Purchase Price Allocation (PPA) is an accounting procedure in acquisitions aimed at attributing value to the assets and liabilities of the acquired company.
This evaluation occurs post-transaction completion. This is done mainly for accounting purposes, following the IFRS and US GAAP standards. These standards require companies to disclose the Fair Value assets and liabilities of the “Acquired Company.”
In simpler terms, PPA helps break down a business’s purchase cost into the values of its various assets and debts, which is crucial for accurate financial reporting.
The effective date of the PPA will typically be the closing date of the acquisition. The company can perform it internally or engage Independent Valuation Experts to execute the process, utilizing various PPA methodology processes.
What are PPA’s Components?
Knowing the PPA’s basic inclusions is the first step to understanding the concept better. Below are the components of PPA:
1. Net Identifiable Assets
Net identifiable assets (NIA) are the assets a company gets when it merges with or buys another business.
To figure out NIA, the company looks at the value of what it gained from the other business. These assets earn the label “identifiable” because the company retains the ability to sell them independently, if necessary.
It reflects “the recorded value” on the acquired company’s balance sheet, comprising both tangible and intangible assets. These assets include the following:
- Tangible Assets are physical assets with a finite useful life, such as property, plant, equipment, and inventory.
- Identifiable Intangible Assets: Intangible assets that can be separately identified and valued. Examples include trademarks, patents, customer relationships, and technology.
- Liabilities: Debts and obligations the acquired company owes to third parties, such as loans, bills payable, and accrued expenses.
2. Write-ups
Writeup refers to the difference between the asset’s carrying and fair market values.
If there is an increase between these two, the company adjusts the asset’s book value. The independent business valuation expert establishes a write-up when completing the target company’s book value.
3. Goodwill
Typically, Goodwill is the difference between the purchase price paid for the acquiring company and its total FMV of assets and Liabilities.
It is the amount paid more than the target company’s net value (Assets – Liabilities).
GAAP and IFRS require a company to re-evaluate its goodwill annually and adjust if needed, as goodwill is not depreciable but amortized sometimes.
For Example, Company A has a valuation price (Including Tangible & Intangible assets) of $15M. Company B acquired company A for $20M. It means the buyer company pays the excess of $5M as part of goodwill.
Note that the Acquiring company will pay any legal, advisory, or consultation fees incurred, which will not be a part of the Purchase Price Allocation.
What are the Methodologies to calculate Purchase Price Allocation?
Purchase Price Allocation (PPA) is a systematic process in business combinations involving five key steps. The steps include:
- Determine the fair value of the consideration paid.
- Revalue all existing assets and liabilities to their acquisition-date fair values.
- Identify the intangible assets acquired.
- Determine the fair value of identifiable intangible assets acquired.
- Allocate the remaining consideration to goodwill and assess the reasonableness of the overall conclusion.
Step 1: Determine the fair value of the consideration paid.
- Assess the value of various forms of consideration, such as cash, shares, promissory notes, and contingent payments, at their acquisition-date fair value.
- Examples include determining the fair value of cash consideration on the closing date and assessing the fair value of share consideration based on trading prices.
Step 2: Revalue All Existing Assets and Liabilities to Their Acquisition-Date Fair Values.
- Recognize existing assets and liabilities acquired in the business combination at fair value on the purchase date.
- Examples include representing actual working capital transferred on the acquisition date and revaluing property, plant, and equipment to their fair values.
Step 3: Identify the Intangible Assets Acquired.
- Separate and document all identifiable intangible assets acquired as part of the business combination.
- Examples include identifying order backlog, customer relationships, non-compete clauses, patents, trademarks, and proprietary technology.
Step 4: Determine the Fair Value of Identifiable Intangible Assets Acquired.
- Evaluate the acquisition PPA methodology and calculate the Internal Rate of Return (IRR) of the acquired business.
- Value identifiable intangible assets using PPA methodologies such as the asset approach, market approach, and income approach.
Step 5: Allocate the Remaining Consideration to Goodwill and Assess the Reasonableness of the Overall Conclusion.
- Allocate any remaining consideration to goodwill and assess the overall reasonableness of the conclusion.
- Use metrics like the Weighted Average Return on Assets (WARA) to evaluate the appropriateness of the overall result and the amount of goodwill.
What are the best practices to follow when calculating Purchase Price Allocation?
Considering the complexity of calculating Purchase Price Allocation, below are the best practices to make an informed decision and arrive at an accurate target company’s worth.
- Classifying and recognizing the acquired company’s total assets and liabilities is important, including both tangible and intangible assets.
- Precision in recording the consideration—whether in cash, shares, or other assets—is important during the PPA process.
For example, cash payments are straightforward, typically reflecting the sum exchanged on the closing date. In assessing share consideration, the trading price of the shares on the acquisition date determines the fair value.
When dealing with deferred payments or promissory notes, it’s essential to consider the time value of money and the associated risk of non-payment to arrive at an accurate fair value assessment.
- Involving valuation experts and financial professionals with experience in business combinations can help ensure accuracy, choose the correct PPA methodology and compliance with accounting standards.
- The reviewer should be able to follow the PPA methodology process sequentially, for which maintaining detailed documentation of the valuation process, including assumptions, PPA methodology, and key inputs used to determine fair values, is important. This will eventually help in audits and ensure compliance with accounting standards.
- Ensuring the separate accounting of all identifiable intangible assets acquired in a business combination from goodwill is crucial. These assets originate from contractual or legal rights or are separable.
Beyond Basics – Tried-and-True Methods for Purchase Price Allocation
Understandably, conducting Purchase Price Allocation is an important process to determine the worth of the acquiring company. This also aligns the acquisition with IFRS standards and other regulatory compliance.
PPA helps the investors and other stakeholders understand how the acquired company will contribute to the organization’s financial health.
It is also evident that choosing the appropriate PPA methodology and valuation involves complex financial and accounting considerations, including the valuation of intangible assets.
The process includes validating a huge combination of assets, requiring specialized knowledge and valuation techniques expertise. It is advisable to involve an Independent valuation professional to make the process easier.
During mergers & acquisitions, both companies should have transparent communication to address any issues that may arise and be ready to solve concerns promptly to ensure a smooth and correct PPA process.
