In the corporate world, the fancy term for “a steal” or just good value is “bargain purchase”. This occurs when a buyer purchases an asset for less than its worth. Such purchases are unfortunately uncommon since organizations will work to generate interest from as many buyers as possible before selling an asset, even a distressed one, to ensure the greatest possible price. Bargain purchases often occur when that competitive buying process simply cannot happen. Specifically, a scenario where a company wants to sell an asset promptly and lacks sufficient time to utilize normal market approaches.
Among the most critical requirements for the exploitation of this purchase, aside from the aforementioned circumstance, is the quality of your balance sheet accounting in determining the given asset’s status as a bargain purchase. In this post, I’ll dive into the more specific definition of bargain purchases, elaborate on the circumstances of it, and conclude with how Excel and quality FP&A softwares can be used to maximize your balance sheet accounting, and hence your seizing of bargain purchase opportunities.
Bargain Purchase Causes/Circumstances
Bargain purchases typically occur in less attractive industries or for unappealing assets. If this wasn’t the case, there would be plenty of buyers to create the competitive process that removes the bargain purchase opportunity. However, they can occur in any market sector. Even multi-billion-dollar corporations could have a division of their business that’s selling at a bargain purchase to rid themselves of it.
Bargain purchases can arise in both equity/stock and market purchases. More often than not, buyers are motivated to only purchase certain desired assets (i.e. customer lists, intellectual property, fixed assets, inventory, etc.) with the intent of avoiding the assumption of all of the target organization’s liabilities, including potential off-balance sheet liabilities. Comparatively, sellers are typically motivated to sell the corporation’s stock to avoid being left with legacy liabilities or undesirable assets. While not always the case, stock acquisitions are generally more prevalent if there are enough potential buyers for the target company being sold.
Typically, a bargain purchase occurs when a company owns an asset or assemblage of assets that are not generating enough income to make keeping the asset(s) desirable, and ownership of the asset(s) drains cash flow or other resources from the owner. In such circumstances, the owner is willing to sell the asset(s) for less than it is worth simply to stop losing money or free up resources. Thus, bargain purchases increase in frequency during economic downturns as more companies and assets are distressed, pushing sellers to sell them fast.
For instance, if a restaurant chain has a massive E. coli outbreak, that leads to a huge drop in revenue in five of its stores. These stores become severely overleveraged. Following this, an investor offers to buy those stores for less than fair value. In such a scenario, if the business is draining money so quickly that the owner has no time to canvas the market for other buyers, then the owner can sell for a price below the aggregate value of the assets and execute a bargain purchase.
If an asset(s) is being sold for a below-market price there is likely something in need of rectifying with the asset. As such, the buyer in a bargain purchase is inherently assuming the risk associated with the distressed asset. This risk transfer is a result of the buyer’s conviction that they can solve the distress of the asset or make better use of it. In the previous example, perhaps the restaurant investor is convinced that they can repurpose the buildings to become more profitable as a different business.
Bargain purchases can also be a result of contract obligations. For example, if a buyer enters a transaction to purchase an asset at an agreed price today but the deal does not close for six months, and six months later the value of the asset will be significantly higher given the changes in the target business, then the buyer may have executed a bargain purchase by being locked in at an earlier, cheaper price. Similar circumstances could arise when buyers enter a transaction and the purchase price is based on a fixed number of buyer’s shares, and the buyer’s stock price drops materially prior to the effective date of the transaction.
Creating Excel Balance Sheets
1. Acme Inc balance sheet
Once you know the period you’re covering and have the values you need, it’s time to create the Excel file. Open up a new file on Microsoft Excel. Put in [Company Name] Balance Sheet at cell A1 for easy identification.
Leave some space for formatting, then on the first column of the third row, write Assets. This is the section where you’ll put in the values for everything your company has. Then on the third column of the same row, write the fiscal year you’re covering.
After Assets, you have to create the corresponding Liabilities and Owner’s Equity section. Liabilities refer to the amount the company owes to third parties, including banks, suppliers, landlords, and the government.
Owner’s Equity, on the other hand, refers to the amount the owners raised for the business, plus any earnings it retains in its accounts. These values in these two sections should equal the amount noted under assets—hence the term Balance Sheet.
