Torrance Group: goodwill, intangibles and contingent consideration on an 80% acquisition (IFRS 3)
On 1 July 20X4 Torrance Group plc acquired 80% of Kestrel Ltd. It paid £60m in cash and agreed to pay a further amount in June 20X6 if Kestrel's average EBITDA for the two years to 31 December 20X5 exceeds £12m; the fair value of that obligation at acquisition was £8m, and Torrance has classified it as a financial liability. Torrance already held 20% of Kestrel, carried at £11m and measured at fair value through profit or loss; its fair value at 1 July 20X4 was £15m. Kestrel's identifiable net assets at acquisition had a carrying amount of £58m. Fair value adjustments were an internally developed brand of £12m (Kestrel had always expensed brand spending), a £5m uplift on plant, and a £3m provision for a warranty claim that Kestrel had disputed and never provided for. No fair value adjustment has a corresponding tax base. The group's tax rate is 25%. Torrance measures non-controlling interests at the proportionate share of net assets. Acquisition costs of £2.2m were paid in August 20X4.
1. Compute goodwill at acquisition and the gain or loss on the previously held interest.
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Step 1 – net identifiable assets at fair value.
| £m | |
|---|---|
| Carrying amount of net assets | 58.0 |
| Brand recognised at fair value | 12.0 |
| Plant uplift | 5.0 |
| Provision for disputed warranty | (3.0) |
| Deferred tax on adjustments: (12.0 + 5.0 − 3.0) × 25% | (3.5) |
| Fair value of identifiable net assets | 68.5 |
Step 2 – goodwill.
| £m | |
|---|---|
| Cash consideration | 60.0 |
| Contingent consideration at fair value | 8.0 |
| Previously held 20% at fair value | 15.0 |
| NCI – 20% × 68.5 (proportionate share) | 13.7 |
| Less fair value of identifiable net assets | (68.5) |
| Goodwill | 28.2 |
Step 3 – previously held interest. On obtaining control, the 20% investment is remeasured to fair value and derecognised, with the difference taken to profit or loss: £15.0m − £11.0m = £4.0m gain. This is separate from goodwill and is not a revaluation reserve movement. Acquisition costs of £2.2m are expensed as incurred, not included in consideration.
Had NCI instead been measured at fair value (say £18.0m), goodwill would be 68.0 + 18.0 − 68.5 = £17.5m on that basis, with the extra £4.3m representing goodwill attributable to NCI; the exam point is that the choice changes both goodwill and the NCI balance, but not the parent's share of net assets.
2. Justify recognising the brand and the disputed warranty provision, and explain the deferred tax treatment.
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Brand. IFRS 3 requires every identifiable intangible of the acquiree to be recognised separately from goodwill at fair value, whether or not the acquiree had recognised it. 'Identifiable' means separable or arising from contractual/legal rights, and the fair value must be reliably measurable. A brand is a marketing-related intangible with an established name, customer recognition and a measurable royalty saving, so the relief-from-royalty method gives a reliable £12m. That Kestrel expensed its own brand spend is irrelevant: the acquirer is accounting for the asset it has bought, and internally generated brand costs are not capitalised by the acquiree only because of IAS 38's own rules. The brand has an indefinite or long life and must be tested annually for impairment if indefinite.
Warranty claim. IFRS 3 requires the acquirer to recognise a present obligation of the acquiree taken over in the combination, measured at fair value, even if it is contingent and even if the acquiree had not provided for it because it disputed liability. The past obligating event (goods sold under warranty) occurred before acquisition; the £3m is the fair value of the obligation the group has assumed. A disputed claim is not a reason to omit it – it affects the measurement, not recognition.
Deferred tax. The brand and plant uplift create taxable temporary differences because their carrying amounts exceed their tax bases (nil and the original tax written-down value respectively), while the provision creates a deductible difference. Tax is measured at the rate expected to apply when the difference reverses, so £14m net × 25% = £3.5m deferred tax liability is deducted in arriving at net assets, which reduces goodwill. Omitting the deferred tax would overstate net assets and understate goodwill by £3.5m.
3. In March 20X5 the contingent consideration is revised to £9.5m after Kestrel's 20X4 EBITDA beat expectations because of a contract signed in November 20X4. Explain the treatment, and how it would differ if the beat had come from a contract won in February 20X5.
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First case – measurement period adjustment. The increase arises from additional evidence about facts and circumstances that existed at the acquisition date: a contract signed in November 20X4 was already in existence and simply not known to Torrance. Because the adjustment is made within twelve months of acquisition, it is a measurement period adjustment under IFRS 3 and is applied retrospectively as if the fair value at acquisition had been £9.5m.
Effect: goodwill increases by £1.5m (consideration 8.0 → 9.5), and the liability is remeasured to £9.5m. Because NCI is measured at its proportionate share of net assets, and the adjustment does not change identifiable net assets, there is no NCI effect - the whole £1.5m falls on parent goodwill. Prior-period comparatives are restated if the 20X4 figures are already issued.
Second case – post-acquisition event. A contract won in February 20X5 is new information about events after the acquisition date. It is not a measurement period adjustment. The contingent consideration is a financial liability measured at fair value through profit or loss under IFRS 9, so the £1.5m increase is recognised in the 20X5 income statement as a remeasurement loss, and goodwill is unchanged. The same logic applies in reverse if the earn-out falls: a decrease due to post-acquisition trading goes to profit or loss.
Judgement and disclosure. The classification turns on evidence, not on the timing of the revision; the twelve-month window is a ceiling, not a permission to reopen settled estimates. The group should disclose the reconciliation of goodwill, the measurement period adjustment and its effect, and the earn-out terms as a contingent liability if the outcome remains uncertain.