Negative goodwill may not mean a bargain purchase

Acquisitions of struggling banks are producing record profits due to negative goodwill ‘bargain purchase gains’. The Q1 2023 earnings of Citizens Bank was $9,504m compared with $264m in the same period last year, largely due to its Silicon Valley Bank deal.

Negative goodwill arising from business combinations is reported as an immediate profit under both IFRS and US GAAP; but does it really represent an increase in shareholder value? We explain the meaning of negative goodwill, its relevance for investors and why we think (at best) only part should be recognised as a profit.

In a recent article we examined some of the financial reporting issues relating to the failure of Silicon Valley Bank (SVB), including how amortised cost accounting meant that losses went unrecognised in the financial statements (and, it appears, unnoticed by the market). However, unreported losses for shareholders in SVB and some other banks now seem to be turning into significant (albeit different) profits for the banks that have acquired these failed businesses.

UBS has recently disclosed an estimated $35bn profit due to its acquisition of Credit Suisse. First Citizens BankShares (Citizens Bank) has recently reported a gain of $9.8bn following its acquisition of part of Silicon Valley Bank, which increased net income from $264m in Q1 2022 to $9,504m in Q1 2023. In both cases the gains arise from the recognition of negative goodwill.

In consolidated group financial statements, the acquisition of a business is reported as the purchase of the individual underlying assets and liabilities. In a process called a ‘purchase price allocation’, the acquisition date fair values1Fair value is used as a measure of the effective price paid for each asset and liability. For assets that are measured at cost, the acquisition date fair value becomes the cost basis to use going forward. of each asset and liability acquired are recognised in the consolidated financial statements, including some that were not previously included in the financial statements of the acquired business, such as certain intangible assets. The difference between the (accounting) value of the individual assets and liabilities acquired and the purchase price is called goodwill.

In most business combinations the purchase price exceeds the sum of the individual assets less liabilities. This produces positive goodwill which is reported as an intangible asset. The accounting for positive goodwill is itself controversial, particularly whether this asset should be amortised, and how (and when) any loss in value should be recognised through impairment. For more about the accounting for positive goodwill, and why we think that current accounting is deficient, see our articles ‘Goodwill accounting – Investors need something different’ and ‘Goodwill impairments may not identify impaired goodwill’.

Negative goodwill bargain purchase profit may not faithfully represent performance

In contrast, recent bank acquisitions have resulted in negative goodwill, where the price paid for the business is less than the sum of the values of the net assets acquired. In accounting this is regarded as a ‘bargain purchase gain’ that companies are required (by both US GAAP and IFRS) to recognise immediately in profit and loss.

Clearly a business combination can add value for the acquiring company where the transaction has positive net present value. However, negative goodwill is not a valid measure of this gain, and, in our view, recognition of negative goodwill in profit and loss does not produce realistic measures of performance.

Citizens Bank purchase of Silicon Valley Bank

Below is an extract from the purchase price allocation note reported by Citizens Bank in Q1 2023, following its acquisition of Silicon Valley Bank. This shows the calculation of the $9.8bn “gain on acquisition”

Citizens Bank did not acquire the whole of SVB. The deal primarily involved assuming the customer deposit liabilities and the acquisition of the cash and deposit balances and loan portfolio assets. Interestingly, the transaction was classified as a business combination rather than simply an asset purchase, so we assume more business activities, including perhaps SVB employees, were also part the deal. Had the purchase not been regarded as a business under US GAAP, no gain would have been reported, with the purchase price simply allocated to the net assets acquired rather than these being recognised at their acquisition date fair values.

Nevertheless, the fact that only part of the business was acquired, and that the deal appears to be closer to a pure asset purchase, is significant in evaluating the transaction, and contrasts with the other negative goodwill transaction we mention above – the purchase of Credit Suisse by UBS.  More on this later.

