How to calculate goodwill

Goodwill

Goodwill is at its core a book entry. A number in the books designed to somehow capture the essence of why anybody would pay more (or less)for a business than what the assets are individually worth on the open market.

It’s not often that philosophers and accountants mix, but the concept of Goodwill is best described by Aristotle when he said: “the whole is greater than the sum of its parts”. What this means is that a collection of something is sometimes worth more than each component on its own.

Think about a pair of knitting needles (property, plant and equipment) and some wool (inventory). On their own not all that useful. But combine them with a granny that knows how to knit (employees) and suddenly you can start producing scarves. Or add in some knitting patterns (intangible assets) and now you have a fully fledged clothing production business.  And so naturally it would make sense to pay more for all those things (assets) together rather than individually.

It's a pretty straight forward example, but what if someone came along and saw this little business and decided to buy it. Without a shadow of a doubt, they’d be prepared to pay more than the individual components, if even only at its most basic level they wouldn’t have to run around buying each of these items and hiring a granny who needs to be trained up. A more likely scenario is that maybe nobody else has those awesome Christmas jersey knitting patterns which are in high demand which means access to something nobody else has. And the premium you’d be prepared to pay goes up.

The above is example is very basic, but that premium is your Goodwill. The same concept applies to any business that gets bought, its just the complexity that increases, and this is what IFRS 3 is trying to help us calculate.

It is also possible that a business has been completely mismanaged in which case you may be able to buy those assets for less than what they would be worth on the open market.

How do I account for Goodwill?

The good news is that IFRS 3 Business Combinations gives us all the guidance we need to calculate goodwill and how to account for it, upon initial purchase of the business and in subsequent years.

The bad news its written by accountants, which makes it difficult to dissect. The good news is that we’ve done the heavy lifting for you below.

The acquisition

The first question to ask is “did I buy a business”? A business is defined in the IFRS as something that takes inputs, and a process transforms them in some way that adds value, the end product which can be sold. I’m paraphrasing here but broadly speaking we all know what a business is.

It doesn’t matter whether you bought a collection of assets and/or liabilities or just bought shares in a legal entity, both qualify for the Goodwill treatment.

Next question is whether you control the business you’ve just acquired. Remember substance over form here, so you need to make that assessment. We won’t go into the details here but there are some really good indicators from shareholding being 50% +1 to being able to call the shots (i.e. being the boss). If you don’t control the new business, stop reading further and consider whether the business is maybe an associate or joint venture or just a plain old investment.

If you’ve bought into the following, IFRS 3 does not apply and you can stop reading:

-           Joint venture

-           Assets that don’t constitute a business

-           An entity under common control (complex shareholding structures that give the group control over an entity even though your shareholding might be split)

How to calculate Goodwill

So you’ve established that you’ve bought a “business” and you control it. Now you need to do the accounting.

Whether you bought assets and liabilities or shares in an entity, the calculation of Goodwill remains the same. Its just the accounting(debits and credits) that differs.

The main aim of IFRS 3 is to limit the amount of Good will you recognise.

As a starting point, make an inventory of all the assets and all the liabilities in the business you’ve acquired. Remember you have 12months to get this done from date of acquisition.

Use this handy decision tree on how to apply IFRS 3 Business combinations and how to calculate goodwill.

‍

Example 1: How to calculate goodwill

‍

How long do I have to calculate Goodwill?

-           use provisional amounts if amounts are not finalised at year end

-           retrospectively adjust these values as information becomes available

-           measurement period ends one year from acquisition date (date which control is gained)

How to account for Goodwill

So you’ve got your Goodwill number after following the calculation above. Now its time to do the accounting.

I bought a collection of assets and liabilities

If you’ve bought a collection of assets and liabilities then you’ll be recording the assets and liabilities and Goodwill in your own accounting records at the date of acquisition. You will treat these as having bought the assets at the start of their lives (“fresh start principle”).In other words you don’t bring in the accumulated depreciation or accumulated amortisation tied to those assets in the sellers books.

Positive goodwill is recognised on the balance sheet at date of acquisition and is tested for impairment annually. But how to account for negative Goodwill you may ask? Negative Goodwill gets recognised as income in the acquirer’s profit and loss in full.

Any contingent consideration (remember we had to recognise this as part of the consideration transferred above) that is not classified as equity is revalued annually through profit and loss and changes do not affect your Goodwill calculation.

Just a side note that may seem obvious, if you’ve bought assets and liabilities you’re not going to have NCI to deal with in the application of IFRS 3, unless in some weird way someone still has an interest in those net assets which is highly unlikely.

‍

I bought shares in a business

If you’ve bought shares in a business you will only record the investment in the subsidiary in your own accounting records at date of acquisition and on an annual basis you will test the investment for impairment in your own books as a normal investment.

All the fancy Goodwill accounting only happens when you consolidate your subsidiary and process your intercompany eliminations. All the Goodwill transactions happen in the consolidated numbers.

Positive Goodwill is recognised on the consolidated balance sheet and tested for impairment annually. Negative Goodwill gets recognised as income in the consolidated profit and loss in full.

Any contingent consideration (remember we had to recognise this as part of the consideration transferred above) that is not classified as equity is revalued annually through profit and loss and changes do not affect your Goodwill calculation.

‍

Get in touch

The only thing we love more than Goodwill calculations are our customers. If you’d like to see how we can automate your consolidation, group reporting or financial statement preparation with the Quick Consols consolidation software and financial statement software, we’d love to hear from you and show you the software in a one on one demo.

You can follow our Linkedin page here for regular updates and take a look at our other content here.