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Accounting

Bargain Purchases in Business Combinations: A Rarity Explained


by Kevin Cannon

Bargain purchases have been exceedingly rare in the era of business combinations under ASC 805. However, they can and do occur under certain circumstances.

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In the years since Financial Accounting Standard (FAS) 141 (now codified as ASC 805, Business Combinations) was implemented in 2001, most business combinations have resulted in the recognition of goodwill or have been goodwill/bargain purchase neutral. Goodwill is the amount by which the consideration paid in a business combination exceeds the fair value of identifiable assets acquired, while a bargain purchase is the amount by which the fair value of assets acquired exceeds purchase consideration. 

Bargain purchases have been exceedingly rare in the era of business combinations under ASC 805. However, they can and do occur under certain circumstances. Most often, bargain purchases may occur in the following situations:

  • The selling company was distressed prior to the sale
  • There was no competitive bidding for the selling company prior to the sale
  • The selling owners were highly motivated to sell 

The accounting treatment for a bargain purchase, for financial reporting purposes, is the recognition of an immediate one-time gain on the acquirer’s income statement. Such non-recurring gains typically come under a great deal of scrutiny, both from financial statement auditors and from regulatory bodies. As an example of the regulatory rigor applied to bargain purchases, one upstream oil and gas company and its auditor recently came under investigation by the U.S. Securities and Exchange Commission (SEC) related to a bargain purchase reported on the company’s books as a result of its acquisition of oil and gas properties. 

As such, care must be taken by all parties involved in accounting for a bargain purchase, as follows:

  • The acquirer should be able to speak to the facts and circumstances of the transaction, and whether they warrant bargain purchase treatment.
  • The auditor should have a clear understanding of the accounting implications of a bargain purchase and the regulatory review process. 
  • The auditor and the acquirer together should thoroughly review the financial projections used as the basis of the transaction, as they will also serve as the basis for the valuation of the acquired assets in the purchase price allocation. 
  • The valuation analyst preparing the purchase price allocation should ensure that all acquired assets have been analyzed and properly valued. Working with the acquirer and auditor, the valuator should also make sure to carefully examine the economics of the transaction, comparing the cash flow projections prepared by the acquirer with the consideration paid, and testing the resulting internal rate of return (IRR) on the transaction against a market participant-based weighted average cost of capital (WACC). In a bargain purchase situation, the IRR will typically be higher than the WACC. 

Bargain purchases can occur in any industry. However, with the recent decline in oil and gas prices, they could potentially become more prevalent in certain sectors of the energy industry. In the event of a bargain purchase in a business combination, this makes it more critical than ever to have a strong, defensible valuation supporting the purchase price allocation.

 

Kevin Cannon is a Director in Opportune’s Valuation practice.