Purchase Price Allocation (PPA): A Neglected Negotiating Tool

What Are Purchase Price Allocations and Why Are They Important?

Purchase Price Allocation (PPA) is a crucial process in mergers and acquisitions that involves dividing the total purchase price of an acquired business among its identifiable assets, liabilities, and equity. When a company buys another, PPA helps break down the price tag, showing how much goes to assets and debts. It’s a way of ensuring everyone gets a fair price for the assets. This allocation is guided by the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC), specifically Topic 805, which requires that assets and liabilities be measured and reported at their fair values at the acquisition date.

The importance of PPA lies in several key areas:

1. Financial Reporting: PPA directly impacts how the acquiring company presents the acquired assets and liabilities on its balance sheet, which is essential for accurate financial reporting.
2. Tax Implications: Different treatments of assets and liabilities can result in varying tax consequences. For example, the allocation can influence taxable income due to depreciation and amortization, affecting cash tax payments.
3. Goodwill Measurement: PPA determines the amount of goodwill recognized in the financial statements. Goodwill represents the excess of the purchase price over the fair value of identifiable net assets, reflecting the value of intangible factors such as brand reputation and customer relationships.
4. Strategic Planning: Understanding the allocation of purchase price assists in evaluating the business model and value drivers of the acquired entity, which is pivotal for strategic decision-making.
5. Compliance and Accuracy: Proper execution of PPA ensures compliance with accounting standards and prevents inaccuracies in financial reporting, which can lead to legal and financial ramifications.

Common Audit Scenarios Requiring PPAs

Here are a few common audit scenarios that may require Purchase Price Allocations (PPAs):

1. Business Combinations: When a company acquires another business, the transaction must be properly accounted for under ASC 805. This includes conducting a PPA to allocate the purchase price to the acquired tangible and intangible assets and liabilities.
2. Mergers and Acquisitions: Companies involved in mergers or acquisitions need to perform a PPA to reflect the fair value of assets and liabilities on their financial statements, especially if the merger involves significant changes in control or ownership.
3. Divestitures: When a company sells a business unit, it may need to conduct a PPA to understand the fair value of the assets being sold and to report the transaction accurately in its financial statements.
4. Impairment Testing: If a company has acquired intangible assets or goodwill, it must periodically test these for impairment. A PPA can provide a baseline for the fair value against which impairment can be assessed.
5. Private Company Elections: Private companies that elect to follow the Private Company Alternative (ASU 2014-18) may need a PPA to understand the components of goodwill and how they relate to the overall valuation of the business, particularly when certain intangibles are not recognized separately.
6. Tax Reporting Purposes: Both buyers and sellers must report their understanding of the PPA for tax reporting. This may arise during audits when the IRS reviews the business combination and the reported values, necessitating a well-documented PPA.
7. Financial Restatements: If a company needs to restate its financials due to errors or changes in accounting policy, a PPA may be required to re-evaluate the fair values of assets and liabilities acquired in past transactions.
8. Regulatory Review: Certain transactions may trigger scrutiny from regulatory bodies, requiring a PPA to substantiate the allocation of purchase price and ensure compliance with accounting standards.
9. Integration Planning: After a merger or acquisition, companies often need to assess the value of synergies and the integration of assets, which can necessitate a PPA to inform strategic planning and operational adjustments.

These scenarios highlight the importance of conducting a PPA to ensure compliance with accounting standards and facilitate accurate financial reporting.

How Purchase Price Allocations (PPAs) are Performed

Purchase Price Allocation (PPA) is performed by dividing the total purchase price of an acquired company among its various assets and liabilities. The process involves several key steps:

1. Determine the Total Purchase Price: This includes the base price agreed upon in the purchase agreement, which often reflects the enterprise value of the target company.
2. Identify Assets and Liabilities: The acquiring company identifies both tangible and intangible assets and liabilities of the acquired company. Tangible assets may include property and equipment, while intangible assets could involve intellectual property, brand value, or customer relationships.
3. Fair Value Assessment: Each identified asset and liability is valued at its fair market value (FMV) at the time of the acquisition. This valuation is essential as it reflects the current worth of the assets and liabilities, rather than their book value.
4. Allocation of Purchase Price: The total purchase price is allocated among the fair value of the identified assets and liabilities. This allocation ensures that the acquiring company’s financial statements accurately reflect the acquisition.
5. Adjusting Financial Statements: The acquiring company adjusts its balance sheet to account for these allocations, impacting financial reporting and tax considerations.

How Does Purchase Price Allocation Work in M&A?

Purchase Price Allocation (PPA) is a critical process in Mergers and Acquisitions (M&A) that involves distributing the total purchase price of an acquired company among its identifiable assets and liabilities. This is necessary to reconcile the differences between the book value (the value recorded on the balance sheet) and the fair market value of these assets and liabilities at the time of acquisition. The process typically follows a four-step approach: first, determining the total purchase price; second, identifying the fair value of the acquired assets and liabilities; third, allocating the purchase price to these identified items; and finally, recognizing any residual amount as goodwill. Goodwill represents the premium paid over the fair value of identifiable net assets, reflecting intangible aspects such as brand reputation, customer relationships, and potential synergies.

