Accounting for goodwill is a key part of business combinations and is therefore regularly examined as part of the Financial Reporting (FR) exam. Goodwill arises when one entity (the parent company) gains control over another entity (the subsidiary company) and is recognised as an asset in the consolidated statement of financial position. Under IFRS 3, Business Combinations, goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised. Goodwill is not amortised but must be tested annually for impairment.
The calculation of goodwill is as follows:
Less: Net assets at acquisition
Less: Impairment to date
Goodwill at reporting date
In the FR exam, this can be worth many marks and contain many forms of adjustment. Each of these lines will be looked at in turn for the major elements which need to be included.
The consideration paid for a subsidiary can take many forms. The common situations arising in the FR exam are that the parent pays for the subsidiary in cash immediately, in cash payable in the future (deferred consideration), in cash payable in the future but where that payment is dependent on certain events (contingent consideration), or through an issue of its own shares to the original shareholders of the subsidiary. In addition to this, candidates will need to know the correct treatment for professional fees incurred as part of the acquisition.
Cash consideration
This is the simplest amount of consideration and represents the cash already paid by the parent as part of the acquisition. You will be told this and it will usually be included in the ‘investments’ line of the parent’s statement of financial position and simply needs to be moved into the goodwill calculation.
Deferred consideration
This is cash payable in the future and needs to be recognised initially at present value. For the FR exam, if the amount is payable in one year, the candidate will be given a discount rate (%) and be asked to calculate this. If the amount is payable in more than one year, the candidate will be given a discount factor as a decimal. The key is to initially recognise the amount payable at present value in goodwill and as a liability.
As time elapses, the discount on the liability must be unwound as the payable date approaches. The unwinding of the discount on the liability is done by increasing the liability and recording a finance cost. A key thing to note here is that goodwill is unaffected, as goodwill is only calculated at the date control is gained.
EXAMPLE 1
Laldi Co acquired control of Bidle Co on 31 March 20X6, Laldi Co’s year end. The purchase consideration included $200,000 payable on 31 March 20X7. An appropriate discount rate for use is 6%.
Required:
Calculate the amount of deferred consideration to be recognised at 31 March 20X6 and explain how the unwinding of any discount should be accounted for.
Answer
The goodwill calculation would include deferred consideration of $188,679 being $200,000 x 1/1.06 1 . This would also be included in the consolidated statement of financial position at 31 March 20X6 as a current liability.
In the year ended 31 March 20X7, this discount of $11,321 ($188,679 x 6%) would then be unwound and recorded as a finance cost in the statement of profit or loss. The full liability of $200,000 would be settled on 31 March 20X7, consisting of the $188,679 originally recognised plus the $11,321 of finance costs.
Contingent consideration
In the FR exam, this will take the form of a future cash amount payable dependent on a set of circumstances. In accordance with IFRS 3, this must be recognised initially at fair value (which will be given in the exam). This fair value is added to the consideration as part of the goodwill calculation and recognised as a provision in liabilities in the consolidated statement of financial position.
Any subsequent movement in the potential amount payable is treated like a movement in a provision under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Any increase or decrease in the amount payable is reflected in the liability and recorded in the parent’s statement of profit or loss. Again, it is key to note that the initial calculation of goodwill is unaffected as this is calculated on the date control is gained.
Share consideration
This is a tricky calculation but is common in the FR exam. It is likely that this amount will not yet have been recorded, testing the candidate’s knowledge of how the transaction is to be recorded. To do this, a candidate needs to work out how many shares the parent company has issued to the previous shareholders (owners) of the subsidiary as part of the acquisition. To work out the value given to the previous owners, the number of shares issued is multiplied by the parent’s share price at the date of acquisition. This full amount is then added to the consideration paid total. The amount then also needs to be added to the parent’s share capital and other components of equity (share premium) to reflect the shares issued (see Example 3 later in the article).
Acquisition costs
All acquisition costs, such as professional fees (legal fees, accountant fees etc), must be expensed in the statement of profit or loss and not included in the calculation of goodwill. Often in the FR exam this will have been recorded incorrectly, perhaps included in the statement of financial position as part of the cost of investments, and you need to make a correcting adjustment.
Under IFRS 3, the parent can choose to measure any non-controlling interest at either fair value or the proportionate share of net assets.
There are two potential ways that the fair value method will arise in the FR exam. The fair value of the non-controlling interest at acquisition may be directly given to candidates, or they may have to calculate the fair value by reference to the subsidiary’s share price. To do this, the candidate will simply have to multiply the number of shares held by the non-controlling interest by the subsidiary’s share price at the date of acquisition.
Under the proportionate share of net assets method, the value of the non-controlling interest is simpler to calculate. This is done by calculating the net assets of the subsidiary at acquisition and multiplying this by the percentage owned by the non-controlling interest.
Under the fair value method, 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 therefore includes elements of goodwill from both the parent and the non-controlling interest.
Including the non-controlling interest at 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.
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.
The most common situations in the FR exam are outlined below:
The final element to consider is the impairment of goodwill. Impairment arises after the acquisition and reflects some form of decline in the expected benefit to be derived from the subsidiary. As mentioned earlier, 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, ranging from loss of customers in the subsidiary to the departure of key staff or changes in technology. 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.
EXAMPLE 2
Fifer Co acquired 80% of the equity shares of Grampian Co on 1 January 20X4 for $5,000,000. The fair value of Grampian Co’s net assets at the date of acquisition was $4,000,000.
At 31 December 20X4, Fifer Co has determined that goodwill is impaired by 10%.
Required:
For each of the following scenarios, calculate the value of goodwill at 31 December 20X4 and explain how the impairment loss would be allocated between the group and non-controlling interest:
Answer
1. Fair value method