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In this blog, we will cover book value, fair value of Assets and Liabilities and subsequently we will go through goodwill creation scenarios where it gets created and some scenarios where it doesn’t.

Book Value of Assets & Liabilities: These are the figures we have written in our book of accounts when we have acquired the assets or liabilities of Target Company, but over the period of time the values of assets keep changing. Assets depreciate with usage; Note: Land (asset) does not depreciate. So book value of the assets represents the value at which the assets/liabilities were bought by the company, it doesn’t reflect the current value of assets/liabilities.

Example to calculate Book Value of Assets/Liabilities

Balance Sheet of a company:

Assets                   Liabilities + Owner’s Equity

100                            20       +     80

If we want to calculate the book value of the company, it will be Assets – Liabilities i.e. 100- 20 = 80, we won’t be considering the owner’s equity because we will be acquiring Assets and liabilities of the target company and paying the owners for the shares they own.

Fair Value of Assets and Liabilities: When the acquirer is planning to acquire any company it looks at the fair value of the company and not at the book value. We know that book of accounts doesn’t show the exact value of assets and liabilities on that day instead these are at book value only.

Just to give you an example, let us say Target Company bought land worth 1 million in 2000 and now the same land costs around 4 million in the market. So when we acquire the company we need to take into consideration 4 million instead of 1 million.

Fair Value: The price at which the goods/assets can be exchanged in the market right now with unbiased view. Because book values are the historical value of the assets we bought, it doesn’t reflect the value at which assets/liabilities can be exchanged in the market right now or the real value of the target company.

Goodwill: It is the excess amount the acquirer company is paying to target company over and above the fair value of Target Company. Now a logical question arises, why would Acquirer Company be willing to pay more than the fair value to acquire the Target Company.

–       Acquirer company feels that it is not 1 + 1 = 2 acquisition, it will be 1 + 1 > 2 acquisition, means after the acquisition it will be able to realize synergy in the operations thereby resulting in cost savings.

–       Acquirer company is not present in particular vertical in which target company is strong, so buying target company would give acquirer company a jumpstart in that vertical, so acquirer company may be willing to pay more than the fair value of target company.

–       If the acquirer company is buying stake in the target company it needs to offer some premium to fair value otherwise there won’t be any incentive for the existing shareholders to sell their stake.

–       There may be bidding war between two or more acquirer companies to acquire Target Company. In case of bidding wars normally the final acquirer ends up paying much more than the fair value of assets of Target Company.

Please note goodwill is always over and above the fair value and not book value.

Prior to 2001, we used to amortize goodwill for 40 years, but after 2001 it was decided that the period is too long, now we assess goodwill every year for impairment. If goodwill has gone down, it will go in goodwill impairment account and will be counted as expense item.

Note: Goodwill can only have impairment (go down), it will not increase i.e. cannot be created until and unless some acquisition happens. In the later parts, I would discuss how we assess goodwill impairment.

Scenario 1 Goodwill:

Company P acquires 100 percent stake in company S for 500 million, the book value of the company S is 250 million while fair value of the company is 350 million. So in this case the goodwill is 150 million (money paid, 500 – fair value, 350).

Scenario 2 Goodwill:

Company P acquires 80 percent stake in the company S for 400 million, the book value of the company S is 250 million while fair value of the company is 350 million.

Goodwill = Money paid to acquire stake – fair value of the stake

Fair value of the company S = 350 million.

Fair value of the 80 percent stake in the company = 350 * .8 = 280 million

Money paid to acquire 80 percent stake in the company = 400 million

Goodwill = 400 – 280 million = 120 million.

Scenario 3 Goodwill:

Company P acquires 80 percent stake in the company for 200 million, the book value of the company is 150 million while fair value of the company is 250 million.

Fair value of the company = 250 million

Fair value of the 80 percent stake in the company = 250 * .8 = 200 million

Money paid to acquire 80 percent stake in the company = 200 million

Goodwill in this case would be zero i.e. there won’t be any goodwill as we are buying the company at fair value.

 

Scenario 4 Goodwill:

Company P acquires 80 percent stake in the company for 175 million, the book value of the company is 150 million while fair value of the company is 250 million.

Fair value of the company = 250 million.

Fair value of the 80 percent stake in the company = 250 * .8 = 200 million

Money paid to acquire 80 percent stake in the company = 175 million.

In the above particular scenario, we are paying less than the fair value to acquire the target company so there won’t be any goodwill creation in this transaction. These kinds of transactions are called bargain purchase where the acquirer is paying less than the fair value to acquire the target. We will discuss later what happens in bargain purchase but for the time being we can note that no goodwill gets created in bargain purchase.

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4 Comments

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    1. Archit Agrawal Post author
      Hi Greg,

      Sorry for the delayed response.

      I haven’t got the opportunity to work on all the FC solutions of SAP, however I have got fair understanding of BPC. It is a very flexible tool for consolidation if the complexity of implementation is less otherwise one can opt for BOFC .

      Regards,
      Archit

      (0) 
  1. Julius von dem Bussche
    Which transactions (and user IDs) can be used in SAP to mystify (mistification) the consolidation?

    Intercompany transactions, closing and disclosure in SAP would be an interesting topic for your next blog?

    Tip: There are also some interesting requirements for intercompany which some vendors translate into digital signature requirements while transfering the data between systems. I would be very interested in reading your views on that.

    Cheers,
    Julius

    (0) 
    1. Archit Agrawal Post author
      Hi Julius,
      Sorry for the delayed response.
      There are solutions provided by SAP to do the financial consolidation eg. SAP BPC or BoFC. One needs to have proper authorization to view/edit data in it. Access to data can be restricted based on various parameters.

      Thanks for the suggestion about the next blog..even I was thinking on the similar lines to cover intercompany transactions after this series.

      I will surely look into the intercompany transactions involving digital signature.

      Regards,
      Archit 

      (0) 

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