PPA is essential for financial reporting and compliance with accounting standards, as it ensures accurate representation of the acquired company’s financial position. It also provides insights for strategic decision-making and tax planning after an acquisition. For example, using methods like the “With or Without” approach or the “Multi-Period Excess Earnings Method,” companies can evaluate the fair value of intellectual property and other intangible assets associated with the acquisition. By systematically valuing assets and liabilities, PPA not only aids in understanding the economic rationale behind a transaction but also plays a pivotal role in the post-M&A integration process. Furthermore, the PPA process involves several critical considerations and methodologies that can significantly impact both the acquiring company’s financial statements and its overall strategy.

Valuation Approaches in Purchase Price Allocation

The valuation of identifiable assets and liabilities in a PPA can be performed using various approaches, including the income approach, market approach, and cost approach.

1. Income Approach: This method estimates the value of intangible assets based on the expected future economic benefits they will generate. For instance, the income approach is particularly effective for valuing customer relationships, patents, and proprietary technologies by discounting the forecasted cash flows back to their present value.
2. Market Approach: This approach determines the value of assets by comparing them to similar assets that have been sold in the market. It provides a benchmark based on market data, which can be especially useful for valuing tangible assets like real estate or machinery.
3. Cost Approach: This method involves calculating the cost to replace or reproduce an asset, adjusted for depreciation and obsolescence. It is valuable for acquiring physical assets, such as equipment or facilities, where replacement cost provides a reliable indicator of value.

Choosing the right valuation approach is crucial, as it influences the reported values of assets and liabilities on the acquirer’s balance sheet. The selected method not only affects financial reporting but can also have significant tax implications and affect future business decisions.

Considerations When Selecting a Valuation Methodology

When determining the appropriate valuation approach for PPA, several factors should be considered:

1. Nature of the Acquired Assets: The characteristics of the purchased assets — whether they are tangible, intangible, or a mixture of both — will significantly guide the selection of the valuation method. For instance, while the cost approach may be suitable for physical assets, intangible assets like trademarks may necessitate the income or market approach to accurately reflect their value.
2. Availability of Data: The availability and reliability of market data can greatly influence the choice of method. If a market approach can be supported by robust data from comparable transactions, it can provide a justified basis for valuation. However, in cases where data is limited, the income approach utilizing projected cash flows might be necessary.
3. Purpose of Valuation: The context in which the valuation is being performed influences the choice of methodology. For instance, if the valuation is intended for financial reporting purposes under accounting standards such as IFRS or GAAP, a more rigorous and standardized approach may be necessary. Conversely, if the PPA is being used for internal management decisions or strategic planning, the organization might opt for a more flexible method that aligns with their operational goals and forecasting models.

Example of Objective’s Purchase Price Allocation

Understanding the nuances of Purchase Price Allocation (PPA) under ASC 805 is crucial for businesses that have recently undergone a merger or acquisition. By exploring a detailed example of a PPA, you can gain valuable insights into how to accurately assess and report the fair values of acquired tangible and intangible assets, as well as associated liabilities. This process not only ensures compliance with GAAP for financial reporting but also aids in recognizing goodwill and its components. Proper execution of a PPA can significantly impact your consolidated financial statements and future audits.

View an example of Purchase Price Allocation

Final Thoughts

Purchase Price Allocation (PPA) is a vital process in Mergers and Acquisitions (M&A) that involves distributing the total purchase price of an acquired company among its identifiable assets and liabilities. This process adheres to accounting standards like FASB ASC Topic 805 and IFRS. The PPA typically follows a four-step approach: determining total purchase price, identifying fair values of assets and liabilities, allocating the purchase price, and recognizing residual goodwill. Goodwill accounts for the premium paid above the fair value of identifiable net assets, reflecting intangible benefits such as brand reputation and potential synergies. PPA is crucial for accurate financial reporting, strategic decision-making, and tax planning, while also facilitating a smoother post-acquisition integration. Overall, PPA serves not only as a compliance tool but also as a strategic asset in negotiations during M&A.

Disclosure

This article is for informational purposes only and does not constitute an offer, invitation or recommendation to buy, sell, subscribe for or issue any securities. While the information provided herein is believed to be accurate and reliable, Objective Capital Partners and BA Securities, LLC make no representations or warranties, expressed or implied, as to the accuracy or completeness of such information. All information contained herein is preliminary, limited and subject to completion, correction or amendment. It should not be construed as investment, legal, or tax advice and may not be reproduced or distributed to any person.  Securities and investment banking services are offered through BA Securities, LLC Member FINRA, SIPC. Principals of Objective Capital are Registered Representatives of BA Securities. Objective Capital Partners and BA Securities are separate and unaffiliated entities.