Purchase Price Allocation (PPA) Valuation
In this article, we will discuss what purchase price allocation is, how it is calculated, and why a business valuation is needed in doing the PPA.
In any merger and acquisition transaction, an important component is the Purchase Price Allocation (PPA). Purchase price allocation is when the acquirer allocates the purchase price into the assets and liabilities of the acquired company. When it comes to PPA, it’s important to know the acquired company’s fair market value, which can be determined through a business valuation.
Purchase Price Allocation Valuation
In acquisition accounting, purchase price allocation is done after a deal has closed, and it is a crucial part of accounting when an acquisition or merger is complete. For a PPA to be accurate, a proper business valuation must be done in order to determine the fair value of the acquired company’s assets and liabilities and the PPA must be performed in accordance with existing accounting standards and regulations.
What is the Purchase Price Allocation?
Purchase Price Allocation (PPA) is a practice in acquisition accounting in which an acquirer divides the purchase price across the assets and liabilities of the target company acquired in the transaction. PPA is required by current accounting rules, such as the International Financial Reporting Standards (IFRS), for any sort of business combination deal, including mergers and acquisitions. It’s worth noting that in the past, purchase price allocation was only required in takeover negotiations.
Main Components of Purchase Price Allocation
There are three components in purchase price allocation, which allows them to identify the basic valuation process and determine the net worth.
- Net identifiable assets – The whole worth of an acquired company’s assets less the total amount of its liabilities is referred to as “net identifiable assets”. It’s worth noting that “identifiable assets” are assets that have a specific value at a given time and whose benefits can be identified and adequately defined. Essentially, net identifiable assets are the book value of assets on the acquired company’s balance sheet. It’s vital to remember that identifiable assets can be both tangible and intangible.
- Write up – If an asset’s carrying value is less than its fair market value, a write-up is an adjusting increase to the asset’s book value. When an independent business valuation specialist completes an assessment of the fair market value of a target company’s assets, the write-up amount is established.
- Goodwill – The amount paid in excess of the target company’s net asset value minus its liabilities is referred to as goodwill. Goodwill is calculated to take the acquisition rate of an organisation and subtract the distinction among the honest marketplace fee of the property and liabilities. Companies are required to re-evaluate every recorded goodwill annually and record impairment adjustments if necessary. This is due to goodwill not depreciating but sometimes amortized over time.
Purchase price allocation example
There are two companies; namely Atlas Incorporated and Bashirian LLC. Atlas Incorporated acquired Bashirian LLC for $12 billion. After the acquisition, Atlas Incorporated must perform purchase price allocation according to existing accounting standards.
The book value of Bashirian LLC’s assets is $9 billion, while the book value of the firm’s liabilities is $6 billion. Hence, the value of the net identifiable assets of Bashirian LLC is $3 billion. This is found by deducting the liabilities from the assets ($9 billion-$6 billion).
After getting a valuation done by an independent business valuation specialist, the fair value of both assets and liabilities of Bashirian LLC was determined to be $10 billion. In order to adjust the book value of the company’s assets to its fair market value, Atlas Incorporated must recognize a $7 billion write up ($10 billion – $3 billion).
Importance of getting a PPA valuation
Under the International Financing Reporting Standards (IFRS), a PPA is required whenever there are any business combination deals (e.g. mergers and acquisitions). If the PPA was not done correctly, it could lead to problems for the acquirer. As per the Accounting Standards Codification (ASC) 805, the acquirer’s auditor has to review the valuations. If this is not done well, the auditor will have the acquirer and appraiser answer many questions, which takes time and costs money.
Understand purchase price allocation valuation
The process of buying an operating business, which includes due diligence, negotiations, and closing procedures, can take months. Accounting for the acquisition is often the last thing on the acquirer’s mind as they close a deal and navigate the operational constraints of integrating two organizations. Accounting for purchasing an operating firm (also known as a business combination) is a complicated process that most accounting and finance professionals do not deal with regularly. Due to a lack of experience with accounting for business combinations, the year-end financial reporting procedure might be complicated.
How to determine purchase price allocation valuation?
In order to determine the purchase price allocation valuation, there are several steps that needs to be taken:
Step 1 – Determine the fair value of the consideration paid
Cash, shares, promissory notes, contingent payments, earnouts, and other kinds of payment can all be used as consideration in a business combination. The consideration must be recorded at its acquisition-date fair value, regardless of its form or time. Here are several examples:
- Cash consideration – On the closing date, cash consideration is usually deemed to be representative of the purchase date’s fair value.
- Share consideration – In many purchase and sale agreements, a presumed price for share consideration is specified. However, this assumed price may or may not represent the true value of the shares issued to execute a PPA. The trading price on the purchase date is often the greatest measure of fair value for companies with shares trading on an active market, such as public companies.
- Deferred payments and promissory notes – Deferred payments occur when the vendor receives all or part of the purchase amount at a later date than the acquisition date. The fair value of delayed monetary consideration should include a discount for the passage of time and the risk of non-payment over the deferral term.
- Contingent consideration – Contingent payments are frequent in business mergers and acquisitions because they allow vendors and buyers to work through pricing differences. Contingent consideration can take several forms, but the most frequent one involves the acquirer agreeing to transfer more consideration if specific financial or operational benchmarks are met within a certain time frame.