Extract from Citizens Bank purchase price allocation for the acquisition of SVB

First Citizens BankShares Q1 2023 10Q

The aggregate fair value of the assets and liabilities acquired that is disclosed in the above purchase price allocation is $45.5bn. This is $6.3bn lower than the book value previously reported by SVB of $51.8bn (disclosed in the footnote to the table). Although some of this difference relates to other items, including a deferred tax adjustment, a significant portion is because the fair value of the loan portfolio is lower than the previous carrying value2One of the problems for investors trying to understand the financial statement effects of business combinations is the lack of disaggregation in the purchase price allocation disclosures. In our view, it would help if companies were required to separately identify the adjustments made to each asset and liability, and analyse these adjustments between fair value differences and other effects, such as differences in accounting policy and deferred tax. For example, the net asset fair value adjustment shown in the table below is after the recognition of a deferred tax liability of $3.3bn. The disclosures seem to suggest that this all arises because of the acquisition fair value adjustments, but we are unable to reconcile this.. Presumably the lower fair value reflects a current assessment of the credit quality of the loans and the effect of changes in market interest rates, including credit spreads.

The purchase price for these net assets, mainly payable in the form of a loan note, was only $35.3bn (the fair value of the total consideration was $35.7bn, as disclosed in the PPA). The purchase price was negotiated to reflect a $16.5bn “asset discount” (the prior carrying value of the net assets less the purchase price). The discount is partly a reflection of the lower fair value for the assets acquired, but the remainder is the negative goodwill gain which is reported in profit and loss. 

Here is our reinterpretation of the above disclosure to show the relationship between the purchase discount and negative goodwill gain.

Summary of the Citizens Bank negative goodwill ‘gain on acquisition’

First Citizens BankShares disclosures and The Footnotes Analyst estimates

The purchase of Silicon Valley Bank business seems like a great deal for Citizens Bank. They have acquired assets at a significant discount to the amount previously reported by SVB and, more importantly, well below the fair value of those assets. Therefore, it seems logical to recognise a profit, and that this should be viewed positively by the market.

Clearly, negative goodwill gains are likely to be non-recurring and investors will allow for this when forecasting future performance. But one-off gains (if they really are gains) are just as much part of profit as recurring items and should never be ignored when analysing performance.

However, we think that the problem for investors is that negative goodwill may not always represent an economic gain for the parent company shareholders and, even if it does, it may be unwise for this gain be recognised as a profit in the income statement. The problem is that goodwill (including negative goodwill) is more complex that it might seem.

The components of goodwill

In most business combinations the goodwill that results from the purchase price allocation is made up of multiple and interconnecting factors, only one of which actually represents an immediate economic gain or loss for the purchasing company shareholders.

In the table below we analyse goodwill into 4 components, each of which could be positive or negative, with goodwill being the sum of these differences. If the components add up to a positive figure the result is recognised as an asset (although this asset is subject to an impairment test). If the sum is negative, the total is reported as a bargain purchase gain in profit and loss. The immediate recognition of a negative goodwill profit applies whatever the combination of the positive and negative components, and even if the deal does not produce a positive net present value.

A more comprehensive way of thinking about goodwill

Investment NPV and synergy gains

The day 1 value effect of purchasing a business is the net present value of that investment. This equals the value gained through the purchase – a combination of the value of the business on a stand-alone basis and any value enhancement achieved through the combination (commonly called synergy gains) – less the price paid for the investment. If a business was previously fairly priced by the market on a stand-alone basis, the net present value of the deal equals the difference between the value enhancement (synergy gains) and the acquisition premium paid (the amount paid in excess of the ‘undisturbed’ price before the acquisition).

Only synergy gains that are ‘paid away’ in the purchase consideration affect goodwill

There can be multiple reasons for a value enhancement through a business combination, some of which may relate to the business of the purchasing entity rather than the new subsidiary. Synergy gains may include cost savings, value gains through reorganisation and improved management, and new value creating opportunities for the combined business. The analysis of these can be challenging for investors and, importantly from a financial reporting perspective, measurement is likely to be highly uncertain.

In many cases the NPV of the investment and the synergy gains will have the opposite effect on overall goodwill. For example, assume a business is acquired for 100 which is a premium of 20 to the stand-alone business value of 80. If the business value is the same as the fair value of underlying net assets (we consider this issue below) then goodwill is 20. But suppose the expected synergy gains from this transaction are 30. As a result, the investment has a positive net present value of 10 that, in effect, reduces the amount of goodwill. Overall goodwill is therefore the expected synergy gains less the net present value of the investment.

