The Goodwill Formula
Goodwill arises when an acquirer pays more for a subsidiary than the fair value of the identifiable net assets it acquires.
It represents the future economic benefit arising from assets acquired in a business combination that are not individually identified and separately recognised, such as an assembled workforce, market position and expected synergies. IFRS 3.32 measures it as a residual at the acquisition date:
| Component | Measurement basis | |
|---|---|---|
| Consideration transferred | Acquisition-date fair value | |
| Plus | Non-controlling interest (NCI) | Fair value, or proportionate share of identifiable net assets |
| Plus | Previously held equity interest | Acquisition-date fair value |
| Less | Identifiable net assets acquired | Acquisition-date fair value, with specified exceptions |
| = | Goodwill (or gain on bargain purchase if negative) |
The calculation is performed once, at the date the acquirer obtains control. The arithmetic is simple; the judgement lies in what enters each line and at what amount.
Consideration Transferred
Consideration transferred is the sum of the acquisition-date fair values of:
- Assets transferred by the acquirer, such as cash or property.
- Liabilities incurred to the former owners, including deferred payments measured at their present value.
- Equity interests issued by the acquirer, at their fair value on the acquisition date, not on the date the deal was announced.
- Contingent consideration, at fair value, even where payment is not probable. The probability of payment is reflected in the fair value measurement, not in a recognition test.
If a non-cash asset transferred has a carrying amount different from its fair value, the acquirer remeasures it to fair value and recognises the gain or loss in profit or loss. The exception is an asset transferred to the acquiree itself, which stays within the group and is kept at its carrying amount.
What is excluded
| Item | Treatment |
|---|---|
| Legal, due diligence, valuation and advisory fees | Expense in profit or loss when incurred (IFRS 3.53) |
| Costs of issuing shares to fund the acquisition | Deducted from equity (IAS 32) |
| Costs of issuing debt to fund the acquisition | Included in the effective interest rate of the debt (IFRS 9) |
| Payments to selling shareholders that depend on continued employment | Remuneration for post-combination services, expensed over the service period |
| Settlement of a pre-existing relationship between the acquirer and acquiree | Accounted for separately, with any settlement gain or loss in profit or loss |
The test for the last two items is whether the payment is made primarily for the benefit of the acquirer or the combined entity, rather than for the former owners in exchange for the business. Payments that are forfeited if a selling shareholder leaves employment are remuneration, regardless of how the sale agreement describes them. A pre-existing lease between the two parties is a common example of the last item, dealt with in leases in a business combination.
Non-Controlling Interest: Fair Value or Proportionate Share
Where the acquirer obtains less than 100%, the NCI in the acquiree is measured at one of two bases. The choice is made for each business combination; it is not an accounting policy applied to all acquisitions.
| Fair value | Proportionate share of net assets | |
|---|---|---|
| Also known as | Full goodwill method | Partial goodwill method |
| NCI measured at | Fair value, based on quoted prices or a valuation technique | NCI % × fair value of identifiable net assets |
| Goodwill includes | Parent's and NCI's share | Parent's share only |
| Effect of a later purchase of NCI | Smaller debit to equity | Larger debit to equity |
| Goodwill impairment testing | Goodwill already includes NCI's share | Goodwill is notionally grossed up for NCI's share |
The fair value of the NCI is not necessarily the parent's price per share multiplied by the NCI's shares. The price paid for a controlling stake usually includes a control premium, which the NCI's shares do not carry.
Which instruments qualify for the choice?
The choice applies only to present ownership interests that entitle their holders to a proportionate share of net assets on liquidation, usually ordinary shares. Other components of NCI, such as preference shares without that entitlement, are measured at acquisition-date fair value.
Previously Held Interest (Step Acquisitions)
When control is obtained in stages, for example by increasing a 30% associate holding to 70%, the acquirer is treated as disposing of its previous interest and acquiring the whole controlling interest at the acquisition date. The previously held interest is:
- Remeasured to fair value at the acquisition date, with the gain or loss recognised in profit or loss (or in other comprehensive income where it was an equity investment designated at fair value through OCI, in which case it is not reclassified).
- Included in the goodwill calculation at that fair value.
Amounts previously recognised in OCI in respect of the interest are treated as if the interest had been disposed of: reclassified to profit or loss or transferred within equity, as the relevant standard requires.
