Understanding Goodwill in Mergers and Acquisitions: Calculation and Complexities, Schemes and Mind Maps of Accounting

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How to Calculate

Goodwill – and Why It

Exists

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This Video: We Haven’t Covered This Before?!! I was looking at this channel the other day and realized that we had videos on Negative Goodwill and Purchase Price Allocation for Noncontrolling Interests … But nothing on a far more basic topic: how to calculate Goodwill in the first place!

Why Goodwill Exists

• SHORT ANSWER: Goodwill is an accounting construct that exists because in M&A deals, Buyers almost always pay more than what Sellers’ Balance Sheets are worth (i.e., Assets – Liabilities)
• The Buyer “gets” all the Seller’s Assets and Liabilities, so that makes its Balance Sheet go out of balance when a deal closes
• We create Goodwill to fix this imbalance and ensure that Assets = Liabilities + Equity on the Combined Balance Sheet
• Basic Calculation: Goodwill = Equity Purchase Price – Seller’s Common Shareholders’ Equity + Seller’s Existing Goodwill +/- Other Adjustments to Seller’s Balance Sheet

Why Goodwill Exists – Simple Example

• EX: Buyer pays $1000 in Cash for the Seller, and the Seller has $1500 in Assets, $600 in Liabilities, and Common Equity of $
• Next: Seller’s Common Equity is written down in the deal, and the Buyer’s Assets go down by $1000, then up by $1500, for a net increase of $500 – but its Liabilities go up by $600! Imbalance!
• To fix this imbalance, we create 2 new Assets in M&A deals: Goodwill and Other Intangible Assets
• Other Intangible Assets are for specific, identifiable items that have value, such as trademarks, patents, and customer relationships – these do not always get created, and we’ll cover them later

How to Calculate Goodwill – More Detail

• In all M&A deals, under both IFRS and U.S. GAAP, Buyers are required to re-value everything on the Seller’s Balance Sheet
• So, if the Seller’s factories, land, inventory, etc. are worth more or less than their Balance Sheet values, they must be adjusted
• Many items that represent timing differences – Deferred Rent, Deferred Tax Liabilities/Assets, etc. also go away because these temporary differences are reversed and reconciled in M&A deals
• And: A new Deferred Tax Liability (and sometimes other new items) often gets created in the deal (see our separate video on this one)

How to Calculate Goodwill – More Detail

• So… a real Goodwill calculation might look more like this:
• Goodwill = Equity Purchase Price – Seller’s Common Shareholders’ Equity + Seller’s Existing Goodwill – Asset Write-Ups + Asset Write- Downs – Liability Write-Downs + Liability Write-Ups
• Rule: If an item increases Assets or reduces L&E, that means less Goodwill is needed to boost Assets – so we subtract that item
• This is why we subtract items such as PP&E and Inventory Write-Ups, and why we also subtract Liability Write-Downs such as DTLs that go away in the deal

How to Calculate Goodwill – Even More Detail

• Results: Other Intangibles are ~33% of the Equity Purchase Price, and Goodwill is ~75%; no write-up for PP&E
• Newly Created DTL is ~37% of the new Intangible Assets – but that ~37% is not necessarily the tax rate for our Buyer
• Our Deal: We might create Other Intangibles such that they represent ~33% of the Equity Purchase Price, record the other items as is, and create the new DTL based on the Buyer’s tax rate
• And: We’d check that the Goodwill is a significant portion of the Equity Purchase Price (e.g., 60-80% range rather than 5-10%)

Last Note: Even More Complexities

• Other Items: Deferred Rent, Deferred Revenue, Inter-Company AR/AP, and more
• Different Deal Types: Deferred Tax line items work differently depending on whether it’s a Stock, Asset, or 338(h)(10) deal
• More Intangibles: Definite vs. Indefinite-Lived, etc.
• Industry-Specific Items: In-Place Lease Value and Above/Below- Market Leases in Real Estate
• And: Don’t forget about Earn-Outs and other Contingent Payments