents capitalized on the balance
sheet and the unrealized gains on investment securities or foreign
currency translation adjustments; components of OCI.
We formalized, from the Ohlson RIV model, a theoretical
link between acquired goodwill of listed companies and their
subsequent residual income; by breaking down the purchase
price and goodwill acquired as Johnson & Petrone . Empirical
test of this relation was intended to test three estimators of future
a) The residual comprehensive income,
b) Broken down into residual income and
c) Additional residual income and the ratio of market-to-book.
Results are the following. First, the relationship between the
acquired goodwill and subsequent residual income is very strong,
on the net income component, which variations appear as the key
to judge the quality of the acquisitions. Second, the residual net
income component carries positive coefficients and higher than
the additional component (other comprehensive income - OCI).
Third, coefficients carried by OCI component are significant and
approaching half the value of the coefficients of residual earnings,
reflecting the interest of that information for assessing external
growth; it is the main contribution of this article, i.e. showing the
benefits of reporting OCI. Finally, acquired goodwill and Marketto-
Book ratio are positively and highly associated, suggesting that
the accounting measure of acquired goodwill is informative for the
The original contributions of this research can be summarized
a) To our knowledge, this is the first study to gather the
Residual Income Valuation and the analytical breakdown of
acquired goodwill, to formalize a link between the latter and
the consecutive residual incomes of the transaction for the
b) Consequently, it is also the first study to empirically estimate
this link, taking as estimator the residual income of the
The breakdown into two segments, net residual income
and additional residual income, highlights some usefulness of
OCIs (Other Comprehensive Income), which appear posteriori
statistically associated with acquired goodwill, thus as having
participated in the formation of transaction prices.