Equity Method Investment: Understanding Goodwill's Role

Goodwill is an intangible asset that arises when a company acquires another company for a price greater than its net asset value. It is the amount of the purchase price over and above the amount of the fair market value of the target company's assets minus its liabilities. When a company uses the equity method to account for an investment in another company, it recognises its share of the target company's net assets at fair value, including any associated goodwill. This means that the goodwill associated with an equity method investment is the difference between the purchase price of the investment and the fair market value of the net assets acquired.

Goodwill is an intangible asset that arises from business acquisition

Goodwill is an intangible asset that arises when one company acquires another. It is the difference between the purchase price and the fair market value of the net identifiable assets acquired, including equity or assets minus liabilities. This difference is often due to the acquired company's brand reputation, loyal customer base, good employee relations, and proprietary technology, among other things. Goodwill is recorded as an intangible asset on the acquiring company's balance sheet and is considered to have an indefinite life, unlike other intangible assets.

The equity method of accounting, governed by ASC 323 and IAS 28, is used when an investor has significant influence over the investee but does not fully control it. This usually occurs when the investor owns 20-50% of the investee's voting stock. In this method, the investment is initially recognised at cost and subsequently adjusted for post-acquisition changes in the investor's share of net assets. Goodwill is calculated as part of this process, and any excess value is allocated to fair value adjustments before any residual amount is considered equity method goodwill. This goodwill is not amortised but is considered when performing an impairment analysis of the investment.

Goodwill is a valuable aspect of business acquisitions, representing the potential competitive advantage and excess purchase price of the acquired company. It is essential for investors to evaluate goodwill when analysing a company's balance sheet, as it can impact the company's earnings and financial results.

Overall, goodwill is an essential concept in accounting and investing, reflecting the intangible benefits and value arising from business acquisitions.

It is the difference between purchase price and fair-market-value of net identifiable assets acquired

Goodwill is an intangible asset that is recorded when one company is purchased by another. It is the difference between the purchase price and the fair market value of the net identifiable assets acquired. This can be calculated by taking the purchase price of the company and subtracting the net fair market value of its identifiable assets and liabilities.

In the context of the equity method of accounting, goodwill, or "equity method goodwill", arises when an investor purchases a share of the investee entity's underlying assets and liabilities. This share is proportionate to their ownership interest. The purchase price paid by the investor for this share is intended to represent its fair value. However, due to differences in valuation methods, the investor's payment may not match their proportionate share of the investee's net assets.

In such cases, the investor must determine the acquisition date fair value of the identified assets and liabilities, which may include intangible assets not recorded on the investee's balance sheet. These fair values are then compared to the recorded balances, and any differences are considered "basis differences" that must be incorporated into the investor's equity method accounting. This excess can be attributed to "equity method goodwill", which is treated as an intangible asset.

It is important to note that not all overpayment is considered goodwill. If the physical assets' value was overestimated, the excess might be considered a "gap filler".

It is recorded as a non-current asset on the balance sheet

Goodwill is an intangible asset that arises when a company acquires another company for a price greater than its net asset value. It is the amount of the purchase price over and above the amount of the fair market value of the target company's assets minus its liabilities. Goodwill is shown on the company's balance sheet and is considered a non-current asset because it is not a physical asset such as buildings or equipment. It is also known as an indefinite-lived intangible asset as it has an indefinite lifespan, unlike other intangible assets.

Goodwill is calculated as the difference between the purchase price and the fair market value of the net identifiable assets acquired (i.e. equity or assets minus liabilities). For example, if Company A buys Company B for $100 million and the fair market value of Company B's net identifiable assets is $80 million, then the goodwill associated with this acquisition is $20 million. This goodwill amount is recorded as an asset on the balance sheet of Company A.

