CALCULATING PURCHASED GOODWILL: PART 3

Following from Part 2 of this article, we are now going to discuss the various forms of cost of investment that a parent company can make when acquiring a subsidiary. For the purposes of goodwill calculation, the cost of investment must be their fair values at the date of acquisition.

The cost of investment in a subsidiary may include the following:

• Cash
• Shares
• Deferred consideration
• Contingent consideration
• Other acquisition costs 

Cash

This is straightforward. The fair value of cash paid is simply the amount paid at the date of acquisition. The double entry would be as follows:

Dr	Investment in subsidiary
Cr	Cash

Shares

Again, the shares issued as purchase consideration must be valued at their fair values at the date of acquisition. The double entry would be as follows:

Dr	Investment in subsidiary
Cr	Share capital
Cr	Share premium

Note that the share capital account can only be increased by its nominal value. The excess of fair value over the nominal value is charged to share premium.  

Illustration

Teddy acquired 75% of Luke on 1 July 20X6 by issuing 100,000 ordinary shares of $1 each. The fair value of the shares on this date was $2.50.

Required:

Show the double entry for recording the cost of investment in Luke in the books of Teddy.

Solution

The shares must be valued at their fair values at the date of acquisition, i.e. $2.50 per share. Therefore, the cost of investment is 100,000 shares x $2.50 = $250,000. The nominal value of the shares is $1. As share capital can only be increased by its nominal value, i.e. 100,000 shares x $1 = $100,000, the remaining $150,000 would be credited to a share premium account.

The double entry is as follows:

Dr	Investment in subsidiary (100,000 x $2.50)	$250,000
Cr	Share capital (100,000 x $1)	$100,000
Cr	Share premium (100,000 x $1.50)	$150,000

As the shares were issued at a price higher than its nominal value, the excess is regarded as the 'premium'. In this case, we would say that the shares were issued at a premium of $1.50 (Issue price $2.50 - Nominal value $1). The share premium account will be credited with the value of the premium, i.e. 100,000 shares x $1.50 = $150,000, or it can simply be the balancing figure in the double entry above as we know that the share capital account can only be increased by its nominal value.

Deferred consideration

This is simply consideration that is payable at a later date. As such, the consideration should be recognised as a liability. The double entry of course would be: 

Dr	Investment in subsidiary
Cr	Liability

The double entry is simple but the amount to be recognised requires some consideration.

Let's say the purchase consideration is $2 million and the parent company has paid $1 million in cash with the balance to be paid two years from the acquisition date. The fair value of the first payment is indeed $1 million as it was paid in cash at the date of acquisition. However, the fair value of the second payment is not $1 million as it is to be paid at a later date after the acquisition. This is because the value of money decreases with time due to inflation. As a result, the fair value of the second payment would actually be lower than $1 million. This brings us to the concept of discounting.

Using the discounting concept, the fair value of the $1 million balance payment would be its present value discounted at the relevant discount rate, say 10%:

	Present value	=  $1 million x 1/1.102
		=  $826,446

Therefore, the double entry for recording the cost of investment in the example above is as follows:

Dr	Investment in subsidiary	$1,826,446
Cr	Cash	$1,000,000
Cr	Liability	$826,446

A note on discounting:

We can always use the present value table to determine the result of the discounting above, but let's just simplify things a little. In the calculation above, the $1 million is payable in two years from the acquisition date. Therefore, the discounting is made for two years (i.e. to the power of two). Look at the illustrative table below to get an idea of discounting.

Amount and timing of payment	Discount rate	Present value calculation
$1 million payable in one year's time	5%	$1 million x 1/1.05 = $952,381
$1 million payable in two year's time	12%	$1 million x 1/1.122 = $797,194
$1 million payable in three year's time	15%	$1 million x 1/1.153 = $657,516
$1 million payable in four year's time	20%	$1 million x 1/1.204 = $482,253

Do not get overwhelmed by the concept of discounting as we are not dealing with the subject of costing. All we need to do is determine the timing of the payment (i.e. how many years) and the discount rate. The calculation should come fairly easily and instantaneous.

Contingent consideration

This is consideration payable when certain conditions are met. Under the Revised IFRS 3, any contingent consideration must be included as part of the cost of investment, whether or not it is probable. This means that it doesn't matter whether the conditions attached to the contingent consideration will actually be met. As the consideration is payable in the future if those conditions are met, a liability is again recognised. The double entry would simply be:

Dr	Investment in subsidiary
Cr	Liability

 
For example, the parent company has agreed to pay a further $500,000 in cash if the subsidiary can achieve a 25% increase in it's net profit margin in the next two years. In this case, the parent company would recognise the contingent consideration as part of the cost of investment regardless of whether the targeted increase in net profit margin would be achieved. As the contingent consideration are payable at a later date, it should be discounted to its present value. Assuming a discount rate of 10%, the present value of the contingent consideration would be:

	Present value	=  $500,000 x 1/1.102
		=  $413,223

The double entry would be as follows:

Dr	Investment in subsidiary	$413,223
Cr	Liability	$413,223

Other acquisition costs

These are the costs directly related to the acquisition of a subsidiary. They may include legal fees, professional fees, valuation fees, etc. Under the Revised IFRS 3, such costs cannot be included as part of the cost of investment. They should be charged to the Statement of comprehensive income as expenses in the period in which they arise.

It is critical to understand and account for the various forms of cost of investment that a parent company can make when acquiring a subsidiary. The amount of cost of investment recognised will ultimately affect the calculation of goodwill arising on a business combination. In Part 4 of this article, we shall look at more complex examples of goodwill calculation involving various forms of purchase consideration.