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Thursday, October 28, 2010

Calculating and Recording Goodwill



A purchaser may attempt to forecast the future income of a target company in order to arrive at a logical purchase price. Goodwill is often, at least in part, a payment for above-normal expected future earnings. A forecast of future income may start by projecting recent years’ incomes into the future. When this is done, it is important to factor out “one-time” occurrences that will not likely recur in the near future. Examples would include the cumulative effect of changes in accounting principles, extraordinary items, discontinued operations, or any other unusual event.

Expected future income is compared to “normal” income. Normal income is the product of the appropriate industry rate of return on assets times the fair value of the gross assets (no deduction for liabilities) of the acquired company. Gross assets include specifically identifiable intangible assets such as patents and copyrights but do not include existing goodwill. The following calculation of earnings in excess of normal:

Expected average future income = $40,000

Less normal return on assets:
Fair value of total identifiable assets = $345,000
Industry normal rate of return = 10%
——– (x)

Normal return on assets = (34,500)

Expected annual earnings in excess of normal = $ 5,500

There are several methods that use the expected annual earnings in excess of normal to estimate goodwill. A common approach is to pay for a given number of year’s excess earnings. For instance: Acquisitions Inc. might offer to pay for four years of excess earnings, which would total $22,000. Alternatively, the excess earnings could be viewed as an annuity. The most optimistic purchaser might expect the excess earnings to continue forever. If so, the buyer might capitalize the excess earnings as a perpetuity at the normal industry rate of return according to the following formula:


Annual Excess Earning
Industry Normal Rate Of Return

$5,500/0.10 = $ 55,000

Another estimation method views the factors that produce excess earnings to be of limited duration, such as 10 years, for example. This purchaser would calculate goodwill as follows:

Goodwill = Discounted present value of a $5,500-per-year annuity for 10 years at 10%

= $5,500 x 10-year, 10% present value of annuity factor
= $5,500 x 6.145
= $33,798

Other analysts view the normal industry earning rate to be appropriate only for identifiable assets and not goodwill. Thus, they might capitalize excess earnings at a higher rate of return to reflect the higher risk inherent in goodwill.

All calculations of goodwill are only estimates used to assist in the determination of the price to be paid for a company. For example, Acquisitions might add the $33,798 estimate of goodwill to the $319,000 fair value of Royal Bali’s other net assets to arrive at a tentative maximum price of $352,798. However, estimates of goodwill may differ from actual negotiated goodwill. If the final agreed-upon price for Royal Bali’s assets was $350,000, the actual negotiated goodwill would be $31,000, which is the price paid less the fair value of the net assets acquired.

Question: Can you have negative goodwill, that is in the case of a bargain purchase where the acquisition price is less than the net book value of the assets. Example Total net asset value = $20mm Capital contrib - $17mm then negative goodwill of $3mm ?

Answer:You just picked a perfect example on how a negative goodwill arisen. That is common happened on business acquisitions. However, the term “negative goodwill” has been dropped from the standard, instead, it is described as the “excess of the acquirer’s interest in the net fair value of the acquiree’s identifiable assets, liabilities, and contingent liabilities over the cost” (IFRS 3, Business Combinations, 6.Goodwill). It does not mean that negative goodwill is prohibited. If it appears that negative goodwill has arisen, it must be recognized immediately in profit or loss (income statement). However, it is worth mentioning here; the IFRS assumes that negative goodwill would arise only in exceptional circumstances. Therefore, before determining that negative goodwill has arisen, the acquirer has to reassess the identification and measurement of the net assets and contingent liabilities acquired and also to look at the measurement of the cost of the business combination.

The Standard says that any negative goodwill recognized would probably be the result of one of these factors:

• Potential errors in the measurement of the fair value of either the cost of the business combination or the identifiable assets, liabilities, or contingent liabilities
• A requirement in an accounting standard to measure the net assets at an amount that is not fair value; for example, deferred taxation and balances recognized on acquisition will not be discounted
• It is a genuine bargain [added: of business] purchase.

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