Goodwill reflects synergy gains to the extent these are ‘paid away’ in the form of a purchase price premium. However, this is only part of goodwill.

Business value versus accounting net asset value

The last two components of goodwill in our table reflect the difference between the stand-alone value of the equity shareholders’ interest in a business and the accounting net asset value.

When a business is consolidated into group financial statements it is not the business itself that is included but rather the underlying individual assets and liabilities. Even though (most of) these assets and liabilities are restated to their fair value at the date of acquisition, and additional intangible assets may be recognised, the sum of these individual items will rarely equal the value of the business3Some commentators suggest that because balance sheet net asset value is often very different from business value this must indicate a deficiency in financial reporting. While it is true that many assets (particularly intangibles) are omitted from the balance sheet and that there are valid arguments to extend asset recognition, we do not think the objective of financial reporting should be to reflect all business value in the balance sheet. Businesses are fundamentally different from a collection of individual assets and liabilities.. The difference can be significant and a major contribution to goodwill.

The difference between business value and net asset value can be positive or negative. Positive factors include:

  • Unrecognised intangible assets: Many additional intangibles are recognised as a result of a business combination. Perhaps unsurprisingly, there appears to be little intangible value in the case of SVB – Citizens Bank has only recognised a small ‘core deposit intangible’ in the purchase price allocation. However, there are some intangibles that do not qualify for recognition in financial statements, such as the value arising from the assembled management team and employees. Effective management will enhance profitability and therefore business value, but this is unrecognised in balance sheet net assets, which contributes to goodwill.
  • Other unrecognised sources of business value: The difference between business value and accounting net asset value is more fundamental than simply unrecognised assets. What is being measured is entirely different. The value of a business reflects the future and may include the effects of growth opportunities or real option value that obviously cannot be a present accounting asset of that business.

The value of a business can also be less than the values of the underlying individual assets and liabilities. Companies that are in trouble, or are uncompetitive, will correctly trade below net asset value to reflect the expected future losses (or profits below a fair return) and the anticipated costs of reorganising and, potentially, discontinuing elements of a business.

You may argue that these future costs and expected losses should be recognised as a liability at the time of the business combination. If such a liability were included in the purchase price allocation, much of the negative goodwill would likely disappear. But in financial reporting there are strict rules that govern the recognition and measurement of liabilities.

Anticipated reorganisation costs are unlikely to be recognised as a liability in a PPA

Accounting does not permit the recognition of expected future losses as a liability even if such losses are highly likely to occur. Anticipated reorganisation costs can only be recognised as a liability once the business is committed to a specific plan. It is not enough for management to simply think there is a risk that losses will be incurred, or a restructuring is likely, as illustrated by this extract from the IFRS standard, IAS 37, below (US GAAP is similar).

IAS 37 Provisions, Contingent Liabilities and Contingent Assets

IAS 37 paragraph 72

Part of the reason why accounting is so strict regarding what can be a liability is to avoid the problems of companies using ‘big-bath provisions’ to manipulate reported results. Prior to the current approach to liability recognition and measurement, acquisition related provisions were a favoured technique to artificially boost profitability following a business combination. Fortunately, that is no longer the case, but the consequence of this can be misleading negative goodwill gains.

Of course, there are accounting adjustments that may arise from poorly performing businesses, such as the potential for asset impairments and the need for onerous contract provisions. However, these should already be captured by measuring the acquired assets and liabilities at fair value.

Bargain purchase gain likely to be followed by reorganisation cost losses

Negative goodwill is often simply an indication that a poorly performing business has been acquired. The recognition of a negative goodwill gain will be followed by losses and reorganisation costs in future periods as these occur. It is for this reason that we think in many cases negative goodwill does not indicate a bargain purchase at all and that the gain reported in profit and loss is misleading and should not be regarded by investors as a valid component of performance.

Only if part of negative goodwill represents a positive net present value for the transaction do we think that an economic gain arises and that it is potentially justified to recognise this as a profit.

Not all assets and liabilities are recognised at fair value

To complicate goodwill further, part of the difference between business value and the net assets recognised in a purchase price allocation is due to not all assets and liabilities being measured at fair value. Deferred tax and pension assets and liabilities are two examples where fair value is not applied, but instead the normal balance sheet measurement basis for these items is used.