However, before creating the Liabilities and Owner’s Equity section, you should first place the subcategories for Assets. This way, you’ll have less trouble with formatting.
2. Insert Your Categories
Each business and industry will have its own unique Asset subcategories. However, these are the typical sections most companies have: Current Assets, Fixed or Long-Term Assets, and Other Assets. These are then further broken down into small categories.
Current Assets can quickly be liquidated. These are typically cash, accounts receivable, inventory, and short-term investments. On the other hand, Fixed or Long-Term Assets are harder to convert into currency. These could be Real Properties, Office Equipment, Long-term investments, and more.
Other Assets are often minor items that aren’t easily defined under current or long-term assets. These could include Prepaid Expenses (like subscriptions), Deferred Tax Assets (like refunds), and Employee Advances.
Although these categories apply to most businesses, your organization may have a unique asset category, so you should review your operations before considering this as final.
II: Liabilities & Owner’s Equity
Similar to Assets, Liabilities & Owner’s Equity has three major subcategories: Current Liabilities, Long-term Liabilities, and Owner’s Equity. As the term suggests, current liabilities are obligations that the company must meet either in one year or in one operating cycle (where one operating cycle refers to the time taken for inventory to be converted into sales).
Current Liabilities could include accounts payable to suppliers and lessors, short-term loans from banks and creditors, income taxes, payable salaries, prepaid goods and services, and the current portion of long-term debt.
Under Long-term Liabilities, you will find Long-term debt, Deferred income tax, and Pension fund benefits, if required by law. Lastly, Owner’s Equity consists of Owner’s equity, which is the amount you put in the business. If you’re running a corporation, both this section and its subsection are called Shareholders’ Equity instead. You will also find Retained earnings under the equity section, which is the amount the business earned in the period less dividends paid out.
3. Adding the Values:
Under Assets, add the values for each subcategory to know how much you have for each section. You then need to add each subtotal to get the total asset value of your company. Likewise, you should also add the values for each Liability and Owner’s Equity subcategory to find how much of your company’s assets are from creditors, the owners, and earnings. Take note that the total values for the Assets section and the Liabilities and Owner’s Equity section should match. Otherwise, there might have been an error in your accounting.
Balance Sheet Accounting With Bargain Purchases
Following a bargain purchase, you must perform a valuation to demonstrate that the fair value of the asset(s) is more than what the buyer paid for, which then results in special accounting treatment.
In typical transactions, buyers take the purchase price and subtract the fair value of the acquired net assets to land on any residual goodwill amount. However, in a bargain purchase, because the purchase price is less than the fair value of the acquired net assets, the math yields an implied “negative goodwill” amount. Ultimately, goodwill is recorded at zero on the balance sheet and the “negative goodwill” balance is recorded as a gain that the buyer would need to expense through the income statement.
Auditors are often reluctant to acknowledge the existence of a bargain purchase, arguing that since there were two independent parties negotiating, the transaction yields a market value of the acquired net assets. As a result, management needs to be prepared to both qualitatively and quantitively support the existence of a bargain purchase if the situation does arise. The qualitative rationale needs to explain why the bargain purchase occurred, including justification on why the seller may have been motivated to sell or avoid a typical vetting process to yield a competitive buyer auction or whether there was something unique in the way the transaction price was agreed upon between the negotiation process and the ultimate close date.
Viewing the situation quantitatively, bargain purchases often yield various metrics that would need to be presented to support why the transaction is not at market, including an internal rate of return above the intrinsic discount rate for the acquired business or a below-market implied pricing multiple for the acquired business. However, it is also critical that such metrics are supported by an underlying forecast for the acquired business that reflects the current reality of the company and how other market participants would view the business.
Bargain purchases are typically composed of a seller who is dealing with a distressed asset in need of selling quickly, and require a buyer willing to purchase that distressed asset in a similar abbreviated timeline (potentially with expedited or even limited diligence). These purchases are rare but become more frequent in economic downturns, and it’s important for those engaging in the transactions to be aware of the unique accounting treatment associated with them.