A European example of problems with identifying bargain purchases
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 17th edition:
- “In 2012, the issuer acquired businesses A, B and C. The three acquisitions were mainly composed of fixed tangible assets, with a low value attributed to customer contracts, customer relationships, brand name or workforce. These acquisitions were accounted for through a Purchase Price Allocation (PPA), in which the issuer measured the fair value of the assets on the basis of the replacement cost of comparable utility.
- As the fair value of the acquired assets and liabilities assumed was in excess of the purchase price of each acquisition, the issuer recognized a gain from bargain purchase for each acquisition.
- In accordance with the provisions of paragraph 36 of IFRS 3, and before recognizing a gain from bargain purchase, the issuer reassessed the assets acquired and liabilities assumed to ensure that their measurement reflected all available information at acquisition date. The issuer considered that bargain purchase occurred due to the economic environment as well as the willingness of every seller to dispose of non-core assets after unsuccessful selling attempts and no competition for the acquired businesses. Furthermore, the strong balance sheet liquidity and access to financial markets of the issuer reinforced the negotiating position of the issuer, which foresaw to realize higher benefits in the long term because of its operational knowledge and large customer base.
- The PPA reflected the fair values of net assets in their current state. Furthermore, the issuer considered that future capital expenditures would result in price reductions and that bargain purchase would compensate for expected future losses or investments to be recognized.”
The enforcer (as ESMA likes to term it) disagreed with the issuer’s accounting, concluding that “the excess of fair value of net acquired assets over purchase consideration was mainly due to measurement errors.” Among other things:
- “As the determination of the fair value of tangible assets in the PPA excluded capital expenditure and additional investments, the enforcer considered that the assessment was inaccurate and should have included expectations of future cash outflows to reflect the current status and level of performance of the assets. Paragraph BC39 of IFRS 13 indicates that the exit price of an asset embodies expectations about future cash inflows and outflows associated with this asset. Fair value of the assets includes expectations of future cash flows and reflects assets’ current status and level of performance. In the enforcer’s view, any market participant would have to carry out similar investments to sustain the current operation, and would consequently take these costs into account in the calculation of the net present value of the assets. Expectations of future expenses will depress the price an acquirer is willing to pay and consequently the net fair value of the assets.”
In addition: “economic obsolescence should have been taken into account, as the acquired businesses faced environmental or regulatory requirements and reduced demand for the businesses’ products.” Overall, one imagines the enforcer tearing into this file with relative glee – the odds are always against an issuer happening upon any bargain purchases, let alone on three of them in rapid succession. Further, as ESMA has documented elsewhere, those bargain purchases that do exist may reflect accounting technicalities rather than a transaction’s economic substance: ““Enforcement experience…shows that in some situations bargain gains result because future restructuring costs (that do not fulfil the conditions of contingent liabilities) cannot be recognized, despite the fact they were considered in the negotiations when determining the purchase price of the acquisition or they were deemed necessary.”
Although it’s not very clearly expressed, the issuer’s reported notion that “bargain purchase would compensate for expected future losses or investments to be recognized” seems somewhat bizarre; most of us would conclude the opposite, that a prospect of a transaction generating future losses argues against it being a bargain purchase, rather than supporting it. That’s not the only instance of screwy thinking here – the issuer seems to have reasoned that the absence of any other bidders for the assets supported its premise that it made a bargain purchase (that is, because no bids existed to indicate otherwise) rather than casting doubt on it. But ESMA cites IFRS 13.BC134 in addressing this point, indicating that market inactivity isn’t an indicator that the transaction price may not represent fair value, but only that further work is necessary to determine whether it does.
ESMA also concluded that the issuer put too much weight on its own “large customer base and operational knowledge,” rather than focusing on IFRS 13’s concept of “an orderly transaction between market participants.” Overall, it seems that even though IFRS 3 all but falls over itself in urging preparers to proceed with care before recognizing a bargain purchase gain, the excitement of the prospect still leads some entities into rather giddy analysis….
The opinions expressed are solely those of the author