Pelham Ltd: goodwill, transaction costs and measurement period adjustments
On 1 July 20X6 Pelham Ltd acquired 75% of Sorell Ltd for $7,500,000 cash plus a promise to pay Sorell's former owners a further $1,000,000 if Sorell's cumulative EBITDA for 20X7 and 20X8 exceeds $4,000,000. At the acquisition date Pelham's directors assess the fair value of that promise at $350,000. Pelham measures the non-controlling interest at fair value of $2,500,000, based on the price paid per share. Provisional fair values of Sorell's identifiable net assets total $9,200,000, including a customer list at $1,400,000. Pelham paid $120,000 to investment banks and $80,000 of costs to issue the debt used to fund the acquisition. In April 20X7, while finalising the 20X6 accounts, Pelham completes the valuations: the customer list is worth $1,100,000, and a warranty claim on goods sold before the acquisition, provisionally valued at $100,000, is now estimated at $400,000.
1. Compute the goodwill arising on the acquisition and explain the treatment of the $200,000 of acquisition-related payments.
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Goodwill at 1 July 20X6
| $ | |
|---|---|
| Cash consideration | 7,500,000 |
| Fair value of contingent consideration | 350,000 |
| Non-controlling interest at fair value | 2,500,000 |
| Less: fair value of identifiable net assets | (9,200,000) |
| Goodwill | 1,150,000 |
Key judgements:
- The contingent consideration is part of the consideration transferred and is measured at fair value, not at the probability-weighted amount of $300,000 (30% x $1,000,000). Fair value reflects the time value, the risk of non-payment and the market's view, not just a probability.
- NCI is measured at fair value, giving full goodwill. Had Pelham used the proportionate share of net assets (25% x 9,200,000 = 2,300,000), goodwill would have been $950,000 and the NCI lower. The choice is available transaction by transaction.
Acquisition-related payments:
- $120,000 bank fees are expensed as incurred – they are not part of the consideration and cannot be capitalised.
- $80,000 debt issue costs are deducted from the carrying amount of the debt and amortised over its term using the effective interest method. They are not goodwill and not an immediate expense.
- Neither amount changes the goodwill of $1,150,000.
2. How should the April 20X7 valuation findings be reflected in the 20X6 financial statements? Recompute goodwill.
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Both findings qualify as measurement period adjustments. They occur within 12 months of the acquisition and relate to facts and circumstances that existed at the acquisition date – a warranty claim on goods sold before acquisition, and the valuation of an intangible that existed at acquisition. They are not corrections of an error and are not taken to profit or loss.
Revised identifiable net assets:
- Provisional total: 9,200,000
- Warranty provision: 100,000 → 400,000, reducing net assets by (300,000)
- Customer list: 1,400,000 → 1,100,000, reducing net assets by (300,000)
- Revised net assets = $8,600,000
Both adjustments move in the same direction; it is easy to net them off by mistake.
Revised goodwill: 7,500,000 + 350,000 + 2,500,000 - 8,600,000 = $1,750,000.
The adjustment is made retrospectively, as if the accounting had been completed at the acquisition date: goodwill is increased by $600,000, the corresponding provisions/intangibles are recognised in the comparative figures, and depreciation or amortisation of the customer list is adjusted from the acquisition date. No prior-period error is reported.
Contrast: if the warranty claim had arisen from a defect introduced in a product manufactured after the acquisition, it would be a post-combination event and charged to profit or loss in 20X7.
3. Sorell's cumulative EBITDA target is met in 20X8 and Pelham pays the full $1,000,000 in early 20X9. Explain the accounting for the increase from $350,000, and how it would differ if, in September 20X6, new information showed the target had in fact already been met at the acquisition date.
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Classified as a financial liability. The promise is an obligation to deliver cash, so it is a financial liability measured at fair value through profit or loss. Each reporting date it is remeasured:
- 31 December 20X6 / 20X7: remeasure to fair value, with the movement in profit or loss.
- On settlement in 20X9: the final remeasurement to $1,000,000 and any foreign-exchange or discounting effects go to profit or loss; the payment extinguishes the liability.
The increase from $350,000 to $1,000,000 is not added to goodwill, because it reflects Sorell's performance after the acquisition – a post-combination event. Goodwill is fixed once the measurement period closes.
Alternative fact pattern (September 20X6). If the new information shows the target was already met at the acquisition date, the acquisition-date fair value of the consideration was misstated. Within the measurement period, that is a measurement period adjustment: goodwill and the consideration are restated, with no profit or loss effect. Once the measurement period has closed (or 12 months have passed), even information about acquisition-date conditions can no longer be pushed back into goodwill and must follow the liability remeasurement rules.
Disclosure should include the range of undiscounted outcomes and the fact that the maximum payable is $1,000,000.