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How to Calculate Goodwill in Consolidated Accounts

When preparing accounts, finance managers generally calculate the value of a company based on the value of its assets minus the amount of its liabilities. However, the actual value of a company can be so much more than that, as can often be seen in stock market valuations. Assets such as brand value, human expertise and loyal customers and partners can have a major impact on the value of a company, which is why companies invest so heavily in developing these assets.

In accounting terms, this extra value is known as ‘goodwill’ and it is considered an intangible asset. The concept of goodwill takes on particular importance when a company is looking to acquire another company. Often, they will need to be willing to pay a price premium over the market value of the company, particularly when that valuation is based simply on the net assets.

 What do businesses mean by ‘goodwill’?

Successful businesses generate goodwill through the B2B and B2C relationships they build. This intangible asset enhances both the image and value of the company. Just think about the perceived value of companies like Apple, Microsoft and Tesla.

The goodwill of a company is made up of many elements, but important factors include:

  • Brand recognition and reputation with customers
  • Employer brand and their ability to attract and retain talent
  • A loyal customer base of brand advocates
  • Engagement with stakeholders and market positioning
  • Technical knowledge or intellectual property that is unique to the company.

These elements may be intangible and difficult to measure in financial terms, but they are critical success factors that can make a business more profitable, sustainable, attractive and valuable.

For example, the brand value of a successful company, such as Microsoft or Coca-Cola, is a huge goodwill asset. Buyers would expect to pay significant sums to purchase a well-known, respected brand. But it’s not just about the brand name or logo. Business partnerships, domain names, intellectual property rights, trade secrets, licenses, trademarks, copyrights and talented employees all contribute to the brand goodwill and value.

Different types of goodwill

Purchased goodwill is the goodwill that is acquired when a company pays a sum larger than the fair value to buy another business. For example, when acquiring a company the buyer might gain access to expertise or intellectual property that conveys in competitive advantage. This purchased goodwill is recorded as an asset under the label of goodwill on the balance sheet.

Inherent goodwill doesn’t involve buying a company or brand. It is simply the value that a company acquires over time and that boosts its reputation. Coca-Cola, for example, is recognised as a market leader and highly recognisable brand. Inherent goodwill is not normally recorded in financial accounts, but nonetheless matters hugely to stock market valuations and in acquisition situations.

Negative goodwill is when something happens, such as bad publicity from a scandal or malpractice, that makes a company or brand less desirable and attractive. In this scenario, the goodwill value goes down and any sale price may be lower than the company’s fair value. It is often said that it takes years to build brand value but only moments to lose it, which is why successful companies pay so much attention to brand and reputation management.

Why is goodwill important to accountants and financial modellers?

Goodwill has many business advantages. These include:

  • Customer loyalty: this can boost repeat sales, recommendations, new customers and organic growth
  • Competitive advantage and differentiation: goodwill can help a company stand out and become a preferred partner, it can also enable it to charge a premium on its goods and services
  • Resilience: if something goes wrong, such as a customer service error, a reserve of goodwill can ease the situation and help retain customer relationships
  • Perceived value increase: goodwill makes a company more attractive to investors, lenders, partners and prospective buyers
  • Attracting talent: in-demand talented people are attracted to work for companies with a good reputation, not least because it makes them look good by association.

In summary, goodwill is a valuable but intangible asset that cannot always be precisely defined and calculated. It is affected by multiple factors, including brand value, intellectual property, and proprietary technology, R&D pipeline, talent pool, and customer loyalty. It is built over time and can vary quite dramatically over time.  

What is goodwill in accounting?

In simple terms, goodwill in accounting is the excess amount that a company pays to purchase another company.

For example:

If company X is worth €350,000 in net assets or open market value but is purchased for €400,000, the difference (€50,000) would be recorded on the balance sheet as goodwill.

According to the Generally Accepted Accounting Principles (GAAP), as goodwill is an intangible asset it is only recorded when there is a sale of the entire business or a subsidiary of the business; it cannot be generated internally. It can only be recorded in the accounts when there is an actual amount that has been paid over the fair price of the company. However, a calculation or estimate of the goodwill is often made during negotiations.  This is often drawn from examining a company’s return on assets ratio.

As a company acquires subsidiaries or other entities, the group will need to take financial consolidation into account. Consolidated accounting is when the parent company combines the financial data from multiple entities to produce consolidated financial statements and/or management reports.  These are essential to give business leaders a comprehensive overview of their group operations, its strengths and weaknesses.

How is goodwill calculated in consolidated accounts?

One of the simplest methods of calculating goodwill is by subtracting the fair market value of a company’s net identifiable assets from the price paid for the acquired business.

Here is a simplified example of a goodwill formula and calculation:

Goodwill = (Consideration paid + Fair value of non-controlling interests + Fair value of equity interests) – Fair value of net identifiable assets

Company X acquires company Y for €2 million

Company Y has assets equalling €1.5 million and liabilities equalling €200,000

The net identifiable assets of the business are €1.5 million minus €200,000 which equals €1.3 million

Goodwill equals €700,000 (€2 million minus €1.3 million).

This means company X paid €700,000 premium above the company’s net identifiable assets

This amount is recorded in the assets section of a company’s balance sheet.

Why is goodwill important in financial modelling?

Financial modelling is used for a variety of scenario planning, budgeting and business analysis purposes. But it’s also used in mergers and acquisitions (M&A). Reliable financial modelling depends (in part) on an accurate reflection of the value of goodwill.

