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Quick Question about the Balance Sheet

I’m having a tough time trying to understand the full effects of an acquisition.

1. When a company makes an acquisition, the goodwill should go up by the premium that’s paid over what the company is worth. How is this connected with the income statement, though?

2. I’ve read several articles saying a high amount of goodwill is bad because it can be impaired. How does this happen?

3. Finally, when you make an acquisition and assets go up on the balance sheet, what equalizes this on the other side of the balance sheet? Do liabilities or equity go up? Do shares outstanding increase due to the fact that you now have another company on hand?

Sorry for all of the questions, I’m just having a tough time understanding this. Thanks in advance.

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1) This isn’t connected to the P&L. Assets (cash), Liabilities (notes payable), or Equity (stock exchanges) are given up in exchange for the acquired company, which likewise is placed on the balance sheet. Goodwill only hits the income statement when it is written off. Goodwill used to also be amortized, but that changed in US GAAP a few years ago.

2) Impairment - This is when an event occurrs that causes the Net Book Value of an asset (in this case, goodwill) to be higher than its fair value. This can trigger the need to write off some or all of goodwill, which has a negative impact on the Income Statement. A good example of what might cause an impairment is if an acquired company had a very important reputation with the public for high quality goods, and some time after the acquisition, a large number of product liability suits are filed. The acquired company’s reputation falls, causing the customer base to diminsih, and the value of the company to fall with its reputation. In this case, the parent company may have to write off some of the goodwill to fairly reflect the value of the acquired company.

3) This answer is buried in #1 above. Company A acquires company B. B’s assets go on A’s books. In some cases, cash is paid. In others, A creates a note payable to B’s owners. Still others, A pays cash for a controlling stake in B’s shares from the market. Still others, A offers some of its treasury stock in exchange for a controlling stake in B’s stock. The difference between what is paid for the stake in B and the FMV of B’s assets is the portion that goes to goodwill, which resides in the Assets portion of the Balance Sheet.

Thanks for clearing this up gangrel.

One last question that I forgot, though…if a company makes an acquisition for a controlling stake in another company’s shares, then should shares outstanding increase by the amount of shares purchased? If so, would it be a fair statement to say that acquisitions ALWAYS cause ROE to decrease? Or does it matter on how profitable the company that was acquired is?

Thanks again

By no means am I an expert here, but I’ll take a run at this.

1. I don’t think that putting Goodwill on the books affects the income statement unless impairment occurs. I believe the offset is cash. You don’t book a loss for paying over FMV. Moreover, Goodwill is not amortized so there will be no future operating expenses related to the Goodwill.

Say company A acquires company B. Company B’s Balance Sheet is shown below.

Assets = 100
Liabilities = 40
Equity = 60

Company A pays 70 in cash for Company B.

Company A would make the following entries

Dr. Assets 100 (increase to assets)
Dr. Goodwill 10 (increase to assets)
Cr. Cash 70 (decrease to assets)
Cr. Liabilities 40 (increase to liabilities)

Note that no income statement accounts are touched. Moreover, assets are increased by 40 and liabilities are increased by 40; your basic accounting equation is still functioning properly.

2. This questions is a little ambiguous. Might need an auditor on AF to explain how Goodwill is tested for impairment… but this is my humble attempt. Every intangible asset is subject to an annual impairment review. When conducting an impairment analysis on Goodwill, expected cashflows of the acquired entity are reviewed for reasonability. If the expected cashflows decrease significantly, then Goodwill may be impaired. Impairing Goodwill would decrease Goodwill and be expensed through the income statement. Goodwill cannot be written up, only impaired. In other words: No hope of gains through Goodwill, only losses. Hope that helps.

3. As we can see in our acquisition example above, liabilities increase as assets increase. I think the short answer is that the number of shares outstanding does not increase. Liabilities increase, equity does not increase. I think saying otherwise would open a whole can of worms related to consolidation accounting, intercompany balances, etc.

This can be a sticky topic… if anyone sees any problems with my response or thinks he can add to my response, please do so.

Good luck Bucks.

The shares acquired are not shares in the parent company, and therefore should not have any impact on WASO.

This can vary a bit, however, depending on how the deal is structured.

Thanks everyone

gobucksgo, at Level II you’ll have an opportunity to revisit the ROE portion of your question. In the recent past, U.S. GAAP permitted two methods of accounting for business combinations, the purchase- and pooling methods. However, GAAP and IAS have required use of the purchase method since 2001 and 2003, respectively.

Following an M&A transaction, ROE tends to be higher for firms that used the pooling method. Let’s briefly examine why.

1) Higher net income under pooling.
Using the pooling method, the two companies are combined using accounting book values. However, under the purchase method, assets are typically written up to their market values, causing an incremental increase in depreciation and decrease in earnings subsequent to the transaction.

2) Lower equity under pooling.
Equity is higher under the purchase method because the book value of equity in the target company is replaced by the purchase price.

This all assumes the fair value of the assets acquired exceeds the book value, and both companies have positive earnings.

Returning to the LI curriculum, you can rationalize this relationship within the context of the DuPont Formula (note: sales are the same under purchase- and pooling).

ROE = (NI/Sales)(Sales/Assets)(Assets/Equity)

So under pooling, and based on the assumptions above, we can see that each component of the formula (and therefore ROE) is higher: net profit margin, total asset turnover, and leverage, respectively.

So anyway, this clearly isn’t a comprehensive discussion of the issue, but hopefully I’ve shed a little more light on your question in a LI-friendly format and offered a glimpse of the interesting material that awaits you at Level II.

Good luck on your upcoming exam.