11.3.1: Initial Recognition and Measurement
- Page ID
- 100527
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)Goodwill arises when one company purchases another business and pays more than the fair value of its net identifiable assets (total identifiable assets – identifiable liabilities). This excess amount of consideration paid by the purchaser is classified as goodwill. As discussed at the beginning of this chapter, since goodwill is not a separately identifiable asset and has no contractual or other legally enforceable rights, it does not meet the definition of an intangible asset. It is therefore classified separately as goodwill on the SFP/BS. Also, a third-party purchase is the only circumstance where goodwill can be recognized. This is due to the complexities of recognizing and measuring internally generated goodwill, which lacks any arm's-length third-party associations.
All the identifiable assets and identifiable liabilities received are initially recorded by the purchaser at their fair values at the date of purchase. The difference between the sum of the fair values and the purchase price (or the fair value of any consideration given up) is classified and recorded as goodwill. Consideration can be cash or other assets, notes payable, shares, or other equity instruments.
For example, on January 1, Otis Equipment Ltd. purchases the net identifiable assets of Waverly Corp. for $40M cash and a short-term promissory note for $12M. Waverly's unclassified year-end balance sheet as at December 31 is shown below.
| Waverly Corp. | ||||||||
| Balance Sheet | ||||||||
| December 31, 2019 | ||||||||
| (in $000s) | ||||||||
| Assets | Liabilities and shareholders' equity | |||||||
| Cash | $ | 50,000 | Accounts payable | $ | 85,000 | |||
| Accounts receivable (net) | 15,000 | Mortgage payable due Dec 31, 2029 | 100,000 | |||||
| Inventory | 35,000 | Share capital | 40,000 | |||||
| Building (net) | 100,000 | Retained earnings | 5,000 | |||||
| Equipment (net) | 25,000 | |||||||
| Patent (net) | 5,000 | |||||||
| Total assets | $ | 230,000 | Total liabilities and equity | $ | 230,000 | |||
To determine the amount of consideration (cash and short-term promissory note) to offer Waverly, Otis completed a detailed fair value analysis of the net identifiable assets, as shown below.
| Fair Values | |||
| December 31, 2019 | |||
| (in $000s) | |||
| Cash | $ | 50,000 | |
| Accounts receivable | 12,000 | ||
| Inventory | 33,000 | ||
| Building | 125,000 | ||
| Equipment | 15,000 | ||
| Patent | 0 | ||
| Accounts payable | (85,000) | ||
| Mortgage payable, due Dec 31, 2029 | (100,000) | ||
| Total fair value of net identifiable assets | $ | 50,000 | |
Differences between fair values and the carrying values of the net identifiable assets are common. For example, the accounts receivable may be adjusted because the bad debt estimate was not sufficient. Inventory may be adjusted due to obsolescence or due to a recent decline in prices from the supplier. Long-term assets values for property, plant, and equipment are usually determined either by independent appraisals or from published pricing guides such as those used for vehicles. Vehicles will lose value as they age, but land and buildings can appreciate over time. The patent may have been assessed a zero value because it was almost fully amortized and was due to expire the next year. Fair values for current liabilities such as accounts payable are usually the same as their book values. Long-term liabilities may require adjustments if interest rates have significantly changed.
The total consideration given up by Otis is $52M combined cash and short-term promissory note compared to the fair value of the net identifiable assets of $50M. The $2M difference will be classified as goodwill. As previously stated, goodwill is not an identifiable asset on its own but simply that portion of the purchase price not specifically accounted for by the net identifiable assets. In other words, goodwill represents the future economic benefits arising from other assets acquired in the business acquisition that cannot be identified separately.
Otis would make a journal entry as shown below.
Any transaction costs incurred by Otis associated with the purchase would be expensed as incurred.
There are many reasons why Otis was willing to pay an additional $2M to purchase Waverly. Waverly may possess a top credit rating with its creditors, an excellent reputation for quality products and service, a highly competent management team, or highly skilled employees. These factors will positively affect the total future earning power and hence the value of the business entity.
If Waverly accepted an offer from Otis of $49M and the fair values of the net identifiable assets of $50M were re-examined and considered accurate, then the $1M difference would be recorded by Otis as a gain (credit) from the acquisition of assets in net income. This is referred to as a bargain purchase.
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