Purchase Price Allocation -Importance and Examples
- Valuation of Infrastructure Assets
- Merger Valuation and Swap Ratio
- Acquisition Valuations
- Fairness Opinions
- Valuation of Plant & Machinery and Real Estate
Overview of Purchase Price Allocation
In acquisition accounting, the practice of assigning a purchase price to the target company's assets and liabilities acquired in a transaction by the acquirer is called purchase price allocation. Allocating the purchase price is a critical accounting step after a merger or acquisition is completed.
Currently accepted accounting standards, such as International Financial Reporting Standards (IFRS), require the use of purchase price allocation methods for all types of business combinations, including mergers and acquisitions.
Please note that our previous accounting standards required the purchase price allocation only for acquisition transactions.
This also includes pre-acquisition pricing analysis of products and services and estimating the uplift/dilution impact on earnings by providing provisional values and economic lives for acquired assets.
It also incorporates quota valuation or structuring into strategic value practices to model potential future impact on revenue valuation of contingent assets and contingent liabilities. Pro-Forma attributes are required for SEC and other regulatory filings.
Acquisition-date fair value measurement of consideration transferred previously held equity interest and remaining non-controlling interest.
Why is Purchase Price Allocation Important?
It helps determine fair value at the acquisition date and analyze useful economic lives of acquired assets, plant and equipment, identifiable intangible assets, and intellectual property such as brands, technology, ongoing research and development, and customer relationships.
The purpose of the PPA is to assess whether the fair values of all assets and liabilities on the opening balance sheet differ from their reported carrying amounts. Suppose the difference between fair value and the carrying amount is material.
In that case, the asset or liability is remeasured to fair value on the balance sheet, and goodwill is recognized as a reconciling item.
Common suspects for revaluation include interest in real estate, machinery, inventory, and affiliates, but may also include long-term loans. Measurement of contract liabilities (also known as revenue accrual) and other liabilities, as well as the valuation of options to buy or sell an investment, valuations of derivatives and other financial instruments, and subsequent market valuations (if any), allocation of the purchase price and goodwill to reporting units (cash-generating units), and tax assessment of corporations related to business combinations also fall under the respective allocation strategy.
Components of Purchase Price Allocation:
The Price Purchase distribution consists of the following components:
- Net Identifiable Products:
Net identifiable assets are the total assets less the total liabilities of the acquired company. An "identifiable asset" is something that has a specific value at a specific point in time, whose usefulness is recognized, and that can be sufficiently quantified.
Identifiable net assets represent the book value of the assets on the acquiree's balance sheet. It is important to understand that identifiable assets include both tangible and intangible assets.
A write-up is an adjusted increase in an asset's carrying amount when the asset's carrying amount is less than its fair value. When independent business valuation professionals assess the fair value of the target company's assets, write-ups are determined.
- Good Will:
Essentially, goodwill is the amount paid in excess of the net value of the target company's assets minus its liabilities.
Goodwill is calculated as the difference between the sum of the fair values of the acquired company's assets and liabilities and the purchase price.
Because both US GAAP and IFRS require companies to remeasure all recognized goodwill at least annually and adjust for impairment when necessary, goodwill is important in its accounting. Goodwill is not amortized but may be amortized from time to time.
Please note that acquisition-related costs (including, but not limited to, various legal, consulting, or consulting fees) are not considered in allocating the purchase price. According to accounting rules, the acquirer must recognize the costs incurred in providing the corresponding service as an expense.
Standards on which Purchase Price Allocation is Based:
One of the key criteria is a thorough understanding of the financial reporting valuation requirements under ASC 805, Business Combinations (ASC 805), and International Financial Reporting Standards 3:
Business Combinations (IFRS 3). This can provide actionable insight. For important issues related to the customer, auditor, and regulatory issues.
Although ASC 805 and IFRS 3 are highly converged standards, certain differences remain between the two. Under ASC 805 and IFRS 3, an acquisition's purchase price is allocated fairly to the identifiable assets acquired, and liabilities assumed, subject to limited exceptions. An asset with an identifiable useful life is depreciated over its remaining useful life.
Examples of Purchase Price Allocation:
Company A recently acquired Company B for $10 billion. After the transaction is completed, Company A, as the acquirer, must allocate the purchase price in accordance with existing accounting standards. Company B's assets have a book value of $7 billion, and Company B's liabilities have a book value of $4 billion. Therefore, the value of Company B's identifiable net assets is $3 billion ($7 billion - $4 billion).
A valuation by an independent business valuation expert determined that the fair value of both the assets and liabilities of Company B was US$8 billion. This finding means that Company A will have to make a write-up of $5 billion ($8 billion - $3 billion) to adjust the book value of the Company's assets to fair market value.
Increase. Finally, since the actual price paid for the acquisition ($10 billion) is the sum of the identifiable net assets and the write-up ($3 billion + $5 billion = $8 billion), Company A must be recognized. Therefore, Company A should recognize goodwill of $2 billion ($10 billion-$8 billion).
Understanding M&A Cycle in PPA:
- Identify the right deal:
Actively select companies and lines of business or respond to market offers (one-to-one or auction). This phase includes setting corporate strategy, identifying growth areas, and selling non-core activities.
- Pricing and Offer:
Initial pricing of the company and an assessment of the ease or difficulty of consolidation or separation and the most appropriate legal and tax structure (and its impact on pricing).
At this stage, A Sales and Purchase Agreement is drafted, the relevant authorities are informed and consulted, and the ‘closing’ procedures are executed.
- Deliver the promise returns:
After the transaction is completed, it should achieve the expected result how to realise synergies and avoid future strategic reassessments where new businesses are seen as non-core activities and sold off (without added value).
How ESPECIA helps in Purchase Price Allocation?
ESPECIA provides its best services in Price Purchase Allocation by understanding the M&A Cycle of the Transactions. They take a reliable estimate of the purchase price to determine the amount that is to be paid in the transaction.
And after allocating the purchase price as much as possible to all the assets acquired and liabilities assumed, what remains is the goodwill – the residual value that the company expects to monetize in the future.
We also focus on creating the actual value by identification of the acquired assets and synergies, consolidating post-deal financial statements, and delivering the promised returns after the transaction, which is also the last step of the M&A Cycle.
Then depending on the transaction structure, we form an income tax perspective as tax treatment for intangibles and goodwill that have to be measured at fair value. Our team of experts measures this value by applying appropriate valuation methods and residual value allocated to capital reserve.
This purchase price allocation highlights emerging patterns in the early days of IND AS adoption related to the recognition and valuation of intangibles in various industries. It also showed that the value attribution to the dealer network is the lowest and is considered an important factor for many industries but not a major factor in acquisitions.
Usually, non-compete clauses only form most of the acquisitions as a buyer's protection. However, the attribution of value to non-compete clauses is rather low, indicating a short lifespan or perceived minimal potential/impact of competition.
The price would be received by selling an asset or transferring a liability in an orderly transaction between the market participants at the measured date.
The equation of an M&A deal is value creation which is equal to the sum of hard synergies and soft synergies, subtracting the transaction costs.
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Amortisation of intangibles is the process by which purchases of non-physical intangibles are expensed over their expected reasonable useful lives.
Amortization Expense amount = Historical cost Intangible asset – Residual value /useful life assumption or necessary daily utilities.
We calculate goodwill as follows:
Goodwill Created value = Purchase Price value – Net Tangible Book Value – Fair Value Write-Up + Deferred Tax Liability (DTL).