Bargain purchases provide an excellent opportunity to secure assets at insanely low prices. These situations often arise when owners need to sell a company quickly to repay debts, exit the market or distribute assets among co-owners. While it certainly saves your company in upfront costs, you need to account for the bargain on the balance sheet. So, how do you accomplish this? Let’s start with the basics.
What Is a Bargain Purchase?
A bargain purchase is a type of business transaction in which one company buys another company or its assets for less than its fair market value. These commonly occur when sellers experience financial difficulties. However, they can also happen when the buyer and seller have different perspectives on the company’s value.
Purchases far below fair market value do not happen often. Companies for sale usually try to generate as much interest from as many potential buyers as possible. This drives up competition and reduces the company’s risk of receiving low-ball offers. However, some companies serve such a niche market that even with the best of efforts, they might not have a lot of potential buyers.
What Is a Good Gain on Bargain Purchase Example?
The best way to understand this principle is to see an illustration of how it plays out in realistic situations. For example, you might have the opportunity to purchase a company for $500,000, even though you know it is worth at least $1,000,000. In this case, you would recognize a $500,000 gain on the purchase when you record it on your balance sheet.
One real-life example involves the sale of Lehman Brothers to Barclays during the Great Recession. Court records indicated that Barclays spent only $45 billion in cash for a company worth roughly $50 billion, which led to a $5 billion gain.
Balance Sheet Accounting for Bargain Purchases
In order to correctly record a bargain purchase on your balance sheet, you first need to account for the difference between the fair market value of the company and the amount you paid. This difference is known as the gain on purchase. Your accounting team might need to record the gains on the purchase as an asset on your balance sheet.
In typical transactions, residual goodwill refers to the difference between the purchase price and fair value. Because bargain purchase deals occur below even the fair market value, this can generate a negative goodwill amount. Accountants sometimes record this as zero goodwill and expense the remaining balance on the income statement.
In some cases, accountants and auditors prefer not to account for purchases as bargains. Supporters of this approach posit that the market value of the assets is equivalent to the price they sell for to the buyer. Both acknowledging and ignoring the presence of these purchases have downsides, so CFOs need to plan accordingly to address the quantitative and qualitative implications.
How To Measure Bargain Purchases
To begin measuring a bargain purchase, you first need to determine the company’s fair market value you intend to buy. You can do this by appraising the company’s assets and liabilities and its potential earnings power. Once you have determined the company’s fair market value, you can compare it to the price you paid for the company. If you paid less than the fair market value, you have made a bargain purchase.
In some cases, the gain is more subjective, and your team might not account for it. For example, a company might have a fair market value of $500,000. Still, the new owner estimates that it could generate $1,000,000 with the proper marketing and leveraging of her own company’s technology.
This type of bargain does not usually show on the balance sheet. One reason for this is that a bargain purchase in finance generally accounts for the assets’ independent value, not the potential or combined worth with your business.
The Tax Implications for Gains on Bargain Purchase in Finance
When you realize a gain on the purchase of a company, you may be subject to capital gains taxes. In fact, the IRS generally requires entities to include the difference between the purchase price and fair market value as income. Taxes on this income can cut your profits, so factor this into your decision-making process.
Additionally, consider the potential tax implications of any debt you assume as part of the purchase. If you take on the seller’s debt, you will be responsible for paying it off. This can have a significant impact on your bottom line, so make sure you understand the terms of the sale before you agree to anything. Here are some examples of potential debts you could become responsible for:
- Working capital loans
- Commercial mortgages
- Equipment loans
- Business lines of credit
The Bottom Line
A bargain purchase can provide a great way to acquire a company at a discounted price. However, you need to be aware of the potential risks and repercussions before entering into any such deal. Additionally, ensure you understand the tax implications and the accounting treatment and plan accordingly.
