CALCULATING PURCHASED GOODWILL: PART 1

Purchased goodwill may arise on a business combination, i.e. when a parent company acquires a subsidiary. It is simply the difference between the cost of investment paid and the fair value of the subsidiary's net assets at the date of acquisition. In other words, it is the difference between what you pay and what you get.

In most cases, the cost of investment would exceed the fair value of the subsidiary's net assets because the parent company believes that the subsidiary's actual net worth is more than what its net assets are showing, and that the subsidiary will continue to generate economic benefits for the parent company in the foreseeable future. 

On the other hand, if the cost of investment is lower than the fair value of the net assets acquired, this will give rise to a negative goodwill. This means that the parent company has just made a bargain purchase. While this is usually rare, it does happen in certain circumstances such as in a forced sale where the subsidiary company is experiencing financial difficulties and is forced to sell its stake at below fair value. You can read more about the IFRS' requirement and treatment of negative goodwill here.

The Revised IFRS 3 Business Combinations now allows two methods under which purchased goodwill can be calculated. They are:

• The proportion of net assets method; and
• The full goodwill method 

Let's have a detailed look on these methods.

The proportion of net assets method

This is the method used to calculate purchased goodwill before IFRS 3 was revised. Therefore, it is also known as 'the old method'. As its name suggests, purchased goodwill is calculated in proportion to the net assets acquired by the parent company, i.e. goodwill attributable to the parent only. This means that the proportion of goodwill attributable the the non-controlling interests (NCI) is not calculated. As explained above, purchased goodwill is the difference between the cost of investment paid (purchase consideration) and the fair value of the subsidiary's net assets acquired, and hence the formula below:

									$
Cost of investment									XXX
For Holding % x Net assets of subsidiary at acquisition date									(XXX)
Goodwill									XXX

It is important to stress that the figures in the calculation above, i.e. the cost of investment and the net assets of subsidiary are their fair values on the date of acquisition.

The full goodwill method

This method is the allowed alternative to calculating purchased goodwill as introduced by the Revised IFRS 3. Therefore, it is also known as 'the new method'. As its name kindly suggests, purchased goodwill is calculated in full, i.e. goodwill attributable to both the parent and NCI. The formula using this method is just an extension of that of the proportion of net assets method, as follows:

									$		$
Cost of investment											XXX
For Holding % x Net assets of subsidiary at acquisition date											(XXX)
Parent's goodwill											XXX
Fair value of NCI at acquisition date									XXX
NCI % x Net assets of subsidiary at acquisition date									(XXX)		XXX
Total goodwill											XXX

As we can see from the above formula, the calculation of purchased goodwill is divided into two parts:

• The first part is exactly the same as the calculation under the proportion of net assets method, except the resulting goodwill is termed 'Parent's goodwill' in order to be distinguished from the goodwill attributable to NCI calculated in the second part of the formula; and
• The second part calculates the goodwill attributable to NCI which is the difference between the fair value of NCI and the NCI's share of the subsidiary's net assets at the date of acquisition.

It is important to be aware that the goodwill attributable to NCI can be calculated in a number of ways depending on the information given in the question. The common information given in the exams are as follows:

• Fair value of NCI at acquisition date - This can be applied directly to the formula above.
• Goodwill attributable to NCI - This is the calculated goodwill figure for NCI. This can be added directly to parent's goodwill.
• Fair value of the subsidiary's shares at acquisition date - The fair value of NCI needs to be calculated based on the fair value of the subsidiary's share price.

It is critical to identify what information is given in the question as this will determine the way purchased goodwill is ultimately calculated. Do not get overwhelmed by the details above. In Part 2 of this article, we shall look at some illustrations to have a clearer understanding of how the formulas above can be applied.