What is Badwill?
Badwill, also known as Negative Goodwill, is referred in the case of mergers and acquisition transaction when a company purchases a target company for a price less than its fair market value. Reasons to companies to sell below fair value or book value include financial distress, huge debt, hostile takeovers, uninformed sellers or no potential acquirer.
Explanation
Whenever an acquirer company buys a target company and pay a consideration value that is higher than its fair market value, the difference is termed as GoodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price.read more. The key reason an acquirer pays the price over its market value is because of the target company’s intangible assets such as brand value and customer distribution network. However, sometimes companies acquire distress companies where the fair value of all the assets is more than the consideration paid to acquire those assets.
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Causes of Badwill
There are several reasons companies sell their assets or business for the sale consideration amount that is way less than the fair market value of the assets, such as:
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- Financial Distress: If a company is in distress and reporting losses in past years consistently or having negative Free Cash Flows consistently in the past years, the chances are the valuation of the company may fall below the market value of its assets.
- Huge Debt: If there is a significant level of leverage in a company with no consistent positive cash flows to meet the financial obligations, it can lead to the sale of the assets of the entity for a lower value than its market price.
- No Potential Acquirer: If a company wants to sell its business or a division but face difficulties in finding the buyer, then this may cause the target company to accept the lower sale consideration.
- Hostile Takeovers: Hostile takeovers refers to the acquisition of the target company by the acquirer without the consent of its Board of Directors. These takeovers take place in a forced way, either filling a lawsuit, by making a tender offerTender OfferA tender offer is a public proposal by an investor to all the current shareholders to purchase their shares. Such offers can be executed without the permission of the firm’s Board of Directors and the acquirer can coordinate with the shareholders for taking over the firm.read more to the shareholders of the target company or gaining ownership in the open market. Hostile takeovers are opposite of friendly takeoversFriendly TakeoversA friendly takeover occurs when the target company peacefully accepts the acquisition offer. The takeover is subject to the approval of the target company's shareholders as well as regulatory approval to ensure that the acquisition complies with antitrust laws.read more wherein both the acquirer and seller mutually agrees to the acquisition of the business, thus, sometimes close the deal with low sale consideration value resulting in badwill
- Uninformed Seller: Sometimes, the seller isn’t aware of the potential growth and market value of its business, and due to the lack of awareness accepts the lower valuation of its business.
Accounting Treatment of Badwill
In the United States, The Statement of Financial Accounting Standards (SFAS) 141 Business CombinationBusiness CombinationA business combination is a type of transaction in which one organization acquires the other organization and therefore assumes control of the other organization's business activities and employees. In simple terms, it is a consolidation of two or more businesses to achieve a common goal by eliminating competition.read more is applied for the accounting treatment of the Badwill.
According to the SFAS 141,
- If the fair value of the assets acquired is more than the consideration price paid for the acquisition of the assets, the resulting difference is termed as Negative GoodwillNegative GoodwillNegative goodwill is a negotiated purchase made by one company for acquiring the other company whose assets value more than the actual amount paid. Here, the selling company faces hardship and is ready to sell off its assets at a meager price.read more.
- In the books of accounts of the acquirer, the value of Negative Goodwill is allocated to reduce the cost of non-current assetsNon-current AssetsNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company's investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark.read more acquired to zero.
- After reducing the cost of non-current assets to zero, the remaining value of badwill is recognized as an Extra-Ordinary GainExtra-Ordinary GainExtraordinary Items refer to those events which are considered to be unusual by the company as they are infrequent in nature. The gains or losses arising out of these items are disclosed separately in the financial statement of the company.read more in Income Statement.
Many countries recognize the Negative Goodwill or Badwill according to the International Financial Reporting Standard (IFRS) 3 along with Accounting Standard Codification (ASC) 805 that contains the guidance note for the recognition of Negative goodwill. The accounting treatment is the same as stated above for IFRS 3 as it combines the contents of SFAS, SEC regulations, and FASB positions.
Journal Entries of Badwill
The acquiring company can recognize the negative goodwill as “Extraordinary gain” or “Bargain Purchase Gain” by following Journal Entry:
Journal
| Date | Particulars | Folio | Debit | Credit |
|---|---|---|---|---|
| XXX | Value of all the Assets Acquired | $0.00 | ||
| To Bank | $0.00 | |||
| To Extraordinary Gain on Bargain Purchase | $0.00 |
Example
Let us say, ABC Inc. acquired the entire business of XYZ Inc. for a consideration value of US $ 500 million. On the date of acquisition, the fair market value of XYZ Inc. net assets (including Property, plants, and EquipmentProperty, Plants, And EquipmentProperty plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. read more and other current assets minus non-current liabilities as well as current liabilities) was the US $ 650 million.
As the fair market value of the net assetsNet AssetsThe net asset on the balance sheet is the amount by which your total assets exceed your total liabilities and is calculated by simply adding what you own (assets) and subtract it from whatever you owe (liabilities). It is commonly known as net worth (NW).read more of XYZ Inc. is more than the consideration value paid by ABC Inc., the transaction can be termed as Bargain PurchaseBargain PurchaseBargain purchase happens when a company acquires another company at a price less than the fair market value of its assets.read more with the Badwill amounting to the US $ 150 million. (US $ 500 million minus the US $ 650 million)
ABC Inc. can recognize the value of negative goodwill of US $ 150 by recording the following journal entry:
Journal
| Date | Particulars | Folio | Debit | Credit |
|---|---|---|---|---|
| XXX | Net-Assets Acquired | $650.00 | ||
| To Bank | $500.00 | |||
| To Extraordinary Gain on Bargain Purchase | $150.00 |
Conclusion
Badwill occurs when the acquiring company acquires the net assets of the target company for a considerable price that is lower than the fair value of the company’s assets. These transactions take place when the target company is in financial distress, or have a significant debt with no positive, consistent cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more to meet the financial obligation or through a hostile takeover.
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