Even assuming that the reported book value (some $84 per share) of The Bear Stearns Cos. is overstated — because substantial asset write-downs have yet to be incurred — it seems apparent to most observers that the “true” book value is probably much closer to the reported figure than to the price JPMorgan Chase & Co. is paying. To be sure, JPMorgan is set to acquire the equity of Bear Stearns for about $2 per share. If that happens, this deal is a rare accounting phenomenon — a so-called bargain purchase.
Before discussing the accounting-treatment implications of the deal, there are some potential tax implications to consider. At this point, little information has been provided regarding the terms and structure of the deal: the press release describes a “stock for stock exchange” in which each share of Bear Stearns will be acquired in exchange for 0.05473 of a share of JPMorgan. So, without more information, the deal appears to be intended to qualify as a tax-free reorganization. If that’s so, the Bear Stearns shareholders will be precluded from recognizing, for tax purposes, the losses they realize on the exchange.
Under the tax code, specifically Section 354(a)(1), “…no gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are…exchanged solely for stock or securities…in another corporation which is a party to the reorganization….” In these cases, the exchanging shareholders will hold the shares they receive at the same basis at which they held the shares surrendered in the exchange (see Section. 358(a)(1)). As a result, a Bear Stearns shareholder — who holds the JPMorgan stock she receives at the same basis at which she held the surrendered Bear Stearns stock — will have to sell the JPMorgan stock received to record a deductible loss for tax purposes.
Alternatively, a Bear Stearns shareholder could sell her stock before the merger. In such cases, an investment of the sales proceeds in JPMorgan stock should not, because of all of the conditions that must be satisfied before the merger can proceed, run afoul of the wash sale rules. The stock of Bear Stearns, the sale of which will produce a loss, and the stock of JPMorgan should not, at least until the date on which the shareholders approve the merger, be regarded as “substantially identical” for purposes of the wash sale rules.*
Accounting for a Bargain Purchase
Accounting for the transaction under new fair-value rules presents other interesting considerations for deals in general. In December the Financial Accounting Standards Board promulgated new guidance with respect to the accounting for business combinations (see FAS 141(R)). That pronouncement defines a business combination as a transaction or other event in which an acquirer obtains control of one or more businesses. It seems clear that the proposed transaction involving Bear Stearns and JPMorgan will constitute such a business combination, and therefore must be accounted for using the acquisition method. Under this method, as of the acquisition date, the acquirer recognizes the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree (which remains outstanding). The acquirer is instructed to measure these items at their acquisition date fair-market values.
Further, the acquirer must recognize goodwill as of the acquisition date. Goodwill usually appears on the acquiring company’s books as the excess paid over the target’s listed book value. Under FAS 141(R), goodwill is measured as the difference between (a) the excess of the consideration transferred and the fair value of any non-controlling interest in the acquiree and (b) the net of the acquisition date amounts of the identifiable assets acquired and the liabilities assumed (or to which the acquired property is subject).
FAS 141(R) goes further, and also recognizes that in rare and extraordinary cases, there can be negative goodwill, which would mean that the business combination is dubbed a bargain purchase. To be sure, the JPMorgan/Bear Stearns deal seems to be one of those cases, in which the amount depicted in (b) would exceed the amount referred to in (a). In fact, FAS 141(R) provides that “…a bargain purchase might happen, for example, in a business combination that is a forced sale in which the seller is acting under compulsion….” Accordingly, FAS 141(R) states that in a bargain purchase, the “excess” is recognized in earnings as of the acquisition date.
Thus, if FAS 141(R) is applicable to this transaction, JPMorgan will be permitted, in fact required, to record as income — in the year in which the business combination is completed — the amount by which the acquisition date fair-market value of Bear Stearns’s net assets exceeds the consideration transferred.
It seems unlikely, however, that FAS 141(R) will govern the accounting for this transaction. The rule is applied only to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, and it clearly states that earlier application is prohibited. Accordingly, assuming the deal is completed in 2008, the new accounting standards for business combinations will not be applicable here.
Thus, the current accounting model for business combinations will almost certainly govern the manner in which JPMorgan will account for what might be termed the “negative goodwill” arising from the acquisition of Bear Stearns. As seems to be the case here, there is an excess of fair-market value of net assets received over the fair value of the consideration paid. As a result, the excess must be allocated as a pro-rata reduction of the amounts that would otherwise have been assigned to the acquired assets, except for some “financial” assets.
If any excess remains once this basis “step-down” is completed, the remainder should be recognized as an extraordinary gain in the period in which the business combination is completed. Accordingly, it seems highly likely that JPMorgan will, as an added enticement to pursue this transaction, be in a position to record a substantial amount of income as a result of what appears to be, by all accounts, its bargain acquisition of Bear Sterns.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com. This extra column was written in response to JPMorgan’s announcement that it would acquire Bear Stearns.
*See Section 1.1233-1(d);Reg “…ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation…In certain situations, they may be substantially identical; for example, in the case of a reorganization the facts and circumstances may be such that the stocks and securities of predecessor and successor corporations are substantially identical….”