For example, an investor holds a 30% associate at an equity-accounted carrying amount of 410,000 and buys a further 40% for 720,000. If the 30% interest has a fair value of 520,000 at the acquisition date, a gain of 110,000 is recognised in profit or loss, and 520,000 plus 720,000 enters the goodwill calculation.
Identifiable Net Assets Acquired
The deduction in the formula is the acquiree's identifiable assets and liabilities, recognised and measured by the acquirer at the acquisition date. The acquiree's own carrying amounts are only a starting point.
Recognition. An item is recognised if it meets the definition of an asset or liability in the Conceptual Framework and is part of the exchange for the business. This brings onto the group statement of financial position items the acquiree did not recognise:
- Intangible assets that are separable or arise from contractual or legal rights, such as customer relationships, order backlogs, brands and in-process research and development.
- Contingent liabilities that are present obligations and can be measured reliably, even if an outflow is not probable. IAS 37 would not recognise these; IFRS 3 does.
Goodwill already recognised by the acquiree is not an identifiable asset and is excluded. Restructuring costs the acquirer plans to incur are also excluded: they are not obligations of the acquiree at the acquisition date.
Measurement. The general rule is fair value. IFRS 3 sets out specific exceptions:
| Item | Measurement |
|---|---|
| Deferred tax | IAS 12, undiscounted |
| Employee benefits | IAS 19 |
| Leases where the acquiree is lessee | Lease liability as if a new lease at acquisition date; right-of-use asset equal to the liability, adjusted for off-market terms |
| Non-current assets held for sale | IFRS 5: fair value less costs to sell |
| Share-based payment awards of the acquiree | IFRS 2 market-based measure |
| Indemnification assets | Same basis as the indemnified item |
Deferred tax on fair value adjustments. Fair value adjustments change carrying amounts but not tax bases. The initial recognition exemption in IAS 12 does not apply in a business combination, so deferred tax is recognised on each adjustment, as explained in deferred tax explained. A net deferred tax liability reduces identifiable net assets and increases goodwill.
Practical Example
Summit Ltd acquires 75% of the ordinary shares of Coastal Ltd on 1 March 20X5. The terms are:
- Cash of 1,500,000 paid on the acquisition date.
- Contingent consideration of up to 300,000, payable if Coastal Ltd reaches an earnings target in 20X6. Its fair value at the acquisition date is 120,000.
- Legal and due diligence fees of 45,000.
Coastal Ltd's equity at the acquisition date is 1,400,000. Summit Ltd identifies the following differences between carrying amount and fair value:
- Plant is worth 200,000 more than its carrying amount.
- Customer relationships not recognised by Coastal Ltd have a fair value of 150,000.
- A pending legal claim, not recognised by Coastal Ltd because an outflow is not probable, is a present obligation with a fair value of 60,000.
The tax rate is 27%, and none of the adjustments changes a tax base. The fair value of the 25% NCI is 500,000.
Step 1: Identifiable net assets
| Item | Amount |
|---|---|
| Equity of Coastal Ltd (carrying amount of net assets) | 1,400,000 |
| Fair value adjustment: plant | 200,000 |
| Customer relationships | 150,000 |
| Contingent liability | (60,000) |
| Deferred tax (27% × 290,000) | (78,300) |
| Identifiable net assets at fair value | 1,611,700 |
Step 2: Goodwill under both NCI bases
| Component | NCI at proportionate share | NCI at fair value |
|---|---|---|
| Cash | 1,500,000 | 1,500,000 |
| Contingent consideration | 120,000 | 120,000 |
| NCI (25% × 1,611,700, or fair value) | 402,925 | 500,000 |
| Less: identifiable net assets | (1,611,700) | (1,611,700) |
| Goodwill | 411,225 | 508,300 |
The difference of 97,075 is the goodwill attributable to the NCI (500,000 less 402,925). The legal and due diligence fees of 45,000 are expensed in profit or loss and do not appear in either calculation.
