In the years following the implementation of FAS 141 (now codified as ASC 805, “Business Combinations”) in 2001, the vast majority of business combinations either resulted in the recognition of goodwill or were neutral for goodwill/bargain purchase. Goodwill is the amount by which the consideration paid in a business combination exceeds the fair value of the identifiable assets acquired, while a bargain purchase is the amount by which the fair value of the assets acquired exceeds the consideration of purchase.
Bargain purchases have been extremely rare in the era of business combinations under ASC 805. However, they can and do occur in certain circumstances. Most often, bargain purchases can occur in the following situations:
- The selling company was in distress before the sale;
- There was no call for tenders for the selling company before the sale; Where,
- The selling owners were very motivated to sell.
Accounting treatment of bargain purchases
The accounting treatment of a bargain purchase, for financial reporting purposes, is the recognition of an immediate one-time gain in the acquirer’s income statement. These one-time gains are generally subject to scrutiny by both financial statement auditors and regulators. As an example of the regulatory rigor applied to bargain-basement purchases, an upstream oil and gas company and its auditor were recently investigated by the Securities and Exchange Commission regarding a bargain-basement purchase. windfall reported on the company’s books following its acquisition of oil and gas properties.
As such, all parties involved in accounting for a bargain purchase should exercise caution, as follows:
- The acquirer must be able to speak to the facts and circumstances of the transaction and determine whether they warrant bargain purchase treatment.
- The auditor should have a clear understanding of the accounting implications of a bargain purchase and the regulatory review process.
- The auditor and the acquirer should together thoroughly review the financial projections used as the basis of the transaction, as they will also serve as the basis for the valuation of the assets acquired in the purchase price allocation.
- The valuation analyst who prepares the purchase price allocation must ensure that all assets and liabilities acquired have been analyzed and correctly valued. In conjunction with the acquirer and the auditor, the appraiser should also ensure that the economics of the transaction are carefully considered, comparing the cash flow projections prepared by the acquirer with the consideration paid, and testing the internal rate of return resulting from the transaction against a market participant-weighted average cost of capital. In a buy-at-discount situation, the IRR will generally be higher than the WACC.
Advantageous purchases in oil and gas transactions
Discount shopping can happen in any industry. However, with the oil and gas commodity price increases seen so far in 2022, bargain shopping could potentially become more prevalent now and in the near future in some sectors of the oil and gas industry. energy, including exploration and production.
Why would that be? In some cases, the purchase price may have been agreed before the recent spike in commodity prices, or it may have been agreed using an average historical commodity price. However, when allocating the purchase price for financial reporting purposes under ASC 805, the value of reserve assets acquired is generally estimated using current and forecast commodity prices at the closing date of the the transaction. Consequently, in a context of rising prices, the estimated value of the reserves acquired could, in certain cases, be higher than the agreed purchase price.
In the case of a bargain purchase as part of a business combination, it is therefore more important than ever to have a solid and defensible valuation supporting the purchase price allocation.