Overview of Fair Value Considerations in Business Combinations

Bargain Purchase Transactions

This article summarizes the fair value measurement guidance and financial accounting considerations in business combinations—and specifically, in bargain purchase transactions. This discussion also describes the principles of acquisition accounting as they relate to fair value measurement. And, this discussion describes many of the valuation analyst considerations regarding the fair value measurement for a bargain purchase transaction.

Introduction

So, is the old saying true that “everyone loves a bargain?” In business combinations, buyers look for a “bargain” while sellers attempt to negotiate the highest possible price. Although true bargains exist in the marketplace, each party in a transaction is generally unwilling to consider a price that varies significantly from its individual perceived value of the transferred assets or business.

For financial reporting purposes, the business combination purchase price is compared to the estimated fair value of net assets acquired. According to the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) topic 820, fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

In certain business combination transactions, the buyer may pay something greater than the fair value of the assets acquired due to synergies and a host of other reasons. In other business combination transactions, the buyer may (1) pay less than the estimated fair value and (2) be considered to have consummated a bargain purchase.

Bargain purchases in business combinations may require additional considerations for both financial accounting and valuation professionals.

This discussion outlines the financial accounting, fair value measurement, and valuation analysis considerations related to business combinations involving bargain purchases. Additionally, this discussion considers the Security and Exchange Commission’s (SEC) scrutiny of fair value measurement valuations.

Financial Accounting Overview

The FASB ASC topic 805 (ASC topic 805) provides guidance on the financial accounting considerations for business combinations accounted for under the acquisition method.

To comply with U.S. generally accepted accounting principles (GAAP), the business combination buyer will record the transaction using the acquisition method and measure the following:

1. Tangible assets and liabilities that were acquired
2. Intangible assets that were acquired
3. Amount of any noncontrolling interest in the acquired business
4. Amount of consideration paid
5. Any goodwill or gain on the transaction

Applying the appropriate valuation approaches and methods, the purchase price is allocated between:

1. Identifiable tangible assets and identifiable intangible assets, and
2. Purchased goodwill.

However, if the fair value of the identifiable net assets exceeds the business combination purchase price, a bargain purchase is deemed to have occurred under the rules of ASC topic 805.

The FASB defines a bargain purchase as “a business combination where the acquisition date amounts of identifiable net assets acquired, excluding goodwill, exceed the sum of the value of consideration transferred.”

The net effect of such a transaction is, essentially, negative goodwill. In the event of a bargain purchase, the purchaser is required under GAAP to recognize a gain for financial accounting purposes. The effect of this gain is an immediate increase to net income.

A reasonable person may question the frequency or volume of bargain purchases. After all, businesses, along with savvy owners and boards of directors, do not often willingly sell assets below fair value. In fact, the FASB and the International Accounting Standards Board consider bargain purchases to be anomalous transactions. Still, these transactions do occur on occasion.

One notable bargain purchase was the acquisition of Lehman Brothers by the United Kingdom bank Barclays in late 2008, resulting in a negative goodwill gain for Barclays of £2.26 billion (approximately $4.1 billion U.S.) (i.e., the £3.14 billion difference between the assets and liabilities acquired minus the acquisition cost of £874 million).[1]

There were likely hundreds of other such transactions in the aftermath of the 2008 market crash and the subsequent Great Recession. Other potential causes of bargain purchases include liquidations, distressed sales, and non-arm’s-length transactions.

In addition to the previous example, we know that bargain purchase issues continue to occur. In August 2017, the SEC issued an order instituting public administrative and cease and desist proceedings against a Big 4 accounting firm and one of its partners involving, in part, bargain purchase issues.

