By Michael French, CPA, ABV, CFE, Managing Director

In the complex landscape of mergers and acquisitions (M&A), purchase price allocation (PPA) plays a pivotal role when a transaction qualifies as a business combination. It is a critical accounting process that involves allocating the purchase price of an acquired company into its various components, including tangible and intangible assets, and liabilities. This allocation is essential for accurate financial reporting and tax purposes, ensuring that the acquiring company properly accounts for the acquired assets and liabilities on its balance sheet.

Purchase price allocations help with the valuation process by accurately reflecting value drivers for an acquired business and helping financial statement users understand each part of the purchased business value.

Valuing the acquired company’s assets is vital to accounting for the transaction under the Financial Accounting Standards Board (FASB) ASC Topic 805, Business Combinations.

Understanding Purchase Price Allocation

Purchase price allocation is the process of assigning the purchase price of an acquired company to its identifiable assets and liabilities. This practice is mandated by accounting standards such as the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP) in the United States.

The primary goal of PPA is to determine the fair value of the acquired company's assets and liabilities, which helps the acquiring company accurately reflect the acquisition in its financial statements.

Why Purchase Price Allocation is Important

PPA is crucial for several reasons:

• Accurate Financial Reporting: By allocating the purchase price to the acquired assets and liabilities, the acquiring company can accurately reflect the acquisition in its financial statements. This transparency is essential for investors, regulators, and other stakeholders who rely on these statements to make informed decisions.
• Tax Implications: PPA has significant tax implications. The allocation of the purchase price to different asset classes can affect the acquiring company's tax liabilities. For example, allocating more value to depreciable assets can result in higher depreciation expenses, reducing taxable income.
• Regulatory Compliance: Adhering to accounting standards and regulations is mandatory for publicly traded companies. Proper PPA ensures compliance with these standards, avoiding potential legal and financial penalties.
• Strategic Decision-Making: Understanding the value of the acquired assets and liabilities helps the acquiring company make strategic decisions regarding the integration and utilization of these assets. It also aids in identifying potential synergies and cost-saving opportunities.

Components of Purchase Price Allocation

The PPA process involves several key components:

• Net Identifiable Assets: These are the total assets of the acquired company minus its total liabilities. Identifiable assets include both tangible assets, such as property, plant, and equipment, and intangible assets, such as patents, trademarks, and customer relationships.
• Write-Up: This is an adjustment made to increase the book value of an asset if its carrying value is less than its fair value. The write-up amount is typically determined through an independent business valuation.
• Goodwill: Goodwill represents the excess amount paid over the fair value of the net identifiable assets. It is calculated as the difference between the purchase price and the total fair value of the acquired company's assets and liabilities. Generally. goodwill is not depreciated but is subject to annual impairment testing.
• Deferred Tax Liabilities: These arise when there is a difference between the book value and the tax base of the acquired assets. The acquiring company must account for these liabilities in its financial statement.

The PPA Process

The PPA process typically involves the following steps:

• Initial Assessment: The acquiring company conducts an initial assessment of the target company's assets and liabilities. This includes reviewing financial statements, conducting site visits, and engaging with management.
• Engaging Valuation Experts: Independent valuation experts are often engaged to determine the fair value of the acquired assets and liabilities. These experts use various valuation methodologies, such as the income approach, market approach, and cost approach.
• Identifying Intangible Assets: Identifying and valuing intangible assets is a critical part of the PPA process. Intangible assets, such as patents, trademarks, and customer relationships, can significantly impact the overall value of the acquisition.
• Allocating the Purchase Price: The purchase price is allocated to the identified assets and liabilities based on their fair value. This allocation is documented in the financial statements and reported to regulatory authorities.
• Recording Goodwill: Any excess amount paid over the fair value of the net identifiable assets is recorded as goodwill. Goodwill is subject to annual impairment testing to ensure it is not overstated.

Challenges in Purchase Price Allocation

Despite its importance, PPA can be challenging due to several factors, including valuation complexity, regulatory scrutiny, integration issues, and impairment testing.

Valuing intangible assets can be complex and subjective. Different valuation methodologies can yield varying results, making it challenging to determine the fair value accurately.

Regulatory authorities closely scrutinize PPA to ensure compliance with accounting standards. Any discrepancies or inaccuracies can result in legal and financial penalties.

Integrating the acquired assets and liabilities into the acquiring company's operations can be challenging. Proper PPA helps identify potential integration issues and develop strategies to address them.

Goodwill is subject to annual impairment testing, which can be complex and time-consuming. Any impairment must be recorded in the financial statements, impacting the acquiring company's profitability.

Summary

Purchase price allocation is a critical aspect of mergers and acquisitions, ensuring accurate financial reporting, regulatory compliance, and strategic decision-making. By allocating the purchase price to the acquired assets and liabilities, the acquiring company can reflect the acquisition's true value in its financial statements.

Despite its challenges, proper PPA is essential for the success of any M&A transaction, providing transparency and accountability to stakeholders.

For more information or a discussion about how to prepare for the PPA phase of your M&A transaction, contact your PKF Advisory team member or:

Michael French, CPA, ABV, CFE
Managing Director
Tel: 949.860.9891
Email: mfrench@pkfadvisory.com