Negative Goodwill and Bargain Purchases in Merger Models

Summary

This tutorial explores the concept of negative goodwill or bargain purchases in M&A deals, focusing on scenarios where the purchase price is less than the seller's equity. It clarifies that negative goodwill doesn't exist under US GAAP or IFRS, instead resulting in zero goodwill and an extraordinary gain. The video explains why such deals occur, particularly with distressed sellers, and provides accounting treatment examples, including simplified methods for financial modeling. Real-life examples, like West America Bank’s acquisition of County Bank during the 2008 crisis, illustrate the application of these concepts in practice.

Takeaways

• 😀 Negative goodwill, or a bargain purchase, occurs when the purchase price is less than the seller's shareholders' equity.
• 😀 Under US GAAP and IFRS, negative goodwill is not recognized. Instead, zero goodwill is created, and an extraordinary gain is recorded.
• 😀 The extraordinary gain represents the absolute value of what would have been goodwill and is reported on the income statement.
• 😀 A maximum zero function is used in financial models to prevent negative goodwill on the balance sheet.
• 😀 On the cash flow statement, the extraordinary gain is reversed because it's a non-cash item, and taxes are adjusted accordingly.
• 😀 Bargain purchases typically happen when the seller is distressed, such as low cash flow, high debt, or declining revenue.
• 😀 Distressed sellers may accept a lower price to avoid liquidation, preserving jobs and business continuity.
• 😀 An example is the hypothetical acquisition of Coco Kreme Doughnuts by Starbucks, where the seller's assets were valued less than their equity.
• 😀 The accounting for bargain purchases has changed—negative goodwill is no longer allocated proportionately to the acquired company's assets.
• 😀 A simpler method for handling these deals is to credit the extraordinary gain directly to shareholders' equity, ensuring a balanced balance sheet immediately.
• 😀 A real-life example of a bargain purchase is West America Bank acquiring County Bank during the 2008 financial crisis, recording a gain of $48.8 million.

Q & A

What is negative goodwill in the context of mergers and acquisitions?

Negative goodwill, or a bargain purchase, occurs when the equity purchase price is less than the seller's common shareholders' equity. However, under both US GAAP and IFRS, negative goodwill does not exist, and instead, an extraordinary gain is recorded for the absolute value of that difference.

What happens in the accounting treatment when negative goodwill would theoretically be created?

In such scenarios, instead of creating negative goodwill, zero goodwill is recorded, and an extraordinary gain equal to the absolute value of the goodwill would be recognized on the income statement. This ensures the financial statements reflect no negative goodwill.

How do you handle extraordinary gains in the cash flow statement when dealing with a bargain purchase?

On the cash flow statement, any extraordinary gain is reversed because gains and losses are typically reversed in cash flow calculations. Additionally, any related taxes are also reversed, reflecting that no actual taxes were paid on the gain.

Why is the balance sheet affected by a bargain purchase transaction?

The balance sheet is affected because the recording of an extraordinary gain changes shareholders' equity. Additionally, the acquisition may require adjustments to the deferred tax liabilities or assets, which will reflect the new values for tangible and intangible assets.

Why would a company like Starbucks be willing to acquire a distressed company for less than its shareholders' equity?

A company like Starbucks may acquire a distressed company for less than its shareholders' equity because the target company is in financial trouble and is at risk of liquidation. By acquiring the company at a lower price, Starbucks may gain value from the distressed company's brand, customer lists, intellectual property, and other intangible assets.

What does the concept of a 'maximum zero function' refer to in the context of bargain purchases?

The 'maximum zero function' is applied to the goodwill calculation to ensure that it cannot become negative. If the purchase price is lower than the book value of the seller's equity, the calculation uses this function to set goodwill to zero and prevent negative values from appearing on the balance sheet.

How does the accounting treatment for negative goodwill differ between the old and current methods?

Under the old method, negative goodwill was allocated proportionally to the acquired company's assets. Under the current method (as per US GAAP and IFRS), negative goodwill is no longer allocated to assets. Instead, an extraordinary gain is recorded in full, with no proportional allocation.

What is the simplified approach for handling negative goodwill in the balance sheet?

A simplified method to handle negative goodwill involves crediting shareholders' equity with the extraordinary gain, directly adjusting the balance sheet. This approach bypasses the need to show the gain on the income statement or reverse it in the cash flow statement, allowing for a balanced balance sheet immediately after the transaction.

Why might the balance sheet be unbalanced immediately after a bargain purchase transaction?

The balance sheet might be unbalanced immediately after a bargain purchase because the extraordinary gain is not reflected in the balance sheet adjustments right away. However, this imbalance is corrected after the first full year following the transaction when the financials balance out.

Can you provide a real-world example of a bargain purchase and its accounting treatment?

A real-world example is the acquisition of County Bank by West America Bank during the 2008-2009 financial crisis. West America recorded a bargain purchase gain of $48.8 million, which was reflected in the income statement as a gain on acquisition, reversed on the cash flow statement, and adjusted through deferred tax liabilities.