What it means
When one company buys another, the buyer has to decide how to show the deal in its accounts. Under the purchase method, the buyer is treated as having bought a collection of assets and liabilities, so it records each at what it is worth on the date of the deal, not at the figures in the target's old books.
Fair value means the price at which an item could be sold between willing parties. A building bought years ago for $4,000,000 may now be worth $6,000,000, and the buyer records it at the higher figure.
The buyer also identifies intangible assets that were not on the target's balance sheet, such as customer lists, brands, patents and software. These are valued and recorded separately because they were part of what the buyer paid for.
If the price paid is more than the fair value of everything identifiable, the excess is recorded as goodwill. Goodwill represents things such as the workforce, future synergies and the value of the business as a going concern, and it is tested for impairment (a reduction in value) rather than being written off automatically.
The older pooling of interests method simply added the books of the two companies together at their original values, which avoided goodwill but made it harder to see what was paid. Major accounting standards have abolished it, so every business combination of this type is now accounted for as an acquisition.
The nuance is that the new bases can reduce profit in later years. Higher recorded values for property and intangibles lead to higher depreciation and amortisation, which is why acquirers often report adjusted profit figures that add these charges back.
In practice
Real-world examples.
Example
A logistics company buys a regional rival for $120,000,000. The finance team hires valuers to measure the vehicles, depots and customer contracts at fair value, and the difference between the price and these values is recorded as goodwill.
Example
A software firm purchases a start-up for its technology. Most of the price is allocated to developed software and customer relationships, so there is little goodwill, but the firm will now record amortisation charges each year.
Example
An accountant at a manufacturing group reviews its consolidated balance sheet after an acquisition. She notices that inventory has been revalued above its cost, so the first sales from that stock will show a lower margin than usual.
Formula
Calculation
Goodwill = purchase price paid - fair value of identifiable net assets acquired
Fair value of identifiable net assets = book value of equity + fair value uplifts + newly identified intangibles
Suppose Alder Group pays $50,000,000 in cash for Birch Ltd. Birch has a book equity of $30,000,000. Its property is worth $8,000,000 more than its book value, and a customer list is valued at $5,000,000. Fair value of identifiable net assets = 30,000,000 + 8,000,000 + 5,000,000 = $43,000,000. Goodwill = 50,000,000 - 43,000,000 = $7,000,000, ignoring deferred tax for simplicity.Case study
Seen in the real world.
Pinnacle Foods Group is an illustrative, fictional company that agreed to buy a smaller sauce maker for $36,000,000. The finance director expected to record a large amount of goodwill, because the sauce maker's own balance sheet showed net assets of only $15,000,000.
During the valuation exercise, the team found that the target's brands were worth $9,000,000 and its production line was worth $4,000,000 more than its book value. These new values reduced goodwill from $21,000,000 to $8,000,000.
The change also meant higher annual charges for amortisation and depreciation, which the finance director explained to the board before the first results were published. The illustrative lesson is that the acquisition accounting follows the substance of what was bought, and it influences reported profit for years afterwards.
Watch out
Common mistakes.
- Recording all of the excess price as goodwill, when identifiable assets such as brands, customer lists and patents must be valued separately first.
- Using the target's old book values, when the buyer is required to measure acquired assets and liabilities at fair value on the deal date.
- Assuming goodwill is written off over a fixed period, when under many standards it is tested for impairment and only reduced if its value has fallen.
Questions
People also ask.
What is the difference between the purchase method and pooling of interests?
The purchase method records the acquired assets at fair value and creates goodwill, while pooling simply combined the old book values and has been abolished.
Is the purchase method still used?
Yes, it continues under the name acquisition method in current international and US standards.
When is goodwill negative?
When the price paid is lower than the fair value of the net assets, which is called a bargain purchase and is recorded as a gain after the figures have been double-checked.
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