Of the numerous violations, perhaps the most relevant to the topic of bargain purchases was failure to properly test fair value measurements and disclosures, and using the work of a specialist. The accounting firm and the audit partner were ultimately fined more than six million dollars.[2]

Accounting Guidance on Business Combinations and Fair Value Measurement

GAAP requires that business combinations with an acquisition date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 (December 15, 2009, for acquisitions by not-for-profit entities), account for the transaction under ASC topic 805, which focuses on the following areas:

1. Provides broad definitions of business and business combinations (The FASB issued new guidance, ASU 2017-01, Business Combinations (Topic 815): Clarifying the Definition of a Business, in January 2017 that amends the previous definition of a business)
2. Requires the use of the acquisition method
3. Recognizes assets acquired and liabilities assumed at fair value as defined in ASC 820—Fair Value Measurement

First, a business is defined in ASU 2017-01 as “an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return.” A business combination is defined as, “a transaction or other event in which an acquirer obtains control of one or more businesses.”

Generally, GAAP identifies that greater than 50 percent of the voting shares of an entity indicates control; however, effective control may exist with a lesser percentage of ownership in certain circumstances.

Second, the acquisition method is required by ASC topic 805, and this method involves the following procedures:

1. Identifying the acquirer
2. Determining the acquisition date
3. Determining the consideration transferred
4. Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquisition
5. Recognizing and measuring goodwill or a gain from a bargain purchase (emphasis added)

Third, ASC topic 805 requires that all identifiable assets and liabilities acquired, including identifiable intangible assets, be assigned a portion of the purchase price based on their fair values. Fair value measurement emphasizes market participant assumptions and exit values.

Finally, when estimating fair value, the following issues should be considered:

1. Market participant assumptions—buyers and sellers with all the following characteristics:
   1. Independent (not related parties)
   2. Knowledgeable
   3. Able to transact
   4. Willing but not compelled to transact
2. Highest and best use—assumes the asset’s utility is maximized and the use of the assets is physically possible, legally permissible, and financially feasible at the measurement date
3. Synergies—are excluded unless feasible at the market participant level

The Accounting Process for Business Combinations

Accountants provide a pivotal role in the analysis and financial accounting of business combinations through purchase price allocations.

The first step in accounting for a business combination is recognizing and measuring the identifiable assets acquired, the liabilities assumed, the consideration transferred, and any noncontrolling interest in the acquired company. The accountants generally rely on independent valuation analysts (analysts) to estimate fair values. ASC topic 805 provides guidance in each of these areas.

Once the tangible assets are identified, those assets are generally valued by reference to the Market Approach or the Income Approach—unless there are insufficient data to do so. In these instances, the analyst may use the replacement cost new less depreciation method of the Cost Approach. Any liabilities assumed are valued in the same manner.

The analysis and valuation of intangible assets is more complex. Intangible assets are accounted for separately from goodwill if the intangible assets (1) possess contractual or legal rights or (2) can be transferred from the acquired entity. Examples of identifiable intangible assets include: patents, copyrights, trademarks, customer lists, noncompete agreements, and assembled workforce.

There are several valuation methods to estimate the fair value of intangible assets, but intangible asset valuation methods are beyond the scope of this discussion.

ASC topic 805 requires that all consideration transferred and any noncontrolling interests be measured at fair value as of the acquisition date. Additionally, the fair value of any contingent consideration (i.e., earn-out provisions) is typically estimated by probability weighting outcomes via various risk simulation tools.

If at the end of the accounting process, the consideration transferred (or purchase price) is greater than the fair value of the assets and liabilities, the difference is recorded as goodwill. Alternatively, if the fair value of the assets and liabilities is greater than the consideration transferred (or purchase price), a bargain purchase exists with immediate impact to the buyer’s income statement (no such burden accrues to the seller).

Corporate acquirers will often engage an analyst to estimate the identified fair value measurements.

Valuation Considerations for Business Combinations

The analyst’s role is important in the estimation of fair value for purchase price allocation purposes. As with most purchase price allocations, the first step the analyst generally takes in assessing a bargain purchase transaction is to identify all assets, liabilities, and consideration transferred.

If early value estimates indicate that a bargain purchase may exist, the analyst may notify the accountant and other stakeholders—as this indication may impact the buyer’s income statement.

As previously discussed, assets are typically valued using the Cost Approach, the Market Approach, or the Income Approach. These generally accepted property valuation approaches are also used to value liabilities and consideration transferred. The analyst should typically consider all three generally accepted valuation approaches and provide explanations for the inclusion or exclusion of each approach.