Step 3: At-acquisition consolidation entry
Using the proportionate share basis, the entry that eliminates Summit Ltd's investment against Coastal Ltd's equity is:
| Account | Debit | Credit |
|---|---|---|
| Equity of Coastal Ltd at acquisition | 1,400,000 | |
| Plant | 200,000 | |
| Customer relationships | 150,000 | |
| Goodwill | 411,225 | |
| Contingent liability | 60,000 | |
| Deferred tax liability | 78,300 | |
| Investment in Coastal Ltd | 1,620,000 | |
| Non-controlling interest | 402,925 |
Transaction costs in the separate financial statements
If Summit Ltd carries its investment at cost in its separate financial statements and has capitalised the 45,000 fees, the investment balance is 1,665,000. On consolidation the 45,000 is reclassified to profit or loss, so only 1,620,000 is eliminated against goodwill.
The fair value adjustments are repeated in every later consolidation: the plant adjustment and customer relationships are depreciated and amortised in the group, with the related deferred tax released. The cash outflow of 1,500,000, net of Coastal Ltd's cash, is presented as described in acquisition and disposal of subsidiaries in the cash flow statement.
Gain on Bargain Purchase
If identifiable net assets exceed the total of consideration, NCI and any previously held interest, the result is a gain on bargain purchase. Before recognising it, the acquirer must reassess whether it has identified all assets acquired and liabilities assumed, and review the procedures used to measure every input to the calculation.
Any excess that remains is recognised in profit or loss on the acquisition date. The gain is attributed entirely to the acquirer, not to the NCI. Bargain purchases typically arise in forced sales, such as a seller in financial distress or required by a regulator to dispose of the business.
Goodwill After the Acquisition Date
No amortisation, annual impairment testing. Under IAS 36, goodwill is allocated to the cash-generating units expected to benefit from the combination and tested for impairment at least annually, and whenever there is an indication of impairment. An impairment loss on goodwill is never reversed.
Measurement period adjustments. Where the initial accounting is incomplete at the reporting date, provisional amounts are used. New information about facts and circumstances that existed at the acquisition date, obtained within the measurement period (a maximum of one year), adjusts the provisional amounts retrospectively, with a corresponding change to goodwill. Where NCI is measured at its proportionate share, the NCI changes too.
Contingent consideration. Changes in fair value from events after the acquisition date, such as Coastal Ltd exceeding its earnings target, do not adjust goodwill. A liability is remeasured to fair value through profit or loss; an equity-classified amount is not remeasured.
No deferred tax on goodwill. IAS 12 prohibits recognising a deferred tax liability on the initial recognition of goodwill, because goodwill is itself a residual that would change with the deferred tax recognised.
Foreign subsidiaries. Goodwill arising on the acquisition of a foreign operation is an asset of that operation, carried in its functional currency and translated at the closing rate, as shown in consolidating foreign operations.
Quick Reference Summary
| Question | Answer |
|---|---|
| What is the goodwill formula? | Consideration transferred + NCI + fair value of previously held interest − identifiable net assets at fair value. |
| Are acquisition costs included? | No. They are expensed, except debt and equity issue costs, which follow IFRS 9 and IAS 32. |
| How is contingent consideration included? | At acquisition-date fair value, whether or not payment is probable. |
| How is NCI measured? | At fair value (full goodwill) or its proportionate share of identifiable net assets (partial goodwill), chosen per acquisition. |
| What happens to a previously held interest? | Remeasured to fair value at acquisition date, with the gain or loss in profit or loss (or OCI), and included in the calculation. |
| Does deferred tax affect goodwill? | Yes. Deferred tax on fair value adjustments forms part of net assets. No deferred tax is recognised on goodwill itself. |
| Is goodwill amortised? | Not under full IFRS. It is tested for impairment at least annually. |
| When can goodwill be adjusted? | Only for measurement period adjustments, within one year of the acquisition date. |
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Conclusion
Goodwill under IFRS 3 is a residual: consideration transferred, plus NCI, plus the fair value of any previously held interest, less the fair value of the identifiable net assets acquired. The amount recognised depends on excluding acquisition costs and payments for post-combination services, including contingent consideration at fair value, choosing the NCI basis for each acquisition, and recognising the acquiree's unrecorded intangible assets, contingent liabilities and the deferred tax on every fair value adjustment.
Once recognised, goodwill changes only through measurement period adjustments, impairment and, for foreign operations, translation, so the acquisition-date calculation and its supporting valuations should be documented in full.
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