Purchase Price Allocation

The most memorable moment in any M&A transaction is often when the deal is signed to buy or sell the company. It is just one stage in the M&A process, and each step impacts the others. We will be looking at the Purchase Price Allocation (PPA), which is one of the important steps need to take after once the deal is closed.

Purchase price allocation (PPA), a form of goodwill accounting, is a method by which a company (the acquirer) allocates the purchase price to various assets and liabilities resulting from the transaction.

The United States has a standard for conducting a PPA. This is the Statement of Financial Accounting Standards No. 141 (revised 2007), “Business Combinations” (“SFAS 141r”)  SFAS 142, “Goodwill and Other Intangible assets” (“SFAS 142”) [2] The FASB “Accounting Standards Codification,” (“ASC”) is effective for the financial statements for interim and year periods that ended after September 15, 2009.

It reorganizes FASB statements and serves as a single authoritative source for U.S. accounting standards and reporting standards for nongovernmental entities. ASC Topic 805 contains the guidelines set forth by SFAS 141r. The International Accounting Standards Board oversees the process by issuing IFRS 3.

The purchase price allocations are made following the purchase method for merger and acquisition accounting. After publication of the Statement of Financial Accounting Standards No. 142, the United States discontinued a second method, known as pooling or pooling of interests. 141 “Business Combinations” (“SFAS 141”), and SFAS 142. [3]

Integration of financial statements

Now that the deal is closed, M&A advisors have left the scene, and integration of the acquired company has begun, lawyers and M&A attorneys have also left. Next, the external accountant comes knocking at the door. The transaction must be properly documented in the financial statements.

The consolidated annual report must now reflect the acquired company. Although it may seem insignificant and perhaps a little boring, this activity should be completed as quickly as possible. The balance sheet of the acquired business is all you need. It’s not difficult. Sometimes it can be not easy.

Alignment of accounting principles

The acquirer may have different accounting principles than the acquired company. As such, the acquired company’s financial statements must be aligned to the accounting principles of its acquirer. If the acquired company plans to change from Dutch GAAP to IFRS, it could be quite a very difficult task, as there are requirements for IFRS 15 (revenue recognition) and IFRS 16(lease accounting).

Allocation of the purchase price

The financial reporting standards (RJ, IFRS) require that the purchase price paid in a business combination be allocated mainly to the assets acquired and liabilities assumed. This process is known as a “purchase price allocation” or PPA. This can be tricky. The purchase price could not have been paid in cash only but may also include equity or deferred or conditional payment like earn-outs. Therefore, it is possible that the final value of the purchase might not be known until the PPA is completed.

Fair value adjustments

To determine mainly the amount of goodwill paid in the transaction, it is necessary to have an accurate and a reliable estimate of the purchase price. Goodwill is the difference in the purchase price and the net assets acquired. This goodwill amount might not be recognized in the balance sheet.

The PPA evaluates if the fair values of all assets or liabilities on the opening balance sheets differ from the declared book value. Suppose the fair value or book value is significantly different. In that case, the asset/ liability is revalued on the balance sheet to its fair worth, using the goodwill amount for a balancing item. Real estate, inventory, machinery, equipment, and investments in associates are all common targets for revaluation. Long-term loans may also be considered.

Identification, valuation, and recognition of new assets and liabilities

The acquired entity might have assets or liabilities that do not meet the criteria to be recognized before, in addition to fair value adjustments for items already on the opening balance sheets. This will be the case if a company has a reputable brand name that it developed internally for the product sold.

The buyer will have likely considered the brand when deciding the purchase price and paid goodwill for it. The reporting standards will require that the brand name be valued and recognized in the books. Another example of identifiable items is customer relationships, contracts or databases, intellectual property, and favorable or unfavorable contract terms.

Cash-generating units that generate goodwill

After all, liabilities assumed and assets acquired have been allocated to the purchase price, goodwill remains. This is the value the company hopes to recover from assets in the future, such as future growth or synergies effects. This goodwill amount must be retested annually to determine if it is recoverable by the company. If the goodwill amount is not recoverable, either in whole or in part, it will impair goodwill.

To monitor the recovery over time and in the cases of multiple cash-generating units, the smallest group that generates assets independently from the rest, such as a product segment or business unit, the final goodwill amount must be allocated to cash-generating units.

Controller Challenges

The person who is being instructed to perform the PA (the internal financial controller) has often never been part of the M&A transactions team. Professionals who once worked on this deal are too busy. A purchase price allocation is not a common event for many controllers. This is why most do not need to be specialists in this type of accounting.

Imagine the challenges this person would face.

The controller is limited in his experience in PPA. He has not participated in the transaction process, often without the support of the M&A Transaction Team and proper (internal transaction documents). This means that the controller must, among other things, determine what was agreed to in the share purchase arrangement (SPA), determine the purchase price, understand the assumptions underlying financial forecasts used as a on basis for the purchase price paid and value any newly identified assets.

The future balance sheet may also be affected by the PPA. The amortization of a brand name that is not yet well-known will decrease the net profit, harming the company’s dividend capacity. Fair value adjustments to inventory and recognition of favorable contracts can affect future EBITDA. This could be an unpleasant surprise after a transaction. These effects could have been discovered if you had performed a pre-PPA analysis before the transaction.

