I was taking some practice questions the other day and got an odd answer that I can’t quite wrap my head around. The question is in regards to Equity Method Goodwill. Normally I would expect the Excess Purchase Price to be allocated to the identifiable assets based on (Fair Value - Book Value)*% of Company Purchased. The answer stops short of allocating the excess purchase price to assets and calls the entire value goodwill. The question is structured so that the FV of the entire company is $320 mil, and the FV of Net Assets is 295, and the BV of those assets is 235. The balance sheet also shows PPE having a FV of 275 and a BV if 230 as well as Land having a FV of 115 and BV of 100.
The answer shows the calculated goodwill as $6.25 mil. Calculated as $80 mil purchase cost - (25% * $295 mil FV of Net Assets) = $6.25 mil goodwill.
My question is, why is this $6.25 mil not allocated to the various assets and amortized later? The only plausible answer I can see is that the pro rata share of that would be allocated to the assets is more than the excess purchase price. For example, looking at PPE we would calculate it as ($275 FV - $230 BV) * 25% = $11.25 mil. Since this amount is greater than the excess purchase price we don’t allocate it to this asset?
Can anyone clarify why the excess purchase price isn’t being attributed to other assets in this case and the entire 6.25 mil amount is being called goodwill?
Been a while with FRA and frankly my line of work hardly requires me to use them but here’s my take:
You clearly mentioned it as equity method of accounting. Not JV, Acquisition or Proportionate Consolidation. Your exposure is limited to the extent of your investment. Nothing more nothing less.
Secondly, you wanna check if Goodwill is ever amortised. I think it is tested for impairment at least annually or if market or the company specific event so renders.
I’m working on Level II FRA as well and came across this recently. For the Equity Method, which I understand is when a company invests in another company and holds minority interest between 20% to 50% or less than 20% if other conditions are met that allows the investing company to exert significant influence over the investee ie. is represented on the board of directors. In these situations, the requirement is to report the investment balance on one line on the balance sheet and on one line on the income statement. My formula is below with the ‘Investment Balance’ being the item reported on the balance sheet. PPE is amortized but it is included in the ending Investment Balance. Land is not amortized as it doesn’t depreciate (for our purposes).
Book Value Fair Value
PPE 230 275
Land 100 115
Equity Interest 25%
Purchase Price 80
Book Value 235
Purchase Price 80
Proportionate share in book value 58.75
Excess purchase price 21.25
Less: Attributable to PPE 11.25
Less: Attributable to land 3.75
Goodwill 6.25
Earnings
Less: Amortization of excess purchase price
Attributable to plant and equipment
Equity Income
Purchase Price
Add: Proportionate share in net income
Less: Dividends
Less Amortization of excess purchase price
**Investment Balance**
You’re absolutely right. I made the mistake of using the FV of Net Identifiable Assets (like in Partial Goodwill under an acquisition) and not using the Book Value of the target company (as you should under Equity Goodwill).