Why goodwill exists, and What are the different ways to calculate it?
Purchased Goodwill is the additional intangible asset that a parent company needs to record in their financial statement, when it acquires a subsidiary. Upon this consolidation, the parent usually pays a greater monetary amount to buy the subsidiary than the actual net identifiable assets of it – that excess is called goodwill.
This equation shall be further discussed and explained in later parts of this article. We’d be first deciphering the basics of the “goodwill” concept.
1.1 Goodwill Definition
IFRS 3 Business Combinations defines goodwill as: ‘future economic benefits arising from assets that are not capable of being individually identified and separately recognised’. Brand name, good customer relations, good corporate governance, or state-of-the-art technology, etc. are some examples: they are immense assets of a business, however are not easy to be valued and recorded in financial statements because their value is tightly associated with the company as a whole.
In other words, this definition affirms that the value of a business as a whole is more than the sum of the accountable and identifiable net assets – this excess is called goodwill.
Companies recording goodwill in their financial statements are required to review its value at least once a year, and record any impairments.
1.2 Goodwill Classification
Goodwill can be:
Generated internally through the normal operations of the business.
This results from a favorable attitude or good customer perception towards the business, thanks to its reputation for honesty, fair dealing, etc. within their trading activities. This type of goodwill always exists alongside with the operations of the business, whether or not it’s being sold or absorbed.
As a result of a business combination
Only on acquisition is purchased goodwill created. The purchased goodwill is the difference between the purchase consideration for the business as a whole and the total fair value of its net assets.
Self-generated goodwill is constantly changing and is often highly volatile, therefore difficult to reach a valuation. Whereas, the cost of purchased goodwill is known with reasonable certainty at the point the acquisition transaction is established.
Due to this uncertainty in measurement, IAS 38 prohibits the recognition of this self-generated goodwill. We therefore shall turn our attention to the second type of goodwill in this article, as our goal is to calculate then recognize it in financial statements.
2. How to Calculate Goodwill on Acquisition?
As mentioned before, goodwill on acquisition is calculated by subtracting the fair value of net identifiable assets of the company acquired from the total purchase price. Here’s the goodwill formula according to IFRS 3:
PURCHASE CONSIDERATION + (FAIR VALUE OF NON-CONTROLLING INTEREST + FAIR VALUE OF EQUITY PREVIOUS INTEREST) – FAIR VALUE OF NET IDENTIFIABLE ASSETS
- When a company acquires another company, or parts/segments of the company, the acquirer is called the parent and the acquiree is called a subsidiary. The amount the parent pays to its subsidiary or its previous shareholders in the form of cash or stock is called purchase consideration (purchase price). Purchase price can easily be measured at the point the transaction is made.
- When the parent does not acquire all the subsidiary’s outstanding stock, some portion of the subsidiary’s ownership rests with outside investors, called non-controlling shareholders. The stake of these outside investors is called non-controlling interest.
- Net identifiable assets recognized in the acquired company is basically the fair value of total assets, subtracting the fair value of total liabilities.
After identifying all of these component numbers, goodwill is calculated as the sum of fair value of purchase consideration and fair value of non-controlling interest (and fair value of equity previous interest, if any), then deducting the fair value of net identifiable assets.
Note that the assets and interests in this formula are measured not in book value, but in fair value – a rational and unbiased estimate of the potential future cash inflows. In order to reflect the fair value, the subsidiary’s assets must be assessed and adjustments must be made by the acquiring company as part of the consolidation.
For example, inventory must be held in the financial statements of the subsidiary at the lower cost and net realisable value, but must be recognised in the consolidated financial statements at fair value on acquisition. Similarly, the subsidiary may hold property under the cost model, but this must be accounted for at fair value in the consolidated financial statements.
Here are some examples of goodwill calculation:
Example 1:
Company X is acquiring company Y at an agreed acquisition consideration of $150 mil
Given: Fair value of non-controlling interest = $12 mil, Fair value of equity previous interest = $0, Fair value of company Y’s total assets and liabilities are $200 mil and $130 mil, respectively. Calculate the goodwill.
1. First, we calculate the Net identifiable assets of company Y:
Fair value of Net identifiable assets = FV of Total assets – FV of Total liabilities
= $200 mil – $130 mil = $70 mil
2. The 3 other component numbers in the Goodwill formula have been given, so the goodwill equation will be as follows:
Consideration paid | $150 |
add: Fair value of Non-controlling interests | $12 |
add: Fair value of Equity previous interests | $0 |
less: Fair value of Net identifiable assets | ($70) |
Goodwill | $92 |
Example 2:
Source: iasplus.com
Explanation
We are calculating the goodwill created through company P’s acquisition of company Q in 20X5.
1. From the given information, we can identify:
- Fair value purchase consideration: 75,000
- Fair value of previously-held interest (interest held from 20X1): 40,000. Notice that this is measured in fair value, not at cost or % assets.
- Fair value of net identifiable asset: 120,000
2. We next calculate the non-controlling interest:
- The two alternatives for measuring non-controlling interests are on a percentage basis against the subsidiary’s net assets, or on its exact fair value number:
As percentage of net assets: NCI = 20% x 120,000 = 24,000
As its fair value: NCI = 28,000
3. Applying the formula, we have answers as above.
EXERCISE
A parent company buys 75% of the equity shares in a subsidiary company for $156,000. The remaining shares were valued at $52,000 and the net assets at acquisition were $170,000.
Solution – Proportionate share method:
Fair value of consideration | 156,000 |
add: Non-controlling interest @ acquisition (25% x 170,000) | 42,500 |
198,500 | |
less: Net identifiable assets | (170,000) |
Solution – Fair value method:
Fair value of consideration | 156,000 |
add: Non-controlling interest @ acquisition (Fair value) | 52,000 |
208,000 | |
less: Net identifiable assets | (170,000) |
3.1 Goodwill on balance sheet
The concept of goodwill makes accounting sense because it is a plug to balance the Consolidated Statement of financial position, whenever it goes out of balance because of the acquirer paying a greater monetary amount than the actual fair value of the acquiree’s net assets.
In the business context, the concept of goodwill is important in that it provides a more accurate picture of the economic resources of a business. Without goodwill, intangible assets potentially yielding great cash inflows like company’s brand name, employee relations, extensive customer base, etc. will not be recorded in the statements.
It’s worth mentioning that companies that don’t own a lot of tangible assets, like software makers, tend to draw higher goodwill. It is because a lower level of identifiable assets would be recognized, while inseparable intangible assets like domain name, proprietary patents and technology play a significant role for these companies.
3.2 Goodwill on acquisition
Acquisitions recording heavy goodwill proportions imply that the buyers are focusing more on the potential growth of the subsidiary, rather than the current assets. An example could be Amazon in its acquisition of Whole Foods, where goodwill accounted for roughly 70% of the purchase price (making Amazon surpass its goodwill balance to over $10bil in 2017), stretching Amazon’s confidence in turning Whole Foods into a huge revenue driver in the future, thanks to its potential at the time.
An example could be Amazon in its acquisition of Whole Foods, where goodwill accounted for roughly 70% of the purchase price (making Amazon surpass its goodwill balance to over $10bil in 2017), stretching Amazon’s confidence in turning Whole Foods into a huge revenue driver in the future, thanks to its potential at the time.
Also worth mentioning is the concept of “badwill”, or negative goodwill, when the parent company acquires the subsidiary with a price lower than its net identifiable assets. This is usually the case for buying companies in distress or having declared bankruptcy. These subsidiaries are in the need of unloading their assets, acquiring cash to pay for debtors and lenders, and so forth, accept to endure an unfavorable deal here.