Why do we attribute the excess purchase price to specific assets before calculating goodwill?

The attribution step matters because the identifiable assets and goodwill have different downstream treatments. Specifically, the excess attributed to depreciable assets must be amortised against future equity income, while goodwill stays on the books (subject to impairment) and does NOT amortise.

Why this matters financially:

Imagine two scenarios — both with $400K excess over book value:

Scenario A: $400K all attributed to goodwill, $0 attributed to identifiable assets.

• Goodwill = $400K (stays forever, impairment-tested)
• Annual amortisation expense: $0
• Equity income each year: full share of NI

Scenario B: $300K attributed to PP&E (5-year remaining life), $100K to goodwill.

• Goodwill = $100K
• Annual amortisation expense: $300K / 5 = $60K
• Equity income each year: $\text{share of NI} - \$60\text{K}$

The two scenarios produce different earnings and different investment-balance trajectories, even though the same $400K excess is paid. Scenario B reports lower equity income for 5 years (because of the $60K amortisation drag), but at year 6, equity income jumps back up because amortisation ends.

The accounting standard requires the attribution:

ASC 323-10-35-13 (and IAS 28) requires that when the cost of an equity-method investment exceeds the investor's share of book value of the investee's net assets, the difference must be allocated:

1. First to the fair-value step-up of identifiable assets (depreciable PP&E, finite-life intangibles like patents, etc.) — these step-ups are amortised over the asset's remaining useful life.
2. Then to the fair-value step-up of indefinite-life assets (land, infinite-life intangibles like brand names not contractually limited) — these step-ups are NOT amortised.
3. Then to the residual = goodwill — also NOT amortised.

This mirrors purchase-price-allocation (PPA) rules under full business combination accounting (ASC 805) — equity-method investments use a simplified version of the same waterfall.

The economic rationale:

The fair-value step-ups represent assets the investor effectively paid extra for. Like any other asset, those should be expensed over the period the investor benefits from them — that's the matching principle. Goodwill represents "the rest" — synergies, brand value, market position — and the accounting convention is to not amortise it because its life is indefinite.

Exam pitfall:

A common trap on CFA Level II is a question that gives you the excess purchase price and asks for goodwill — but the question deliberately omits the fair-value attribution. If the question says "all of the excess is attributable to goodwill," then goodwill = excess directly. If it says "fair-value step-up on PP&E is $X," you MUST subtract before computing goodwill.

Why the lecture works through Lucia/William deliberately:

The instructor walks through the attribution step-by-step because every CFA candidate gets this wrong the first time. The waterfall is non-obvious and the textbook formulas are unhelpful. Drilling the worked example fixes it.