The analyst should document his or her rationale for the valuation approaches both considered and employed in arriving at an estimate of value. This provides context for the parties involved in the bargain purchase transaction.

Given the nature of bargain purchase transactions, it can often be difficult to implement a Market Approach. This fact can lead to more reliance on the Income Approach or the Cost Approach.

The Income Approach generates an indication of the fair value of an asset based on the cash flow that an asset is assumed to generate over its useful economic life (UEL). The Income Approach is often applied through a discounted cash flow (DCF) method.

A valuation using the DCF method is based on the present value of estimated future cash flow over the expected UEL of the asset (or business) discounted at a rate of return that incorporates the relative risk of realizing that cash flow as well as the time value of money.

The DCF method is often used in estimating the business enterprise value of the acquired company. In the event of a bargain purchase, the enterprise value exceeds the price paid for the business. This relationship gives rise to important considerations for the analyst.

One such consideration is the analysis and reconciliation of the weighted average cost of capital (WACC), weighted average return on assets (WARA), and the internal rate of return (IRR).

The WACC is calculated as the required rate of return on the investment in the acquired company by a market participant. It is generally comprised of an after-tax required rate of return on equity and an after-tax rate of return on debt. The WACC is often an important component in applying the DCF method, as it is typically used to determine the present value of expected future cash flow.

It may be necessary to estimate the WACC before establishing the stratification of the rates of return for the acquired assets. Determining the WARA allows the analyst to compare this figure to the WACC and assess the reasonableness of the required return on assets and the return required by suppliers of capital.

The WARA should typically result in a similar overall cost of capital as the WACC. This is because the WACC can be viewed as a weighted average of the required rates of return for the individual assets of the acquired company. Essentially, the operations of the acquired company are considered fundamentally equivalent to the combined assets of the acquired company.

In a purchase price allocation for a transaction occurring at or above fair value, it is generally expected that the IRR (based on projections used to value the transaction and the overall purchase price), the WACC, and the WARA are closely aligned.

In the case of a bargain purchase transaction, the IRR typically exceeds the WACC, and the WACC typically exceeds the WARA.

The misalignment between the three measures can potentially be attributed to the absence of goodwill that is often generated under normal market conditions. Goodwill generally has a higher required rate of return than the other acquired assets, which tends to increase the WARA. For financial accounting purposes, goodwill is generally a residual value and the rate of return is calculated as an implied rate of return. Within the context of WARA, the rate of return on goodwill can be estimated by reconciling the weighted average rates of return of all the identified assets to the WACC of the acquired company.

It is important for the analyst to understand the interrelatedness of the IRR, WACC, and WARA in the context of a bargain purchase transaction. The analyst should be prepared to discuss these three measures and what contributed to the differences between them. This may be an area of concern for analysts when reconciling the fair value of the bargain purchase transaction, as auditors generally require an explanation of the differences between the three measures.[3]

It is also important for the analyst to carefully consider the environment in which the transaction took place, as the ramifications of improperly classifying a transaction as a bargain purchase can be substantial.

Typically, certain underlying business and economic conditions are present in bargain purchase transactions. These conditions may include signs of financial distress of the target company, shortcomings in the bidding process, and desired divestiture of noncore business segments of the target firm.[4]

The analyst should gain an understanding of why the transaction was consummated below the estimated fair value as part of his or her due diligence. This understanding provides the analyst with important context surrounding how and why the transaction is not occurring at the estimated fair value.

Purchase Price Allocation Examples

Business combinations range from simple to complex, but most transactions contain similar asset structures. In Exhibit 1, the acquiring company transferred consideration of $1.2 million for net assets of $1.05 million resulting in $150,000 recorded as goodwill.

Alternatively, Exhibit 2 demonstrates a combination where the consideration paid (lowered to $1 million) is less than the estimated fair value of the net assets received. This situation is commonly referred to as negative goodwill—or a bargain purchase.