  • Deferred tax: The lack of discounting and probability weighting for deferred tax can distort goodwill. We have previously highlighted this measurement problem in the context of deferred tax assets arising from tax loss carry forwards. In our article ‘Deferred tax fails to reflect economic value’ about the tax losses of Vodafone, we showed how the reported asset was significantly higher than its economic value to shareholders, due to the accounting not allowing for the time value of money. If a company in this situation were acquired, this valuation difference could well create a misleading negative goodwill bargain purchase gain.
  • Pension liabilities: A further example of valuation differences affecting goodwill is the measurement of pension liabilities. In a business combination purchase price allocation, pension liabilities are measured at the same amount that applies in other circumstances. As we explained in our article ‘A pension accounting asset may be an economic liability’ the reported liability may be lower than fair value – the amount that an acquirer would likely factor into a business valuation. Understating this liability can also result in lower positive or higher negative goodwill.

UBS versus First Citizens Bank

So have UBS and Citizens Bank increased shareholder value as a result of their acquisitions, and is the negative goodwill gain any indication of this? Considering our analysis above we are sceptical about whether you will learn much about their respective acquisitions through the negative goodwill gain. The past difficulties of Credit Suisse and the challenge of integrating that business may well mean that the immediate negative goodwill gain recognised by UBS will be offset by reorganisation costs and losses in subsequent periods.

However, for Citizens Bank the outcome may well be different. The fact that only part of the business was acquired, and that it seems the transaction was closer to a pure asset deal, may well mean that these subsequent challenges and expenses are avoided. In this case the purchase price discount and resulting bargain purchase gain could be a more reliable indication of a positive net present value for the investment.

But whatever the circumstances, our advice is to not assume that negative goodwill gains are an indication of a positive net present value for an acquisition, you will need to evaluate the value effects of a business combination for yourself.

Measurement uncertainty

We think that only a positive net present value could potentially be justified as an immediate profit in a business combination. The problem is that this gain is merely one potential component of negative goodwill, and it is difficult to separate the economic gain from the other accounting differences. Furthermore, the negative goodwill amount itself is uncertain because it relies on the valuation of individual assets and liabilities, for which many do not have readily determinable fair values. This is acknowledged by Citizens Bank in their critical accounting estimates disclosure.

Extract from Citizens Bank critical accounting estimates disclosure

First Citizens BankShares Q1 2023 10Q

This measurement uncertainty is a further reason why we think it is questionable whether a bargain purchase gain should be recognised. In financial reporting it is rare to find a day 1 value gain included in profit and loss, partly due to this measurement uncertainty. For example, in financial instrument accounting, there are restrictions in recognising day 1 gains when fair values are ‘level 3’. And in the recent IFRS 17 for insurance contract accounting, day 1 gains are recognised as a contractual service margin liability and only included in profit and loss over the life of the contract. The deferral of day 1 gains is applied irrespective of how valuable these contracts might be and the positive net present value that may result.

In our article about the recent debate regarding positive goodwill, we argued that goodwill primarily arises from a different basis for measuring businesses compared with accounting assets and liabilities, and that the best approach to goodwill accounting may be to eliminate it against equity rather than report it as an asset. We think that the same approach to negative goodwill would be better than recognising an immediate profit.

Insights for investors

  • Goodwill largely reflects a difference between the acquisition date shareholder interest in business value and the value of individual assets and liabilities. The balance sheet is not intended to fully capture business value.
  • It is the positive or negative net present value of a business combination that determines gains or losses for the acquiring company’s shareholders. Goodwill impairments and particularly negative goodwill gains may be a poor indicator of net present value.
  • Acquisitions which result in negative goodwill gains could actually reduce shareholder value if a negative NPV is offset by the goodwill valuation differences.
  • The lack of recognition of reorganisation costs and future losses as a liability in the purchase price allocation can be a significant factor in creating negative goodwill. As a result, negative goodwill gains may be offset by losses in subsequent periods.
  • In financial reporting it is rare to find day 1 valuation difference gains recognised as an immediate profit. We question the usefulness for investors of including negative goodwill gains in profit and loss.

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