Brookline Valuation Services recently prepared a valuation report that estimated fair values of certain identifiable intangible assets of an acquired company. The valuation was used by the acquirer for financial statement reporting purposes. The key unique feature of this particular transaction was the presence of negative goodwill.
One of the first steps in the allocation process is to ascertain the reasonableness of the purchase price and implied internal rate of return. This involves considering the value of the acquired business as a whole. We have utilized a discounted cash flow methodology for this analysis. Management provided revenue, earnings and cash flow projections.
The business enterprise analysis is essentially a calculation to determine the implied internal rate of return (IRR) from the acquisition. The indication of value, as developed from the cash flow projections provided by management should approximate the purchase price. The discount rate is the implied internal rate of return necessary to equate the cash flow stream to the purchase price. Reconciliation of this rate of return with the weighted average cost of capital (WACC) and weighted average return on the assets (WARA) acquired is an important step in determining the reasonableness of the underlying assumptions and indications of value determined in this report.
The implied IRR was significantly higher than the WACC and WARA. If an IRR is higher, oftentimes there is an indication of a bargain purchase situation. In other words, the purchase price, for the expected cash flows, was lower than what a market participant would likely expect to pay for the Company resulting in the higher implied rate of return on the acquisition.
As a result, the purchase price allocation results in negative goodwill. Goodwill is calculated as the residual difference between the purchase price and the fair value of the tangible and intangible assets acquired and liability assumed. Under ASC 805, negative goodwill is not recorded, but rather, if a bargain purchase is considered, the related gain should be recognized as of the acquisition date.
ASC 805 defines a bargain purchase as a business combination in which the total acquisition-date fair value of the identifiable net assets acquired exceeds the fair value of the consideration transferred plus any non-controlling interest in the acquiree, and it requires the acquirer to recognize that excess in earnings as a gain attributable to the acquirer.
Generally speaking, a bargain purchase is rare. However, for the subject acquisition there were factors that drove down the purchase price, resulting in the bargain purchase and gain recognition.
The seller of the assets had become motivated due to prolonged lapse of time between entering into a plan of divesture the target company and the ultimate sale caused by a previous failed sale transaction with another buyer.
As a result of the unique circumstances surrounding the subject acquisition, and considering the current fair value standard, it appears reasonable a gain would be recognized.
How often do you see bargain purchase especially in the current economic environment?