Badwill (Definition, Example) | Accounting Treatment

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 Goodwill. The key reason an acquirer pays a 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.

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:

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 offer to the shareholders of the target company or gaining ownership in the open market. Hostile takeovers are opposite of friendly takeovers 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 Combination 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 Goodwill.
In the books of accounts of the acquirer, the value of Negative Goodwill is allocated to reduce the cost of non-current assets acquired to zero.
After reducing the cost of non-current assets to zero, the remaining value of badwill is recognized as an Extra-Ordinary Gain 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.

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Journal Entries of Badwill

The acquiring company can recognize the negative goodwill as “Extraordinary gain” or “Bargain Purchase Gain” by following Journal Entry:

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 Equipment 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 assets of XYZ Inc. is more than the consideration value paid by ABC Inc., the transaction can be termed as Bargain Purchase 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:

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 flows to meet the financial obligation or through a hostile takeover.