In Exhibit 2, the acquiring company will recognize an immediate gain on its income statement of $50,000. The results of a bargain purchase will have financial accounting implications, including: potential adjustments to total assets, shareholders’ equity, taxable income, and net income.

Exhibit 1:

Illustrative Business Combination Acquisition Accounting

Transaction Price Indicates Positive Goodwill Value

		Fair Value
	Tangible Assets and Liabilities:
	Cash	$100,000
	Net Working Capital	150,000
	Tangible Personal Property	400,000
	Real Property	300,000
		$950,000
	Liabilities Assumed	(100,000)
	Identifiable Intangible Assets:
	Patents	125,000
	Trademarks	75,000
	Fair Value of Assets and Liabilities	1,050,000
	Goodwill	150,000
	Consideration Transferred (purchase price)	$1,200,000

Exhibit 2:

Illustrative Business Combination Acquisition Accounting

Bargain Purchase Indicates Negative Goodwill Value

		Fair Value
	Tangible Assets and Liabilities:
	Cash	$100,000
	Net Working Capital	150,000
	Tangible Personal Property	400,000
	Real Property	300,000
		$950,000
	Liabilities Assumed	(100,000)
	Identifiable Intangible Assets:
	Patents	125,000
	Trademarks	75,000
	Fair Value of Assets and Liabilities	1,050,000
	Goodwill (bargain purchase element)	(50,000)
	Consideration Transferred (purchase price)	$1,000,000

Securities and Exchange Commission Perspective on Bargain Purchase Transactions

Even though the number of SEC enforcement actions decreased from 110 in 2016 to 76 in 2017, there is evidence that bargain purchases (and other asset valuations) are being increasingly scrutinized.[5]

While the SEC does not provide a basis or strategy for its enforcement actions, they may consider bargain purchase transactions as red flags for balance sheet overstatements.

Therefore, buyers (along with accountants and analysts) should scrutinize bargain purchase transactions to avoid complications with the SEC or other financial reporting deficiencies.

In August 2017, the SEC issued an order instituting public administrative and cease and desist proceedings against a national audit firm and one of its partners along with the relevant entity, Miller Energy Resources, Inc. (Miller).[6]

Miller is a Tennessee corporation located in Knoxville, Tennessee. Specifically, the SEC action noted the following violations:

1. Rule 102E and Section 4C of the Exchange Act
2. Failure to Properly Plan the Audit (AU 331 and 332)
3. Failure to Exercise Due Professional Care and Professional Skepticism (AU 230, 316 and 722)
4. Failure to Properly Test Fair Value Measurements and Disclosures, and Using the Work of a Specialist (AU 328, 342 and 336)
5. Failure to Obtain Sufficient Competent Evidential Matter (AU 315 and 326)
6. Failure to Supervise the Engagement Team Properly (AU 311)
7. Failure to Prepare Required Documentation (AS 3)
8. Failure to Issue an Accurate Audit Report (AU 508)
9. Failure to Perform Adequate Personnel Management (QC 20 and 40)
10. Failure Related to Adequate Competency and Proficiency (AU 210 and 161, QC 20)

In 2010, Miller acquired oil and gas interests located in Alaska initially valued at $4.5 million. Miller subsequently inflated the value of the assets to $480 million in its 2010 financial statements, resulting in a bargain purchase gain of $277 million.

In March 2016, Miller and its subsidiaries filed a voluntary petition for Chapter 11 reorganization and cancelled and extinguished all common and preferred shares.

Prior to the Miller acquisition of the Alaskan assets, the former owners tried and failed to sell the oil and gas interests in the open market. These efforts began in late 2008 and ended in mid-2009. Additional attempts to sell the assets via bankruptcy auction also failed. Ultimately, the assets were abandoned.

During 2009, the abandonment was rescinded, and Miller acquired the oil and gas interests for $2.25 million plus the assumption of certain liabilities. Miller disclosed the value of the assets as $480 million ($368 million for properties and $110 million for fixed assets) and recorded a gain of $277 million in its first SEC Form 10-Q filing following the purchase. At that point in time, the Alaska assets were greater than 95 percent of Miller’s assets.