The equity method of accounting, governed by ASC 323, is used when an entity holds significant influence over another company but does not fully control it. This usually occurs when an investor owns between 20% to 50% of the investee company's voting stock. In this case, the investor must initially measure its equity method investment at cost and identify any differences between the cost basis of its investment and its proportionate share of the underlying assets and liabilities of the investee. These differences are referred to as basis differences and must be accounted for as if the investee were a consolidated subsidiary. Any excess in the cost basis over the proportionate share of net assets is considered goodwill, specifically "equity method goodwill". However, this goodwill is not amortized but is considered when performing an impairment analysis of the equity method investment.

Goodwill is reported as a non-current asset on the balance sheet and must be tested annually for impairment under IFRS and US GAAP standards. Goodwill impairment occurs when the market value of an asset drops below its historical cost due to adverse events such as declining cash flows or increased competition. When impairment occurs, the value of goodwill must be written off, reducing the company's earnings, and is recognised as a loss on the income statement.

Goodwill is not amortised but tested annually for impairment

Goodwill is an intangible asset that is recorded when one company is purchased by another. It is the portion of the purchase price that is higher than the sum of the net fair value of all the assets purchased and the liabilities assumed in the acquisition. Goodwill is commonly associated with the value of a company's brand name, customer base, customer relations, employee relations, and any patents or proprietary technology.

Goodwill is not amortised. Amortisation is an accounting technique used to lower the value of an intangible asset over a set period of time. In 2001, a legal decision prohibited the amortisation of goodwill as an intangible asset. However, in 2014, this ruling was partially rolled back, and private companies were given the option to amortise goodwill over 10 years or less. Nevertheless, this election is not mandatory, and goodwill is generally not amortised.

Instead, goodwill is tested annually for impairment. Goodwill impairment is an accounting charge that is recorded when the carrying value of goodwill on financial statements exceeds its fair value. Impairment occurs when there is a deterioration in the ability of acquired assets to generate expected cash flows, causing the fair value of the goodwill to fall below its book value. Goodwill impairment results in a decrease in the goodwill account on the balance sheet and is recognised as a loss on the income statement, negatively impacting the company's net income.

The requirement to test for goodwill impairment is aligned with generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS). The Financial Accounting Standards Board (FASB) has set out the basic procedure governing goodwill impairment tests, and companies are required to review their goodwill for impairment at least annually.

Goodwill is calculated using the Deal Goodwill Formula

Goodwill is an intangible asset recorded when one company is purchased by another. It is the portion of the purchase price that exceeds the sum of the net fair value of the acquired company's assets and the liabilities assumed in the process. This difference is due to factors such as brand reputation, customer service, employee relations, and proprietary technology.

The Deal Goodwill Formula for calculating goodwill is represented as follows:

Goodwill = Consideration paid + Fair value of non-controlling interests + Fair value of previous equity interests - Fair value of net assets recognised

Here's a breakdown of the components:

• Consideration paid by the acquirer to the seller, which can be in the form of stocks, cash, or cash-in-kind.
• Fair value of non-controlling interests in the acquired company, representing the portion of equity ownership not attributable to the parent company.
• Fair value of equity in previous interests.
• Fair value of net assets recognised in the acquired company, calculated as the net of the fair value of assets and the fair value of liabilities (available on the balance sheet).

By substituting these values into the formula, we can determine the goodwill generated in the transaction.

Let's illustrate this with an example. Suppose company ABC Ltd plans to acquire a 95% stake in company XYZ Ltd. The purchase consideration is $100 million. According to a valuation company, the fair value of the non-controlling interest is $12 million, and the fair value of identifiable assets and liabilities to be acquired is $200 million and $90 million, respectively. There are no previous equity interests.

Using the formula:

Goodwill = $100 million (consideration paid) + $12 million (fair value of non-controlling interests) + $0 (fair value of previous equity interests) - $110 million (net identifiable assets)

Calculating the net identifiable assets:

Net identifiable assets = $200 million (fair value of identifiable assets) - $90 million (fair value of identifiable liabilities) = $110 million

Therefore, the goodwill generated in this transaction is $2 million.

This calculation method ensures that the balance sheet remains balanced, as the goodwill amount is added to the assets side to account for the excess purchase price over the fair market value of the acquired company's net assets.

Frequently asked questions