Step 2 – Revalue all existing assets and liabilities to their acquisition-date fair values
Existing assets and liabilities acquired in a business combination must be recognized at fair value on the purchase date, as required by IFRS 3 and ASPE 1582. Here are several examples:
- Working capital – The PPA should represent the actual working capital transferred on the acquisition date, as well as any working capital modifications specified in the purchase and sale agreement.
- Property, plant, and equipment – Determining the fair value of property, plant, and equipment may require the assistance of a machinery and equipment appraiser or a real estate appraiser, depending on the estimated fair value and complexity of the property, plant, and equipment acquired.
- Intangible assets and goodwill – On a preliminary basis, any existing intangible assets and goodwill reported on the acquired company’s closing balance sheet are revalued to nil.
Step 3 – Identify the intangible assets acquired
The final step in completing a PPA is to ensure that all identifiable intangible assets acquired as part of the business combination are documented separately from goodwill. An intangible asset is considered identifiable if it comes from a contractual or legal right or is separable, according to both IFRS 3 and ASPE 1582. The following are examples of intangible assets commonly acquired incorporate combinations:
- Order backlog – Identified as an intangible asset due to its contractual nature, based on a study of open purchase orders and/or in-progress projects as of the acquisition date.
- Customer relationships – A contract with a specific customer is not required in order for the relationship to be valuable. Recurring revenue is generally a good indicator of the importance of a customer relationship.
- Non-compete clauses – Typically added as separate clauses in the purchase and sale agreement for shareholders who are either leaving the acquired company or staying with the acquirer.
- Contracts done above or below market rates – Long-term contracts conducted above or below market rates may meet an identifiable intangible asset criterion. A common example is a long-term facility lease secured at a rate that is presented above or below current market rates.
- Patents and proprietary technology – Each patent and piece of technology should be evaluated on its own. The presence of a patent does not always imply value, and acquired technology does not need to be patented to be valuable.
- Trademarks and tradenames – Review the trademarks and trademarks used by the acquired company and stated in the acquisition and sale agreement to see if they have market value. Whether or not the acquirer intends to use the name in the future, trademarks and trade names can be valuable.
Step 4 – Determine the fair value of identifiable intangible assets acquired
An examination of the acquirer’s acquisition methodology is usually the first step in preparing a PPA. The acquisition’s Internal Rate of Return (IRR) is then calculated by finding the rate that corresponds to the net present value of the acquired business’s after-tax forecast cash flows to the purchase price. The next stage is to value the identifiable intangible assets after the acquired intangible assets have been identified and computed the purchase IRR. For evaluating intangible assets, there are three widely accepted methods:
- Asset approach – The asset approach examines the total value of your company’s assets in order to determine the value of your business. Assets include tangible items (e.g. real estate, cars) and intangible assets like intellectual property (copyrights and trademarks). In other words, the asset-based value is equal to the book value of the company or the equity that the shareholders hold.
- Market approach – In the market approach, the value of your business is determined based on the selling price of similar assets. This approach studies the business’s recent sales of similar assets and makes adjustments for the differences between them. The market approach is best to use when there is abundant data available on comparable transactions.
- Income approach – Income approach values a business at the present value of its future earnings or cash flows, which are determined by projecting the earnings of the business. The cash flows and future earnings are then adjusted for changes in growth rates, taxes, cost structure and others.
Step 5 – Allocate the remaining consideration to goodwill and assess the reasonableness of the overall conclusion.
Goodwill is allocated to any consideration that is not allocated to the fair value of the assets (including identified intangible assets) and liabilities. A study of the Weighted Average Return on Assets can be used to determine the appropriateness of the overall result and the amount of goodwill (WARA). According to this research, the difference between the expected returns on all assets (excluding goodwill) and liabilities purchased and the acquisition IRR is the indicated rate of return on goodwill.
Issues you might get in purchase price allocation valuation
PPA can have a considerable impact on the income statement and balance sheet, depending on the magnitude and nature of the transaction. The amortization of intangible assets recorded at fair value throughout their useful lives affects profits and, as a result, taxation. In the event of a business cycle downturn, goodwill is vulnerable to impairment risk. An incorrect allocation of purchase consideration can have a number of negative consequences for your business:
- Depreciation and amortization are understated or overstated, resulting in volatility and other negative effects on net reported income.
- Year-end audit concerns are caused by a lack of documentation that explains the methodology, data reliability, and assumptions employed.
- Failure to allocate value to intangible assets results in an increase in goodwill, which raises the risk of impairment during annual testing; in the case of public firms, this could substantially influence investor sentiment and share price.
- Recasting the value of intangible assets, incurring major delays; could happen if your company is considering an IPO and detects PPA reporting errors from previous acquisitions during due diligence.
Get Eqvista to help with your PPA valuation!
Eqvista has considerable expertise in performing PPA valuations for mid-market transactions, having done so for hundreds of clients in various industries. Our team of seasoned finance professionals with worldwide accreditations from CFA and ASA provides smooth audit review support. For more information, contact us now!