Business Combinations: Goodwill
Under the acquisition method, the purchase price is allocated to the identifiable assets and liabilities of the acquired firm on the basis of fair value. Any remainder is reported on the balance sheet as goodwill. Goodwill is said to be an unidentifiable asset that cannot be separated from the business.
Under U.S. GAAP, goodwill is the amount by which the fair value of the subsidiary is greater than the fair value of the subsidiary’s identifiable net assets ( full goodwill). Under IFRS, goodwill is the excess of the purchase price over the fair value of the acquiring company’s proportion of the acquired company’s identifiable net assets ( partial goodwill). However, IFRS permits the use of the full goodwill approach also.
Full goodwill (required under U.S. GAAP; allowed under IFRS):
Partial goodwill (only allowed under IFRS):
or
Let’s look at an example of calculating acquisition goodwill.
Wood Corporation paid $600 million for all of the outstanding stock of Pine Corporation. At the acquisition date, Pine reported the following condensed balance sheet:
Pine Corporation Condensed Balance Sheet
The fair value of the plant and equipment was $120 million more than its recorded book value. The fair values of all other identifiable assets and liabilities were equal to their recorded book values. Calculate the amount of goodwill Wood should report in its consolidated balance sheet.
Solution
Goodwill is equal to the excess of purchase price over the fair value of identifiable assets and liabilities acquired. The plant and equipment was written up by $120 million to reflect fair value. The goodwill reported on Pine’s balance sheet is an unidentifiable asset and is thus ignored in the calculation of Wood’s goodwill.
Continuing the previous example, suppose that Wood paid $450 million for 75% of the stock of Pine. Calculate the amount of goodwill Wood should report using the full goodwill method and the partial goodwill method.
Solution
Full goodwill method:
Wood’s balance sheet goodwill is the excess of the fair value of the subsidiary ($450 million / 0.75 = $600 million) over the fair value of identifiable net assets acquired, just as in the previous example. Acquisition goodwill = $40 million.
Partial goodwill method:
Wood’s balance sheet goodwill is the excess of the acquisition price over Wood’s proportionate share of the fair value of Pine’s identifiable net assets:
| Item | Amount |
|---|---|
| Purchase price | $450 million |
| Less: 75% of fair value of net assets | 0.75 × $560 = $420 million |
| Acquisition goodwill | $30 million |
Goodwill is lower using the partial goodwill method. How is this reflected on the liabilities and equity side of the balance sheet?
The value of noncontrolling interest also depends on which method is used. If the full goodwill method is used, noncontrolling interest is based on the acquired company’s fair value. If the partial goodwill method is used, noncontrolling interest is based on the fair value of the acquired company’s identifiable net assets.
In the previous example, noncontrolling interest using the full goodwill method is 25% of Wood’s fair value of $600 million, or $150 million. Using the partial goodwill method, noncontrolling interest is 25% of the fair value of Pine’s identifiable net assets, or $140 million. The difference of $10 million balances the $10 million difference in goodwill.
The full goodwill method results in higher total assets and higher total equity than the partial goodwill method. Thus, return on assets and return on equity will be lower if the full goodwill method is used.
Goodwill is not amortized. Instead, it is tested for impairment at least annually. Impairment occurs when the carrying value exceeds the fair value.
However, measuring the fair value of goodwill is complicated by the fact that goodwill cannot be separated from the business. Because of its inseparability, goodwill is valued at the reporting unit level.
Under IFRS, testing for impairment involves a single step approach. If the carrying amount of the cash generating unit (where the goodwill is assigned) exceeds the recoverable amount, an impairment loss is recognized.
Under U.S. GAAP, goodwill impairment potentially involves two steps. In the first step, if the carrying value of the reporting unit (including the goodwill) exceeds the fair value of the reporting unit, an impairment exists.
Once it is determined the goodwill is impaired, the loss is measured as the difference between the carrying value of the goodwill and the implied fair value of the goodwill. The impairment loss is recognized in the income statement as a part of continuing operations.
The implied fair value of the goodwill is calculated in the same manner as goodwill at the acquisition date. That is, the fair value of the reporting unit is allocated to the identifiable assets and liabilities as if they were acquired on the impairment measurement date. Any excess is considered the implied fair value of the goodwill.
Let’s look at an example.
Last year, Parent Company acquired Sub Company for $1,000,000. On the date of acquisition, the fair value of Sub’s net assets was $800,000. Thus, Parent reported acquisition goodwill of $200,000 ($1,000,000 purchase price − $800,000 fair value of Sub’s net assets).
At the end of this year, the fair value of Sub is $950,000, and the fair value of Sub’s net assets is $775,000. Assuming the carrying value of Sub is $980,000, determine if an impairment exists and calculate the loss (if applicable) under U.S. GAAP and under IFRS.
Solution
U.S. GAAP (two step approach):
1. Since the carrying value of Sub exceeds the fair value of Sub ($980,000 carrying value > $950,000 fair value), an impairment exists.
2. In order to measure the impairment loss, the implied goodwill must be compared to the carrying value of the goodwill. At the impairment measurement date, the implied value of the goodwill is $175,000 ($950,000 fair value of Sub − $775,000 fair value of Sub’s net assets).
Since the carrying value of the goodwill exceeds the implied value of the goodwill, an impairment loss of $25,000 is recognized ($200,000 goodwill carrying value − $175,000 implied goodwill) thereby reducing goodwill to $175,000.
IFRS (one step approach):
Goodwill impairment and loss under IFRS is 980,000 (carrying value) − 950,000 (fair value) = $30,000.
Bargain Purchase
In rare cases, acquisition purchase price is less than the fair value of net assets acquired. Both IFRS and U.S. GAAP require that the difference between fair value of net assets and purchase price be recognized as a gain in the income statement.