What Is Bargain Purchase?
A bargain purchase occurs in an acquisition method of accounting when the amount an acquirer pays to gain control of another entity is less than the fair value of the identifiable net assets acquired. This uncommon scenario results in a gain recognized by the acquirer on its financial statements as part of a business combination, reflecting that the acquired business was bought at a discount. Bargain purchases are a specific outcome within the broader field of financial reporting and accounting for corporate transactions.
History and Origin
The accounting treatment for bargain purchases has evolved with global accounting standards. Prior to revisions, the excess of the fair value of net assets acquired over the consideration paid, sometimes referred to as "negative goodwill," was handled differently, often amortized over a period. However, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) embarked on a joint project to converge their respective standards for business combinations. This led to the issuance of IFRS 3 Business Combinations (revised 2008) and ASC 805 Business Combinations (formerly FAS 141(R)). These revised standards established the current approach, requiring immediate recognition of a gain on a bargain purchase in profit or loss. The IASB concluded that immediate recognition provides the most representationally faithful treatment for such a gain.6 This convergence effort was part of a broader push towards globally accepted accounting standards, as highlighted by the U.S. Securities and Exchange Commission (SEC), aiming to improve the comparability of financial information for investors worldwide.5
Key Takeaways
- A bargain purchase arises when the cost of acquiring a business is less than the fair value of its identifiable net assets.
- It results in a gain for the acquirer, which is recognized immediately in profit or loss under both International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP).
- Bargain purchases are rare and typically occur under distressed circumstances for the seller or unique market conditions.
- Before recognizing a bargain purchase, the acquirer must re-assess the measurement of the identifiable assets acquired and liabilities assumed, as well as the consideration transferred.
- The concept is explicitly addressed in accounting standards for business combinations, such as IFRS 3 and ASC 805.
Formula and Calculation
A bargain purchase occurs when the fair value of the identifiable net assets acquired exceeds the consideration transferred. The gain on a bargain purchase is calculated as follows:
Where:
- FV of Identifiable Assets Acquired: The fair value of all assets obtained, including tangible and intangible assets, that can be individually identified and recognized.
- FV of Liabilities Assumed: The fair value of all obligations taken on, such as accounts payable or long-term debt.
- Consideration Transferred: The total value of the assets transferred, liabilities incurred, and equity interests issued by the acquirer to obtain control of the acquiree. This can include cash, other assets, contingent consideration, and equity instruments.
The assets acquired and liabilities assumed are measured at their fair values at the acquisition date.4
Interpreting the Bargain Purchase
The recognition of a bargain purchase gain indicates that an acquirer has obtained a business at a price lower than its assessed fair value. This does not imply accounting trickery, but rather suggests unique circumstances surrounding the acquisition. Often, a bargain purchase reflects a forced sale by the acquiree due to financial distress, regulatory mandates, or a tight deadline. For example, a selling company might need to divest an unprofitable division quickly, or a regulator might compel a struggling institution to be acquired.
From an investment perspective, identifying a legitimate bargain purchase can signal a shrewd acquisition by the acquirer, potentially leading to enhanced equity for its shareholders if the acquired business can be successfully integrated and turned around. However, it also prompts scrutiny, as auditors and investors will want to ensure that all assets and liabilities were properly identified and valued, and that the consideration was accurately measured. A robust valuation process is critical to justify the bargain purchase claim.
Hypothetical Example
Assume diversified conglomerate "Alpha Corp" decides to acquire "Beta Systems," a small technology firm specializing in niche software, which is facing severe liquidity issues. Beta Systems' primary assets include valuable intellectual property (software patents, customer lists) and some high-tech equipment.
Alpha Corp performs its due diligence and assesses the fair value of Beta Systems' identifiable assets at $15 million and its liabilities at $3 million. This means the fair value of the identifiable net assets is $15 million - $3 million = $12 million.
Due to Beta Systems' urgent need for cash to avoid bankruptcy, Alpha Corp negotiates a purchase price of only $10 million in cash.
