If your business plans to acquire another company, there are two basic ways to account for goodwill.
In a business combination, you can calculate goodwill by using either partial or full goodwill methods:
- The partial goodwill method, where you measure the assets and liabilities but recognize only the goodwill associated with the controlling interest in the company, or
- The full goodwill method, which is fundamentally the same as the partial method except that the non controlling interest (NCI) includes goodwill.
These methods are best illustrated by examples using Australian Accounting Standards Board 3 Business Combinations. AASB 3 states that in recognizing and measuring goodwill or a gain from a bargain purchase, the purchaser must recognize goodwill as the result of the following calculation:
The consideration transferred measured at fair value plus any non-controlling interest in the acquired company plus the fair value of any previously held equity interest in the acquired organization minus the assets purchased (after subtracting liabilities assumed).
For example, Sawmill acquires Leg Turner by buying 80 percent of its equity for $200 million cash. The total value of the identifiable net assets measured in accordance with AASB3 is $50 million. Sawmill chooses to use the partial goodwill method in this, which means it recognises all of the identifiable net assets on the acquisition date. The non-controlling interest (NCI) is recorded as its proportionate share of those assets. Using the formula, then, goodwill is recognized as:
|Fair value of consideration (cash)||$200 million|
|NCI as proportion of identifiable assets||$20 million|
|Previously held interest||N/A|
|Minus net assets acquired||(50 million)|
Because NCI is recorded using the partial method, goodwill is recognised only for Sawmill’s portion. (No goodwill is recognized for the NCI).
Using the full goodwill method, you measure all of the assets and liabilities associated with the controlling and non-controlling interests, including goodwill. Full goodwill is recognized as:
The consideration for the interest in the target plus the fair value of any NCI in the target plus the value of any previously held equity in the target minus the net of the assets acquired and liabilities assumed.
Using the same acquisition of Leg Turner for $150 million in cash, let’s assume the value of total identifiable net assets is $50 million. Sawmill chooses to measure NCI using fair value, which is $100 million. In this case, goodwill is calculated this way:
|Cash consideration||$200 million|
|Fair Value of NCI||$100 million|
|Previous interest owned in target||N/A|
|Identifiable net asset acquired||($50 million)|
It can be a complicated matter to determine the fair value of NCI. However, in some instances it’s quite simple. The purchasing entity simply based the value on active market prices for the share it doesn’t hold and that are publicly traded. When there is no active market however, the purchasing business must measure fair value using other valuation techniques including:
- A market measurement that uses market multiple for publicly traded companies that are comparable to the target firm, or
- An income valuation using a discounted cash flow analysis.
If you are planning an acquisition involving goodwill, consult with your adviser for the best method to use.