Understanding 'Goodwill'




Goodwill, we’ve all heard this term being used! Especially in the context of a business combination. But what is it, and how is it calculated and accounted for?

In this article I am going to be demystifying the concept of goodwill and its calculation (in accordance with the guidance set out in IFRS 3, namely focusing on the 2 non-controlling interest valuation methods).

Goodwill is a popular examinable topic, not only is it frequently tested in the Financial Accounting and Reporting exam, but it also appears in the Corporate Reporting exam. Therefore, a good understanding of this topic is important.

What is goodwill?




Often referred to as the established reputation of a business, it’s the asset we can’t see, touch, hit and kick! In other words, its lack of physical substance makes it intangible. Despite the acceptance of this intangible, when it comes to single entity reporting, IAS 38 prohibits the recognition of internally generated goodwill. Therefore, a company such as Apple (my favourite brand ever!) even with its hugely loyal customer base and its reputation for an amazing product portfolio, it’ll never be allowed to capitalise an amount for its own ‘wonderfulness’!

Why? (I hear you ask) To answer this, we simply need to appreciate the definition of an intangible. To recognise an intangible, it must be identifiable. This means it must either be separable (capable of being sold on its own) or arising from legal/contractual rights.

Unfortunately, Apple’s own reputation (therefore its internal goodwill) is neither separable, nor does it arise from legal/contractual rights. Indeed, this goodwill that we refer to for Apple, is merely the perception of Apple’s ‘awesomeness’ conjured by its success and its customers.

Not capitalising this internal goodwill, is a sensible rule to have. If companies like Apple were permitted to recognise internally generated goodwill, then all companies would start to place overestimated values on this amount (I mean every business would deem themselves ‘wonderful’). Furthermore, it would compromise the ‘enhancing qualitative characteristic’ of ‘verifiability’, i.e. how on earth would you validate the amount companies place on their own goodwill? The difficulty in doing so and the unfaithful representation that may arise, further justifies the prohibition of capitalising internally generated goodwill.


When can you capitalise goodwill?




When a business acquires another, it is likely that the price they pay to acquire the trade and net assets, exceeds the net book values (NBV) of what has been acquired. This excess is referred to as goodwill arising on a business combination and it can be capitalised by the acquirer. It’s different to the above situation because this goodwill arises in a business combination and is governed by the guidance in IFRS 3. Furthermore, the amount can be quantified by considering the excess paid by the acquirer over and above the NBV of what has been acquired.


How do I calculate goodwill?


In the exams, you’ll likely see goodwill being tested in situations where a parent obtains a controlling interest in a subsidiary. Goodwill is calculated at the acquisition date and simply put; it’s the comparison of what the parent has paid to acquire the shares in the subsidiary, compared against what the parent is getting back (which is essentially the investment in the net assets of the subsidiary).

Calculating goodwill using the proportionate share method


Let’s consider a basic example to start with:

P Ltd acquired 100% of the shares in S Ltd for £1,000,000, the net assets of S Ltd at acquisition amounted to £930,000. What is the goodwill on acquisition?

We can calculate goodwill as:


Consideration paid £1,000,000

Less 100% of the net assets acquired at acquisition (£930,000)

Goodwill £70,000


What if the shareholding weren’t a 100% acquisition, and there are some non-controlling interests (NCI) How would this affect the calculation?

Now let’s assume the following:

P Ltd acquired 80% of the shares in S Ltd for £1,000,000, the net assets of S Ltd at acquisition amounted to £930,000. What is the goodwill on acquisition?

Earlier I mentioned that goodwill is simply the comparison of what the parent has paid to acquire the shares in the subsidiary, compared against what the parent is getting back (which is essentially the investment in the net assets of the subsidiary). Therefore, we can calculate the goodwill as:


Working 1.1

Consideration paid £1,000,000

Less 80% of the net assets acquired at acquisition

(80% x £930,000) (£744,000)

Goodwill £256,000


The solution to an exam question however, will often set out the calculation as noted below:

Working 1.2

Consideration paid £1,000,000

Add NCI at acquisition (20% x £930,000) £186,000

Less 100% of the net assets at acquisition (£930,000)

Goodwill £256,000


Both methods give you the same answer, so why is it then that the examiner will opt to show the solution as presented in working 1.2?

This is because the method I have described above is the calculation of goodwill using an NCI valuation that is termed ‘proportionate method’ or sometimes called ‘share of the net assets method’. Under this method, the goodwill calculated will only reflect the goodwill attributable to the parent, hence called ‘proportionate’ i.e. it is the parent’s portion of the goodwill in the subsidiary.


There is an alternative method (discussed below) and if you do not present your answer like shown in working 1.2, you’d get the incorrect answer when using this alternative method!


Calculating goodwill using the fair value method

Consolidation requires that 100% of the net assets of the subsidiary are added to the net assets of the parent. It can be argued that if we are showing 100% of the net assets of the subsidiary in the group accounts, then we ought to show 100% of the goodwill in the subsidiary and not just the parents proportionate share (consistency right?) Consequently, IFRS 3 permits an alternative method for valuing NCI when calculating goodwill, termed the ‘fair value method’ or sometimes (appropriately) called the ‘full goodwill method’.

Under this method, the goodwill calculated will incorporate both the parent’s and NCI’s share of goodwill. Hence, it is the total goodwill of the subsidiary.

Let’s look at an example to put this into context. We’ll use the same numbers as above, with additional information about the fair value of the NCI at acquisition.

P Ltd acquired 80% of the shares in S Ltd for £1,000,000, the net assets of S Ltd at acquisition amounted to £930,000. The fair value of the 20% not acquired on acquisition amounted to £200,000. What is the goodwill on acquisition using the fair value method of NCI valuation?

We can produce the answer as follows:

Working 1.3

Consideration paid £1,000,000

Add NCI at acquisition (given) £200,000

Less 100% of the net assets at acquisition (£930,000)

Goodwill £270,000


You’ll observe that the goodwill is higher, and it will be! This is because we have incorporated the fair value of the NCI at acquisition. This represents what it would cost to purchase the NCI shareholding at the acquisition date. It is an amount that will always be provided for you in the exam (largely because you would not have the adequate information to value the NCI shareholding at acquisition).

We have established from working 1.2 that 20% of the share in the net assets of the subsidiary at acquisition, amounted to £186,000, whilst the cost of purchasing the 20% shareholding at acquisition is valued at £200,000 (i.e. the fair value). The difference between these amounts (£200,000 - £186,000) being £14,000 is indicative of the goodwill that is attributable to the NCI. £14,000 is also the difference between the goodwill calculated under the fair value method and the proportionate method (£270,000 - £256,000). This is the only difference between the 2 methods.


You can observe this if we present the workings for both methods side by side:

Working 1.2 Working 1.3

Consideration paid £1,000,000 £1,000,000

Add NCI at acquisition £186,000 £200,000

Less 100% of the net assets at acquisition (£930,000) (£930,000)

Goodwill £256,000 £270,000


In sum, of the £270,000 goodwill calculated in working 1.3, £256,000 is attributed to the parent and £14,000 to the NCI.

The NCI valuation methods that impact goodwill, is one of those adjustments that takes a moment to wrap your head around. Rest assured, once you do get to grips with it, the goodwill calculation can be a joy to work through #addictedtoaccounting.

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