The bargain purchase gain for Alpha Corp would be calculated as:
Upon completion of the business combination, Alpha Corp would recognize a gain of $2 million on its income statement in the period of acquisition. This gain would increase Alpha Corp's reported earnings for that period. The acquired assets and liabilities would be recorded at their fair values on Alpha Corp's balance sheet.
Practical Applications
Bargain purchases primarily appear in the realm of mergers and acquisitions (M&A) and corporate restructuring. They are most commonly observed in situations where the seller is under significant pressure to dispose of an asset or business quickly, such as:
- Distressed Sales: A company in bankruptcy or near insolvency may sell divisions or assets at a steep discount to meet creditor demands or avoid liquidation.
- Forced Divestitures: Regulatory bodies might mandate the sale of certain business units to prevent monopolies or anti-competitive practices, often under time constraints that can lead to lower selling prices.
- Liquidations: During a company's liquidation process, assets are often sold below their fair value to quickly convert them into cash.
- Niche Market Exits: A company may exit a specific market that no longer aligns with its core strategy, and if there are few potential buyers, it might accept a bargain price.
Federal Reserve studies, for instance, frequently analyze patterns in bank mergers and acquisitions, where accounting for such transactions, including potential bargain purchases, is a critical component of regulatory oversight.3 The accounting for these scenarios must adhere strictly to standards like International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP).
Limitations and Criticisms
While a bargain purchase might appear to be a clear win for the acquirer, its recognition is subject to strict scrutiny. One of the primary limitations is the inherent difficulty in precisely determining the fair value of all identifiable assets and liabilities in a complex business combination. Critics argue that subjective valuations can potentially lead to an artificial recognition of a gain, particularly if future economic benefits from certain assets are overstated or contingent liabilities are understated.
Auditors pay close attention to bargain purchases to ensure that the gain is not a result of errors in valuation or accounting. Before a gain can be recognized, accounting standards require the acquirer to re-assess the identification and measurement of all acquired assets and liabilities, as well as the consideration transferred. If, after this re-assessment, the excess still exists, it is then recognized as a gain. The convergence of accounting standards between U.S. GAAP and IFRS, while largely successful in some areas, has faced challenges and continued differences in others, which can sometimes complicate the consistent application of rules for business combinations across jurisdictions.2,1
Bargain Purchase vs. Goodwill
The concept of a bargain purchase is directly opposite to goodwill. In a business combination accounted for under the acquisition method, goodwill arises when the consideration transferred by the acquirer exceeds the fair value of the identifiable net assets acquired. This excess represents the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized. Examples include brand reputation, strong customer relationships, or synergistic benefits from combining operations.
Conversely, a bargain purchase occurs when the consideration transferred is less than the fair value of the identifiable net assets. Instead of recognizing an intangible asset like goodwill, the acquirer recognizes a gain in profit or loss. Essentially, goodwill is the premium paid for a business beyond its separable net assets, while a bargain purchase reflects a discount obtained on those assets. Both are distinct outcomes of the acquisition accounting process, impacting the acquirer's consolidated financial statements differently.
FAQs
Why do bargain purchases happen?
Bargain purchases typically occur when the seller is under duress, such as facing financial distress, regulatory pressure to sell quickly, or needing to divest an operation that is no longer core to its strategy. These circumstances can force a seller to accept a price below the fair value of the business's net assets.
Is a bargain purchase a good thing for the acquirer?
From an accounting perspective, recognizing a gain from a bargain purchase immediately boosts the acquirer's reported profit. Strategically, acquiring a business at a discount can be highly beneficial if the acquirer can integrate it effectively and realize its true value. However, the circumstances leading to a bargain purchase often imply underlying issues with the acquired entity that the acquirer must address.
How is a bargain purchase recorded on the financial statements?
A gain from a bargain purchase is recognized directly in profit or loss on the acquirer's income statement in the period the business combination occurs. The acquired assets and liabilities are recorded at their acquisition-date fair values on the balance sheet.