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Why do some companies hawk their assets at less than fair value?
David M. Katz, CFO Magazine
May 1, 2011
What a difference a quarter makes. Had JPMorgan Chase bought Washington Mutual on or after January 1, 2009, it would have faced reporting requirements that would have cast the deal in a different light. The earnings outlook would likely have looked weaker over the long term, for one thing, taking away some of the luster that the deal enjoyed at the time.
Indeed, JPMorgan's September 25, 2008, purchase of failing Washington Mutual's banking operations from the Federal Deposit Insurance Corp. looked like a steal: for the $1.9 billion it shelled out that day, it acquired an operation with a fair value amounting to a cool $10 billion. Under the Financial Accounting Standards Board's business-combinations rule then in effect, the $8.1 billion difference between the fair value of the assets and the purchase price constituted the bulk of what was then called "negative goodwill."
For JPMorgan, the ability to account for goodwill under the old regime was anything but negative. Instead of having to book the $10 billion as an extraordinary gain on its income statement, the bank used that $8.1 billion to reduce the fair value of the WaMu assets it acquired. The company reported the remaining $1.9 billion gain as negative goodwill on its income statement. (That figure was only coincidentally the amount of the purchase price.)
Now in the process of parceling out the $8.1 billion gain as income in the years following the acquisition, the bank appears to be slowly but surely boosting its income by decreasing the depreciation and amortization of its assets. "As a result, $8.1 billion of nonrecurring gain takes on the appearance of a more recurring quality," contend the authors of a report by the Georgia Tech Financial Analysis Lab on the changes in accounting for negative goodwill.
The Future Is Now
As of 2009, FASB began to regard "negative goodwill" as a contradiction in terms, and now calls the product of such sweet deals "bargain purchase" amounts. As a result, acquirers can no longer set those amounts off against the fair value of acquired assets and report increased income over future years. Now the acquirer must recognize the entire fair value of the bargain-purchase gain as soon as the deal is done.
Further, the new reporting standard asks companies a fundamental question: Why would a target want to sell its assets to you at less than their fair value?
Spilling the Beans
A look at JPMorgan's 2008 10-K at the time it was issued would have provided hardly a clue as to what could have driven WaMu to provide the acquirer with such a bargain. For more, you would have had to consult the news media — and learned that the purchase was merely the biggest of the distressed sales of banks the FDIC was engineering in the wake of the biggest economic downturn since the Great Depression.
Under FASB's revised 141(R) standard, though, JPMorgan would have had to spill the beans. Besides reporting the amount of the gain recognized in a bargain purchase, and the line item in the income statement in which the gain is recognized, acquirers must supply a "description of the reasons why the transaction resulted in a gain."
Since 2009 was the first year in which corporate preparers of the previous year's 10-Ks were required to supply such disclosures, CFOs are only now getting a view of how their peers strike such deals and disclose them, according to Charles Mulford, director of the Georgia Tech lab and an accounting professor at the university. "It's the first glimpse we have into how companies are applying this new accounting standard, and so [finance chiefs are] getting some practical insight into how others are applying it," he says.
Traditionally, bargain purchases have been largely triggered by distressed or bankrupt firms eager to get cash for their assets. Although comparative figures don't yet exist, that motive was no doubt enhanced by the economic conditions of 2009. For the Georgia Tech report, researchers Mulford and Eugene Comiskey examined disclosures related to 71 bargain-purchase transactions that took place in 2009. Of those, 24 involved FDIC-assisted acquisitions of distressed commercial banks.
Perhaps because the standard has just been implemented, many filers failed to provide the reason for the bargain-purchase transaction. Of the 47 remaining nonbank deals the researchers reviewed, reasons for the purchases were disclosed in just 19 cases.
Among those that did supply a rationale, there was evidence of boilerplate. "The gain on bargain purchase resulted from the value of the identifiable net assets exceeding the value of the purchase consideration," Astro-Med reported in its January 31, 2010, 10-K. In its annual report issued on the same date, Netezza Corp.'s language describing an acquisition was identical.
Still, in the aggregate, the disclosures reveal that there are many reasons for bargain purchases other than financial distress. Among them, an acquirer's willingness to gobble up all the target's assets at once, instead of in a piecemeal sale; the target's desire for a quick exit from a noncore business; and the absence of competitive bidding.
Often the reasons seem unique. In May 2009, for example, EDAC Technologies, a maker of jet-engine components, acquired the manufacturing business unit of MTU Aero Engines North America for $9.5 million. For that price, EDAC was able to report in its January 10-K a net gain of $11.9 million, resulting in a bargain purchase under the new rules.
What motivated MTU to offer such a bargain to EDAC? To be sure, MTU had incurred significant losses in the manufacturing unit in previous years, and reported that "the sale comes as a result of a review and realignment of our entire production structure." But what really held the price down was a condition attached to the sale. "They did not want to see their people terminated upon the transaction," says Glenn Purple, CFO of EDAC. The acquirer met that condition, "leading us to realize a sizable gain."
In other cases, the acquisition of an intangible, initially hard-to-measure asset can produce excellent value for the acquirer. In the production of metals, for instance, the assurance of a stable energy source can be a very valuable commodity.
That is part of the reason that Dow Corning's November 2009 acquisition of Globe Metais Industria e Comercio, a silicon metal producer with manufacturing operations in Brazil, qualified as a bargain in terms of accounting. The acquirer's purchase price exceeded the value of the assets it obtained by $14.8 million, according to the 2010 10-Ks of both Dow Chemical and Corning, which own Dow Corning in a joint venture.
Dow Corning's gain stemmed mainly from its obtaining "access to a stable and favorably priced supply of electricity under a long-term contract" and other intangibles, according to the parent companies' financials. The other factors were the condition of Metais's property, plants, and equipment relative to their replacement cost, and the benefit of a tax reserve that dovetailed with Dow Corning's plans for the acquisition.
As beneficial as such acquisitions might be in terms of the acquirer's strategy and management of risk, however, they provide no long-term advantage in the eyes of sophisticated investors and credit analysts. "We try to neutralize or take out unusual, nonrecurring items to find sustainable earnings and sustainable cash flow," says Sherman Myers, a director at Standard & Poor's.
If financial-statement users ultimately understand which gains to discount, then the new standard might well advance FASB's oft-stated goal of highlighting the "true economics" of a transaction.
That might motivate companies to dip into the hordes of cash currently on their balance sheets in order to grab a bargain-basement deal. Says Mulford: "If you can do a deal with all cash at one time, or if you can find a target that's illiquid or in a hard-to-understand industry with no other bidders, there might be opportunities to gain acquisitions at less than fair value."
David M. Katz is New York bureau chief and senior editor for accounting at CFO.