The SEC determined the $368 million was based on reserve reports that were not suitable for fair value measurement purposes, and the $110 million was duplicative. Because of the incorrect fair value measurements, it was determined that Miller materially misstated the fair value of its assets.

It is evident from the Miller case that the SEC expected more scrutiny from all the parties involved (accountants, analysts, and company management). It is also evident that while large bargain purchase transactions are possible, a gain of $277 million on a $4.5 million purchase (more than 61 times) is highly questionable and likely to receive additional scrutiny from the SEC.

Conclusion

Although generally a rare occurrence, business combinations may, in certain situations, result in a bargain purchase. Such transactions give rise to important considerations for the parties involved.

The buyer should be aware of the requirements and the process for identifying assets, liabilities, and consideration transferred. The buyer should also understand the procedures employed by the analyst in arriving at the estimated fair value of the assets, liabilities, and consideration transferred.

The analyst should ensure that appropriate methods are employed in the valuation analysis, and should be prepared to discuss and reconcile any potential differences between the WARA, WACC, and IRR. One concern of the FASB and the SEC is whether the assets and liabilities acquired are appropriately reported at fair value. Bargain purchase transactions may be a red flag for potential asset overstatements.

Finally, failure to understand the implications of a bargain purchase transaction can lead to several pitfalls, including inaccurate financial accounting as well as legal action from the SEC.

This article was previously published in Willamette Insights, Autumn 2018 and is republished here with permission.

[1] Juan Ramirez, Handbook of Basel III Capital: Enhancing Capital in Practice (Hoboken, NJ: John Wiley & Sons, 2017): 86.

[2] SEC Administrative Proceeding File Number 3-18110.

[3] “Application of the Mandatory Performance Framework for the Certified in Entity and Intangible Valuations Credential” (Corporate and Intangibles Valuation Organization, LLC, 2017), 25.

[4] Eugene E. Comiskey and Charles W. Mulford, “Changes in Accounting for Negative Goodwill: New Insights into Bargain Purchase Transactions. Why Sell for Less Than Fair Value?” whitepaper, http://hdl.handle.net/1853/39313 (April 2011), 23.

[5] David Woodcock, Joan E. McKown, and Henry Klehm III, “SEC Enforcement in Financial Reporting and Disclosure—2017 Year-End Update, “Harvard Law School Forum on Corporate Governance, https://corpgov.law.harvard.edu/2018/02/19/sec-enforcement-in-financial-reporting-and-disclosure-2017-year-end-update/ (January 2018).

[6] SEC Administrative Proceeding File Number 3-18110 (2017).

John Kirkland is an associate in the Atlanta, Georgia, practice office of Willamette Management Associates. He performs the following types of valuation and economic analysis assignments: merger and acquisition, business and stock, forensic analysis, transfer pricing, estate tax, intellectual property, marital dissolution, lost profits/economic damages, and appraisal reviews. Mr. Kirkland prepares these valuation and economic analyses for the following purposes: taxation planning and compliance (federal income, gift, and estate tax; state and local property tax; transfer tax), forensic analysis and dispute resolution, and strategic information and corporate planning, ESOP transaction and financing, and ESOP-related litigation.

Mr. Kirkland can be contacted at (404) 475-2303 or by e-mail to jckirkland@willamette.com.

Dean Driskell is a managing director in the Atlanta practice office of Willamette Management Associates. Dean is based in Atlanta. With more than 25 years of experience in financial analysis, accounting, reporting, and financial management, Mr. Driskell specializes in performing financial consulting services for clients involved in various types of accounting, economic, and commercial disputes as well as fraud and forensic accounting matters. Serving clients and their counsel in both private and public sectors, he has provided technical analyses, accounting/restatement assistance, and litigation support across a variety of industries, including banking, oil and gas, health care, real estate, utilities, pulp and paper, construction, insurance, farming, chemicals, entertainment, consumer products, manufacturing, and various service entities.

Mr. Driskell can be contacted at (404) 475-2325 or by e-mail to dean.driskell@willamette.com.