Last editedJuly 20223 min read
Mergers and acquisitions require extensive financial analysis to determine mutually agreeable terms, and this extends to what the financial statements will look like in the aftermath of a purchase. Purchase price allocation is one process used by valuation professionals to work out the fair value on paper of all assets and liabilities. So, what is purchase price allocation, and how does it work? We’ll explore its definition and give an example below.
What is purchase price allocation?
PPA, or purchase price allocation, is an acquisitions accounting process used to assign value to an acquired company’s assets and liabilities. This process takes place after the deal has already concluded. For example, imagine Company A has just purchased Company B, with all paperwork signed. Company A must assign fair value to all of Company B’s assets and liabilities, so that the accountants know what should be recorded on Company A’s financial statements. There is usually some unallocated value as well, due to purchase price allocation, goodwill and the company’s employees.
What is purchase price allocation used for?
PPA purchase price allocation is part of the International Financial Reporting Standards (IFRS), used in Australia and many other countries. It is most frequently used in the valuation of acquired companies for mergers and acquisitions. In the past, PPA was only required for acquisitions rather than mergers, but the updated standards require it to be used in both instances. You might also apply PPA if a new party takes control of the company, as in the case of a shareholder purchasing enough equity to take controlling interest.
What are the components of purchase price allocation?
There are three components of PPA to be aware of, including net identifiable assets, write-up, and purchase price allocation goodwill.
Net identifiable assets: This includes the total asset value for the acquired company once liabilities have been subtracted. Identifiable assets can include both tangible as well as intangible assets, provided they hold value at any point or clear benefits. These should appear on the target company’s balance sheet as the asset book value.
Write-ups: These refer to any adjustments to the asset’s book value according to an independent valuation expert. If there’s a difference between the carrying value and the current fair market value, the difference must be corrected with a corresponding write-up.
Purchase price allocation goodwill: If the acquiring company has paid more than the target company’s net value, the leftover amount is its goodwill. In other words, it’s the difference in price between the company’s fair market value and its purchase price. According to IFRS standards, goodwill needs to be evaluated at least once a year, with any adjustments recorded.
There might be other associated costs with mergers and acquisitions. These include things like legal fees, consultant costs, and advisory fees. However, these won’t be included as part of PPA calculations because they don’t relate to the asset value of the acquired company.
Purchase price allocation example
To put these various components into perspective, imagine the following purchase price allocation example.
Company A has just purchased Company B for a purchase price of $10 billion. The sale has been completed, so Company A now needs to perform a full PPA for accounting compliance.
Company B’s book value of assets equals $8 billion, while its book value of liabilities equals $2 billion. To calculate net identifiable assets, you subtract the liabilities ($2 billion) from the assets ($8 billion) to equal $6 billion.
Next, an independent valuation professional assesses the company to determine that the fair market value of the assets is $7 billion. Company A must adjust the asset value to reflect this difference in value: $7 billion (fair market value) - $6 billion (net identifiable assets) = $1 billion write-up.
The final step is to record goodwill. Company A paid $10 billion for the company, but the total of the net identifiable assets and write-up is $7 billion. This leaves a difference of $3 billion, or the goodwill.
Using good accounting software can help you keep track of all assets, liabilities, and more, all of which helps when the time comes to calculate purchase price allocation. GoCardless integrates with major accounting partners like Xero, Chargebee, and others, ensuring a streamlined workflow throughout the mergers and acquisitions process.
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