Goodwill is the residual of the purchase price allocation, and the deferred tax on the fair value step-ups is the line most often left out.
Goodwill is the purchase price less the fair value of the net identifiable assets acquired, measured after removing the target's existing goodwill and after a deferred tax liability on every fair value step-up. In the illustrative case below, a price of 150,000,000 for a company with 52,000,000 of book net assets produces goodwill of 66,500,000. Leave out the deferred tax and the same allocation gives 54,000,000, understated by 12,500,000.
Worked in full in Mergers and Acquisitions by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Goodwill is a residual. Nobody values it directly; it is whatever is left of the price once every asset and liability that can be identified has been put on the balance sheet at fair value. So the calculation is really a purchase price allocation, and the errors are always in the lines above the residual.
| Item | Amount | Useful life |
|---|---|---|
| Consideration paid for the equity | 150,000,000 | |
| Target's book net assets | 52,000,000 | |
| of which existing goodwill from its own past deals | 6,000,000 | |
| Step-up: customer relationships (not on its balance sheet) | 34,000,000 | 10 years |
| Step-up: brand | 12,000,000 | Indefinite |
| Step-up: property, plant and equipment to fair value | 4,000,000 | 8 years |
| Tax rate | 25% |
Because this is a share deal, the tax authority still sees the target's assets at their old values. The accounts see them at fair value. That difference is what creates the deferred tax liability.
Net identifiable assets = book net assets − existing goodwill + fair value step-ups − tax rate × step-ups
Goodwill = consideration − net identifiable assets
In Excel, with the step-ups in C5:C7: =Price-(BookNA-OldGW+SUM(C5:C7)*(1-Tax)).
| Line | Amount |
|---|---|
| Book net assets | 52,000,000 |
| Less existing goodwill (not an identifiable asset) | −6,000,000 |
| Book net assets excluding goodwill | 46,000,000 |
| Plus step-ups: customer relationships, brand, equipment | 50,000,000 |
| Less deferred tax liability at 25% of step-ups | −12,500,000 |
| Net identifiable assets at fair value | 83,500,000 |
| Consideration | 150,000,000 |
| Goodwill | 66,500,000 |
Goodwill is 66,500,000, or 44.3 per cent of the price. A useful cross-check is to build it from the premium instead: the price exceeds book net assets by 98,000,000; take away the 50,000,000 of step-ups, add back the 12,500,000 of deferred tax and the 6,000,000 of old goodwill, and the answer is the same 66,500,000. If the two routes disagree, a line is missing.
The split between goodwill and identified intangibles is not cosmetic. Under full IFRS and for US public companies, goodwill is not amortised; it is tested for impairment at least once a year. (US private companies may elect to amortise it, usually over ten years, and IFRS for SMEs amortises it, but the allocation is done the same way.) The customer relationships and the equipment step-up are amortised, and that charge sits in the acquirer's earnings for years:
| Item | Annual amount |
|---|---|
| Amortisation of customer relationships, 34,000,000 over 10 years | 3,400,000 |
| Extra depreciation on equipment, 4,000,000 over 8 years | 500,000 |
| Less release of deferred tax at 25% | −975,000 |
| After-tax charge to earnings | 2,925,000 |
Why the deferred tax unwinds. The amortisation is not deductible, because the tax base was never stepped up. The deferred tax liability releases in step with it, so the earnings charge is the amortisation times one minus the tax rate, not the full 3,900,000.
Goodwill of 66,500,000 is the part of the price that the buyer cannot point to on a balance sheet: the assembled workforce, the expected synergies, the market position and, often, the premium paid to win the auction. It has to be justified every year in the impairment test, which compares the carrying value of the cash-generating unit, goodwill included, with its recoverable amount. The larger the residual, the less headroom the buyer has before an underperforming year turns into a write-down that reaches the income statement in one go.
The valuer's figure for customer relationships moves goodwill and earnings in opposite directions. Each 1 of intangible identified lowers goodwill by 0.75, because a quarter of it comes back as deferred tax.
| Customer relationships | Goodwill | After-tax amortisation a year |
|---|---|---|
| 20,000,000 | 77,000,000 | 1,875,000 |
| 34,000,000 | 66,500,000 | 2,925,000 |
| 48,000,000 | 56,000,000 | 3,975,000 |
A buyer that wants higher reported earnings has an incentive to identify less, and one that fears an impairment has an incentive to identify more. Neither is a valuation argument, which is why auditors challenge the allocation line by line.
Start from book net assets, take out the old goodwill, add the fair value step-ups, deduct deferred tax on them, and subtract the result from the price: here 66,500,000 of goodwill and 2,925,000 a year of after-tax amortisation from what was identified. Check it by rebuilding it from the premium over book. The free workbook for this case carries the full allocation of the price beside the combined income statement it feeds.
In a share acquisition the buyer revalues the target's assets for accounts but not for tax, so the tax base stays at the old book value. The gap creates a deferred tax liability, 25 per cent of 50 million of step-ups or 12.5 million here, which reduces net identifiable assets and so increases the residual. Goodwill rises from 54.0 to 66.5 million.
Not under full IFRS or for US public companies: goodwill is tested for impairment at least annually instead, although US private companies may elect to amortise it. Identified finite-life intangibles are amortised, which is why the split matters for earnings. In the illustrative case 34 million of customer relationships over 10 years and 4 million of equipment step-up over 8 years cost 2,925,000 a year after tax.
Yes. In an asset deal the tax base of the assets is usually stepped up to the price paid, so no deferred tax liability arises on the step-ups. With the same 150 million price and 50 million of step-ups, goodwill is 54,000,000 rather than 66,500,000, and in some jurisdictions the goodwill itself becomes deductible for tax.
The allocation of the price, with the deferred tax liability IFRS 3 requires on the intangibles, is built in the combined accounts workbook for Mergers and Acquisitions. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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