Purchase Price Allocation

The purchase price allocation is an accounting practice to assign fair value to the assets and liabilities in a merger or acquisition. Moreover, the purpose of PPA is to accurately allocate the purchase price of an acquired company among its tangible and intangible assets and liabilities.

The method, falling under the International Financial Reporting Standards (IFRS), is applied in numerous countries. Companies consider it an essential step after concluding a merger and acquisition transaction. Hence, it does not account for the charges and expenses incurred during the acquisition. Therefore, the acquirer initiates the process after completing the acquisition by assuming the target company.

• Purchase price allocation determines the fair value of assets and liabilities owned after a merger or acquisition.
• It is done under the IFRS and US GAAP as a necessary accounting procedure for financial reporting and tax purposes.
• Good accounting software can facilitate the entire process of recording and tracking asset and liabilities values, enabling the derivation of PPA when needed.
• Furthermore, it assists in recognizing different assets at their fair value after completing the acquisition, allowing the determination of various GAAP ratios.

The purchase price allocation (PPA) is an accounting process used in business acquisitions to allocate the purchase price of the acquired company among its tangible and intangible assets. In simple terms, when a merger or acquisition occurs, it is the process of two companies merging to form a collaboration of a new or different company.

Furthermore, in an acquisition, a financially stronger company takes over a small or less stable business for various reasons. Thus, in both cases, the power and holdings reside with one company, and when such an acquisition occurs. The leading company takes over its target business and receives its assets and liabilities.

Therefore, after concluding the deal, the company executes the purchase price allocation schedule to understand the fair value of assets. This is necessary to actively track, record, maintain, and adjust the company's financial books.

Moreover, auditing a purchase price allocation includes the following steps:

• Understanding the transaction
• Review documentation
• Perform substantive testing
• Reviewing amortization and impairment
• Review disclosure
• Consider tax implication
• Documentation
• Finalize audit report

Moreover, a purchase price allocation asset deal can offer several advantages, such as acquiring specific assets that align with the buyer's business strategy, avoiding unwanted liabilities, and simplifying regulatory approvals.

According to the PPA rules, the allocation process does not account for acquisition-associated costs, including legal fees, consulting charges, and advisory expenses. Additionally, due to its complexity and the participation of valuation experts, companies perform purchase rice allocation meticulously to ensure adherence to accounting standards and regulations. Overall, the primary aim of purchase price allocation analysis is to provide accurate and transparent financial reporting in compliance with accounting standards after an acquisition.

The components of purchase price allocation analysis are -

#1 - Net Identifiable Assets

It includes both tangible and intangible assets. The simple determination of net identifiable assets is the total values of the target company's acquired assets minus the total liabilities. Hence, the critical aspect of such assets is that they are the book value of assets on the balance sheet, which is a proper value at a point in time with recognizable benefits.

#2 - Goodwill

Goodwill is treated as an asset that does not depreciate but, in some cases, gets amortized over time. It is the difference between the asset's fair market value and the target company's liabilities. Here, the amount paid is surplus to the acquired company's net assets minus its liabilities. As per IFRS, the acquirer must recalculate the recorded goodwill at least once a year and track impairment adjustments. Besides, it reflects the intangible value of the acquired company's reputation, brand, customer base, and other factors that are not individually identifiable.

#3 - Write up

A write-up only arrives if an acquired asset's carrying value is less than its fair value. Moreover, a  write-up is an adjusting increase to an asset's book value if its carrying value is less than its fair market value. It is only derived when the acquirer business specialist concludes the assessment of the target company's fair market value.

The step-by-step process to deduce the purchase price allocation of any company's tangible and intangible assets -

1. Fair value indication of the identifiable assets.
2. Determining the distinguishing gap between the collective fair values and the purchase price of assets and liabilities in goodwill.
3. Assuming liabilities at fair value and adjusting newly acquired assets from the target company.
4. Recording balance on the acquirer's balance sheet.

Let’s understand the concept better with the help of examples.

Example #1

Suppose two friends, Michael and Mason, own two firms in the same industry; Michael's company is comparatively more significant than Mason's. One day, Michael suggests acquiring Mason's company, and he agrees. Michael buys Mason's company at the price of $9 million. After the acquisition is concluded, the purchase price allocation needs to be performed by Michael.

Hence, as per the book value records, Mason has assets equal to $5 million and, at the same time, has total liabilities of $3 million. The liabilities are subtracted from the assets amounting to $2 million to determine the net identifiable assets.

After Michael appoints an independent valuation professional to determine the fair market value of the assets, that is, the book value is $5 million. Therefore, the asset's fair market value comes to be $4 million. Michael must adjust the asset value to derive the difference; thus, $4 million - $2 million equals $2 million (write-up).

At last, the goodwill is recorded; Michael paid $9 million for Mason's firm, but the total of net identifiable assets and write-up amounted to $4 million; the difference of $5 million is the recorded goodwill.

Example #2

Amdocs, a software company founded in Israel, signed an acquisition agreement to take over Teoco Services Assurance for $90 million. Teoco is a telecom software company based out of Virginia in the US. The deal is done to offer end-to-end orchestration offering and enable communication service providers to monetize dynamic customer experiences.

Moreover, Amdocs estimates Teoco's revenue to be insignificant in fiscal 2023, adding around 0.5% to overall revenue in fiscal 2024. Amdocs anticipates the revenue from Teoco to be immaterial; Amdocs will finish allocating the purchase price after which the effect on GAAP diluted EPS will be established. However, it is expected to remain neutral for the fiscal year of 2023 to 2024.

The importance of purchase price allocation rules are -

• PPA ensures that the acquiring company's financial statements accurately reflect the actual value of the acquired company's assets, liabilities, and intangible assets.
• This analysis leads to detailed disclosures in the financial statements' footnotes. These disclosures explain the allocation process, valuation methodologies, critical assumptions used, and the impact on financial results.
• Hence, a well-executed PPA provides insights into the composition of acquired assets and liabilities.
• It distinguishes between different forms of assets and liabilities and makes the independent company aware of the future aspects of the following merger or acquisition.
• Proper PPA enables meaningful comparison of different acquisitions and their impacts on financial performance.
• Moreover, it helps with taxation purposes, keeping the record, and making accounting adjustments.

This article has been a guide to Purchase Price Allocation and its meaning. Here, we explain its examples, how to calculate it, importance, and components. You may also find some useful articles here -

• Negative Goodwill
• Mergers and Acquisitions Types
• Synergy in M&A