Goodwill and Bargain Purchase

Goodwill and Bargain Purchase are key concepts in accounting for mergers and acquisitions. They arise when the purchase price of an acquired company differs from the fair value of its identifiable net assets. These concepts are central to the purchase method of accounting for business combinations, where the acquirer must allocate the purchase price to the identifiable assets and liabilities of the acquired company and recognize any remaining amount as either goodwill or a gain from a bargain purchase.

Goodwill

Goodwill is an intangible asset that represents the excess amount paid by an acquirer over the fair value of the identifiable net assets (assets minus liabilities) of the acquired company. It is recorded when the purchase price of the acquired company exceeds the fair value of its identifiable net assets. Goodwill reflects intangible factors like the reputation of the company, customer loyalty, brand value, intellectual property, and synergies expected from the merger.

Calculation of Goodwill: Goodwill is calculated as follows:

Goodwill = Purchase Price − Fair Value of Identifiable Net Assets

Where:

• Purchase Price: The total amount paid by the acquirer for the acquisition, including cash, shares, or any other consideration.

• Fair Value of Identifiable Net Assets: The fair value of the target company’s assets minus its liabilities at the acquisition date.

Characteristics of Goodwill:

• Intangible Nature: Goodwill does not have a physical existence but represents the potential value of the target company’s future earning capacity.

• Indefinite Life: Goodwill does not have a fixed useful life and is not amortized. Instead, it is subject to an annual impairment test.

• Impairment Testing: Goodwill is tested for impairment at least annually or when there are indicators that it may be impaired. If the fair value of the reporting unit falls below its carrying amount, an impairment loss is recognized.

Example of Goodwill:

Consider an acquirer purchasing a target company for $50 million. The fair value of the target company’s assets is $40 million, and the fair value of liabilities is $10 million. The net identifiable assets amount to $30 million. In this case, the goodwill recognized would be:

Goodwill = 50 million − 30 million = 20 million

This $20 million represents the intangible value, such as brand reputation and customer relationships, that the acquirer believes will generate future benefits.

Bargain Purchase

Bargain purchase occurs when the purchase price of the acquired company is less than the fair value of its identifiable net assets. In this case, the acquirer acquires the assets at a discount. A bargain purchase results in the acquirer recognizing a gain instead of goodwill. This situation may arise if the target company is in financial distress, underperforming, or is being sold at a price below its intrinsic value.

Calculation of Bargain Purchase:

When the fair value of the identifiable net assets exceeds the purchase price, the difference is recorded as a gain. The calculation is as follows:

Bargain Purchase Gain = Fair Value of Identifiable Net Assets − Purchase Price

Where:

• Fair Value of Identifiable Net Assets: The fair value of the acquired company’s assets minus liabilities.

• Purchase Price: The price paid by the acquirer for the acquisition.

Characteristics of a Bargain Purchase:

• Immediate Gain: The acquirer recognizes a gain on the income statement as the fair value of the net assets acquired exceeds the cost paid.

• Exception: A bargain purchase is considered an exceptional event and is relatively rare. It is often seen in situations where the target company is distressed or there is a highly advantageous acquisition.

Example of Bargain Purchase:

Suppose an acquirer purchases a target company for $20 million, while the fair value of the target company’s assets is $50 million and its liabilities amount to $20 million. The net identifiable assets are $30 million. In this case, the bargain purchase gain would be:

Bargain Purchase Gain = 30 million − 20 million = 10 million

This $10 million is recorded as a gain on the acquirer’s income statement.

key differences Between Goodwill and Bargain Purchase

Accounting Treatment of Goodwill and Bargain Purchase:

1. Goodwill: Under IFRS and US GAAP, goodwill is recognized as an asset on the acquirer’s balance sheet. However, it is not amortized but subject to annual impairment testing. If the carrying value of goodwill exceeds its fair value, an impairment loss is recognized.

2. Bargain Purchase: If a bargain purchase is identified, the acquirer must reassess the purchase price and the fair value of the net assets. If the bargain still exists, the acquirer recognizes a gain on the acquisition in the income statement. This gain reflects the difference between the fair value of the assets and liabilities acquired and the purchase price.

Implications of Goodwill and Bargain Purchase:

• Goodwill: Goodwill represents the acquirer’s belief that the acquisition will create long-term value. However, its indefinite life requires regular impairment testing, and it may be subject to significant fluctuations due to market conditions or poor performance of the acquired company.

• Bargain Purchase: While the acquirer may recognize a gain immediately, this could indicate that the target company is facing financial distress, which may affect its long-term performance. The gain from a bargain purchase should be recognized cautiously and after thorough evaluation of the target company’s financial health.