Analysts will take into account a number of factors when calculating the value of goodwill in an M&A Model. These include:

  • The book value of all the assets on the target company’s balance sheet. This includes current assets, non-current assets, fixed assets, and intangible assets from the company’s most recent set of financial statements.
  • An analysis of the fair current market value of each asset (this process can be somewhat subjective)
  • Any adjustment calculations: this is the difference between the fair value and the book value of each asset.
  • Excess purchase price: this is the difference between the actual purchase price paid to acquire the target company and the Net Book Value of the company’s assets (assets minus liabilities).

Once they’ve completed this analysis, they can estimate the goodwill by deducting the fair value adjustments from the excess purchase price. This is the goodwill figure that will normally go on the acquirer’s balance sheet when they close the deal.

What needs to be considered when calculating goodwill?

 

Consideration paid

The consideration paid when acquiring a new subsidiary or other entity can take many forms. For example:  

  • Cash consideration: this is the most straightforward form of consideration - it is simply the cash already paid by the parent company as part of the acquisition
  • Deferred consideration: this is cash payable in the future by the acquirer to parties with a financial interest in the acquisition
  • Contingent consideration: this is where payment is dependent on certain events or circumstances, such as performance or profitability
  • Share consideration: this is where the parent company issues its own shares to the original shareholders of the subsidiary.
Acquisition costs

In any M&A situation there will normally be professional fees, such as legal costs and advisory fees, to pay. These acquisition costs are reported as expenses in the statement of profit or loss and not included in the calculation of goodwill.

Non-controlling interest

The parent company can choose to measure any non-controlling interest at either fair value or the proportionate share of net assets.

  • Under the proportionate share of net assets method, the value of the non-controlling interest is calculated by multiplying the net assets of the subsidiary at acquisition by the percentage owned by the non-controlling interest.
  • Under the fair value method, the value of the non-controlling interest at acquisition will be higher, meaning that the goodwill figure is higher. This is because including the non-controlling interest at fair value incorporates an element of goodwill attributable to them. Under this method the goodwill figure includes elements of goodwill from both the parent and the non-controlling interest.

Including the non-controlling interest in the proportionate share of the net assets is really reflecting the lowest possible amount that can be attributed to the non-controlling interest. This method shows how much they would be due if the subsidiary company were to be closed down and all the assets sold off, incorporating no goodwill in relation to the non-controlling interest. Under the proportionate method, the goodwill figure is therefore smaller as it only includes the goodwill attributable to the parent.

Net assets at acquisition

At the date of acquisition, the parent company must recognise the assets and liabilities of the subsidiary at fair value. This can lead to a number of potential adjustments to the subsidiary’s assets and liabilities. Examples from the ACCA Financial Reporting syllabus include:

Tangible non-current assets

These will be held at the carrying amount in the subsidiary’s financial statements but will need to re-calculated to fair value in the consolidated statement of financial position. This will result in an increase to the value of property, plant and equipment. Instead of recording a revaluation surplus, it will actually result in a decrease to goodwill (that being the difference between the consideration paid and the net assets acquired in the subsidiary)

Intangible assets

The subsidiary may have internally generated intangible assets, such as internally generated brand assets, which do not meet the recognition criteria of Intangible Assets. While these cannot be capitalised in the subsidiary’s individual financial statements, they must be recognised in the consolidated statement of financial position. This will result in an increase in the value of intangible assets with a corresponding decrease in goodwill.

 Inventory

The subsidiary must hold any inventory at the lower of cost and net realisable value, but this inventory must be reflected in the consolidated statement of financial position at fair value. This will result in an increase to inventory value and a decrease in goodwill.

 Contingent liabilities

 These will simply be disclosure notes in the financial statements of the subsidiary, relating to potential future liabilities that do not have a probable outflow of resources embodying economic benefits. In the consolidated statement of financial position these must be recognised as liabilities at fair value, if there is a present obligation and it can be reliably measured. This will increase liabilities in the consolidated statement of financial position and actually increase goodwill (as the net assets of the subsidiary at acquisition will be reduced).

Impairment of goodwill

The final element to consider is the impairment of goodwill. Once goodwill has been recorded by the acquirer, there may be subsequent analyses that conclude that the value of this asset has been impaired. If so, the amount of the impairment is recognised as a loss. This reduces the carrying amount of the goodwill asset.

Impairment arises after the acquisition and reflects some form of decline in the expected benefit to be derived from the subsidiary. There is no amortisation of this figure, so the parent must assess each year whether there are indicators that the goodwill is impaired.

There are many indicators of impairment including loss of customers or key personnel or material changes in technology or market conditions. If an entity decides that the goodwill is impaired, it must be written down to its recoverable amount. Once goodwill is impaired, the impairment cannot be reversed.

The cumulative impairment is always deducted, in full, from the goodwill figure in the statement of financial position. If the non-controlling interest is recorded at fair value, then a percentage of impairment will be allocated to them (based on the percentage owned in the subsidiary), with the remainder being allocated to the group. If the non-controlling interest is held at the proportionate method, then the entire impairment is allocated to the group due to the fact that no goodwill has been attributed to the non-controlling interest.

The valuing of goodwill ahead of an acquisition can be a complex topic. There are many factors to consider when effectively deciding on what premium to pay for an asset. This is part of the reason that Mergers and Acquisitions is such a specialist subject sector of the financial services market.