Purchase Price Allocations in Restructuring Transactions

As an analysis of the transaction database MergerMarket shows, transactions out of insolvency have steadily increased in Germany in recent years and reached a new record high in 2020.

Due to the global coronavirus pandemic and the associated shocks to the economy, it can be assumed that the number of transactions not only out of insolvency, but generally in the field of restructuring, will also increase significantly in 2021. This can also be inferred from the comparison of the number of transactions out of insolvency in the coronavirus-stricken year 2020 with the year before:

This correlates with an increased number of turnaround investors who have gained extensive expertise in restructuring and mastered the art of turning financially distressed companies or their parts into ample investments.

In these transactions, very low to negative purchase prices can be achieved under certain circumstances as the acquirer assumes liabilities and the upcoming expenses for the restructuring of the target company.

Balance sheet disclosure obligation according to IFRS/HGB

Even with these low or even negative purchase prices, the purchase price allocation must be carried out during the initial consolidation within the course of the consolidated financial statements, both according to German accounting (HGB) and international financial reporting standards (IFRS). In the course of the purchase price allocation, the purchase price is allocated to the acquiree's identifiable assets, liabilities and contingent liabilities that are revalued at fair values. Any remaining difference between the purchase price and the revalued equity constitutes goodwill that must be reported as an intangible assets.

In the case of transactions in the context of restructuring, low purchase prices often lead to a negative consolidation difference, i.e. where the revalued equity (at fair value) exceeds the purchase price paid. In this case, additional regulations on the treatment of such a difference come into play.

German and international accounting principles are consistent with regards to the treatment of negative consolidation differences. Both ultimately require recognising the negative consolidation difference in the profit and loss statement (P&L). However, on a closer look, there are some differences between the approaches which we explain below.

Stronger focus on liabilities

Regarding international reporting standards, purchase price allocations are subject to IFRS 3 ‘Business Combinations’ (see M&A Vocabulary in M&A Newsletter February 2021). However, in the case of purchase price allocations performed in the context of restructuring, liabilities should be examined more closely to determine whether contingent liabilities or onerous contracts exist. Here, the regulations of IAS 37 continue to apply, according to which, for example, future operating losses cannot be recognised as liabilities.

The main difference lies in the treatment of contingent liabilities, which, under IAS 37, cannot be recognised and are disclosed in the notes to the financial statements only for information purposes. In the context of acquisitions according to IFRS 3, contingent liabilities (probability of occurrence < 50 per cent) can be recognised and must be carried as liabilities at their settlement amount.

IFRS: Gain from Bargain Purchase

If the revalued net assets exceed the cost, a negative consolidation difference (negative goodwill) arises. If this is due to the acquirer’s own bargaining skills and/or bargaining position, the acquirer gets the so-called bargain purchase. This means that the acquirer was able to negotiate a favourable purchase price. According to IFRS 3.36, before recognising a gain on a bargain purchase, the so-called reassessment has to be performed. The acquirer must reassess whether all of the assets acquired and all of the liabilities assumed were correctly identified and measured. Any additional assets or liabilities that are identified in that review must be recognised. This ensures that all information available at the acquisition date has been appropriately considered. If the reassessment confirms that a negative consolidation difference arose, it must be recognised immediately in the P&L (see IFRS 3.34).

HGB: Distinction Between Lucky Buy vs. Gain from Bargain Purchase

According to the regulations of the German Commercial Code (HGB), a negative consolidation difference must first be disclosed on the liabilities side as "goodwill arising from capital consolidation".

According to GAS 23, a distinction should be made between "negative consolidation differrences with equity or debt characteristics (the so-called lucky buy) and ‘technical’ negative consolidation differences".

If the negative consolidation difference arises from a lucky buy transaction, the more specific regulations of the GAS require a scheduled amortization of the difference in profit or loss over the weighted average remaining useful life of the acquired depreciable assets. If the difference is attributable to a non-depreciable asset, the difference is realised upon disposal through unscheduled amortization.

The "negative consolidation difference with debt characteristics" exists if expenses or losses expected at the acquisition date have reduced the purchase price. These can include restructuring expenses, expected losses, but also undervalued provisions. Depending on the circumstances, such a difference must be reversed through the P&L as of the acquisition date or periodically.

A technical difference can result, for example, from a belated initial consolidation of a company acquired some time ago or from the acquisition of an I/C receivable below book value, and should be examined separately on a case-by-case basis.

Conclusion

Generally, the negative consolidation difference, or negative goodwill, is calculated identically under the German and international reporting standards. However, the subsequent accounting can differ significantly and distort balance sheet analyses. Under IFRS, the consolidation differrences are recognised immediately in profit or loss, whereas under HGB rules (see GAS 23.144 et seq.) their amortization must be spread over the period in which they arose, or, in some cases, gains from them can even only be realised upon resale of the shareholding.

Purchase price allocations require a detailed analysis of the acquired assets and their proper valuation. In the context of restructuring, low purchase prices involve further requirements to the purchase price allocation.

Professional assistance with the purchase price allocation can help ensure the proper representation of the acquisition and a smooth initial consolidation process, especially in the context of restructuring.