What is a Bargain Purchase?

Explanation

Bargain purchase happens when the company is generally dealing with the liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more crunch. To get out of the situation, distressed businesses offer discounted prices to the acquirer to quickly sell off the business. The difference between the selling price and fair market value of the assets is recorded as a one-time gain due to negative goodwillNegative GoodwillNegative goodwill is a negotiated purchase made by one company for acquiring the other company whose assets value more than the actual amount paid. Here, the selling company faces hardship and is ready to sell off its assets at a meager price.read more on the acquirer’s income statementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more.

In the 2008 financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more, many financial firms were offering a huge discount at their fair market value as they were dealing with financial distress. This situation presented a lot of opportunities for bargain purchases in the market. In addition, other companies who could take advantage of this situation could add on to their asset base at a comparatively lesser cost than they would have paid in normal scenarios.

How to Calculate a Bargain Purchase?

Following are the details of steps taken in such an arrangement by the acquirer company:

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  • Recording of Asset and Liability at Fair Market Value: The acquirer company would record asset and liability at its fair market value before invoking the process of the bargain purchase. Fair market value is the price that a buyer and seller agree to pay and receive against the property.Reassessment of Assets and Liabilities: After the above step, the acquirer company would reassess to check whether all the assets and liabilities are properly recorded at their fair market value, and nothing has been left out.Contingent Consideration: In this step, the acquirer company would analyze and determine the fair value of any contingent consideration payable to the owner company. Contingent consideration is the amount relating to the additional asset or equity interest, payable back to the owner company.Record of Difference in the Books of Accounts: In the last step, the acquirer company will record the difference between the consideration paid to the owner company and the fair market value of their asset as a one-time gain in its income statement due to negative goodwill.

Example

An XYZ company is dealing with a liquidity crunch and paying all its taxes; it decided to sell off 80% of its share to ABC Company at a price below fair market value at $6,500,000 in cash. ABC company appointed a valuation agency to determine the value of the assets and liabilities of the XYZ company. Valuation agencies confirm the fair value of net assetsNet AssetsThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW).read more as $9,000,000 (Assets $12,000,000 and liabilities $3,000,000). The fair value of non-controlling interestNon-controlling InterestIt generally projects curves on the data sets. For example, to forecast population growth, forming a non-linear relationship between time and growth.read more of 20% is $2,000,000.

Solution:

Now, as per our discussion in earlier headings, gain on bargain purchase will be calculated as follows:

Gain on Bargain Purchase = Fair Value of Net Assets – Consideration/ Selling Price – Non-Controlling Interest

  • = $9,000,000 – $6,500,000 – $2,000,000= $500,000

Therefore, from the above calculation, it can be concluded that the gain on the bargain purchase deal was $500,000, which will be recorded as gain due to negative goodwill in ABC’s income statement.

Bargain Purchase vs. Goodwill

To understand the role of goodwill in bargain purchase, we will first have to understand the concept of goodwill. GoodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company’s net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company’s net identifiable assets from the total purchase price.read more is the amount by which the selling price or consideration paid to the owner company by the acquirer company exceeds the fair market value of its asset. It is recorded on the balance sheet of the acquirer’s company as goodwill from the business combination.

In the case of a bargain purchase, which is a rarity in business combinationsBusiness CombinationsA business combination is a type of transaction in which one organization acquires the other organization and therefore assumes control of the other organization’s business activities and employees. In simple terms, it is a consolidation of two or more businesses to achieve a common goal by eliminating competition.read more, the consideration paid to the owner company is less than the fair market value of its assets. And this difference is recorded as a one-time gain in the books of the acquirer’s company due to negative goodwill.

So, in a way, it can be said that negative goodwill is the opposite of goodwill. Negative goodwill generally indicates that the selling party was distressed and therefore sold its assets below their actual worth.

Conclusion

Bargain purchase is a rare phenomenon that happens in the case of business combinations. In the 2008 crisis, many distressed companies opted to sell their assets at less than their book valueBook ValueThe book value formula determines the net asset value receivable by the common shareholders if the company dissolves. It is calculated by deducting the preferred stocks and total liabilities from the total assets of the company.read more due to a liquidity crunch. Other companies took advantage of this opportunity. On the whole, an acquirer company should take the utmost care while evaluating the distressed companies’ assets and liabilities to support their purchase price valuation.

This has been a guide to bargain purchases. Here we discuss how to calculate bargain purchase along with an example. You may learn more about financing from the following articles –

  • BadwillCollective BargainingFair Value vs Market ValueHistorical Cost vs Fair Value