How to put your efforts into creating real value?

It is important to recognize that M&A deals are a continuous process, with each step affecting the next. A pre-PPA analysis is essential in an M&A deal. It focuses on the early identification of acquired assets, synergies, and what the (consolidated post-deal) financial statements will look like.

This is done before closing the deal. The financial controllers, delegated to do the purchase price allocation, need proper support and documentation to quickly prepare the work and get approval from an external accountant. This allows the company to focus on what adds value, delivering the promised returns following the transaction. It’s the final step in the M&A cycle.

In a nutshell: The M&A Cycle

Below is a diagram of the M&A Lifecycle with a brief description of each phase. We will be publishing articles about each stage of the M&A Lifecycle in the coming months. These articles will share stories and thoughts, and information to help you gain insight into the process and reap the benefits of a deal. We will highlight the importance of integrating your actions and steps and the potential consequences of dealing with each step individually.

Identify the Right Deal. You can either actively select companies or business units or react to market offers (one-on-1or via auction). This involves setting a corporate strategy, identifying growth areas, or selling non-core businesses.

Pricing and offer. Pricing and offer.

Perform due diligence. What should we buy? It is important to evaluate the true value of the company and the existence of “skeletons in the closet,” financial aspects like balance and cash flow, and non-financial analysis (e.g., Company culture, integrity, operation synergy benefits, and operational analysis real estate.

 Execution.

Get the promised returns. Once the transaction is completed, you must achieve the expected results. This includes how to realize synergies and prevent them from happening in future strategic re-assessments. The new business will then be treated as a non-core operation and be resold without any added value. The final step is Post-Merger

Integration.

Purchase price allocation / Business combinations

Our professionals type of services familiar with the requirements of ASC 805, Business Combinations (ASC 805) and an International Financial Reporting Standard a 3 Business Combinations (3 IFRS 3), which allows them to provide practical insight into key issues that concern clients, auditors, and regulators.

ASC 805 is a standard with a high degree of convergence. However, there are some differences between them. ASC 805 and IFRS 3 stipulate that the purchase price for the acquisition will be allocated to identifiable assets and liabilities, with some exceptions. The identifiable finite-lived assets are then depreciated/amortized over their remaining useful lives.

Duff & Phelps can assist you with complex valuation issues arising within the context of ASC 805, IFRS 3, and throughout the transaction continuum.

How to Manage Purchase Price Allocation (PPA) for Tax Purposes ?

Companies have many opportunities to grow and prosper in a competitive market. However, mergers and acquisitions (M&As) also bring new reporting and tax requirements. A purchase price allocation (PPA) is one of these requirements.

It is a fair-value analysis that the buyer performs to inform investors about what was acquired through a merger or acquisition. The purchase price allocation is an important requirement for financial reporting. It can impact income tax filings to IRS. This article will focus on the basics and their significance for income tax purposes.

Here is a summary of purchase price allocations for tax purposes—also, some tips on complying with reporting requirements and managing future tax obligations.

What is the tax treatment of purchase price allocations?

A purchase price allocation is an appraisal under ASC 805 to determine the fair value of all intangible and identifiable assets. The residual value is considered goodwill. An independent appraiser does a PPA to determine the fair value (FMV) of all assets. Financial Accounting Standards Board (FASB) has established that rules for financial reporting purchase price allocations.

An important component of price allocation is identifying and classifying tangible and intangible assets and liabilities of a company. To comply with IRS regulations, both the seller and buyer in an M&A transaction must declare the allocation on their annual tax returns (Form. 5894).

The U.S. tax code Section 1067 states that these assets must have a purchase price. This residual method breaks down assets into categories that determine the applicable tax rates. Here is a breakdown of all the asset classes.

Class I: Cash or cash equivalents

Class II: Foreign currency, personal property, and certificates of deposit that are actively traded

Class III: Accounts receivables and mortgages. Credit card receivables are in the third class.

Class IV: Inventory

Class V: All uncategorized assets, equipment, land, and property

Section 197 intangibles – Class VI: This is the section that excludes goodwill and going concerned

Class VII: Goodwill and going concerned

PPAs can be used to correctly allocate the transaction’s value to the various assets required by Section 1067. The appraiser will calculate the value of all tangible or identifiable intangible assets associated with the purchase. This is done by subtracting the write-ups and identifiable assets from the total purchase price. The PPA determines the value of write-ups.

PPAs can be important depending on the transaction. They set the initial tax base, which determines how each acquired company’s assets will tax in the future. Tweet this! (Tweet this!) A poor PPA can have a major impact on the opening balance sheet of an acquiring company, mislead investors, and ultimately lead to tax liability. Are you planning an acquisition very shortly? To ensure you meet your compliance requirements, talk to us as part of your acquisition strategy.

A sample of how PPAs are used for tax reporting

This scenario will show that there are two companies. Company A and Company B. Company A will acquire 100% of Company B’s assets at the cost of $20 million.

Company B’s assets and liabilities are equal to $15 million based on their book value. Company B’s net assets are equal to $12,000,000 ($15 million less $3 million). A valuation specialist completes an appraisal, which determines that the FMV of Company B’s assets and liabilities is 14 million. To adjust the FMV, Company A will need to recognize a $2,000,000 write-up ($14,000,000 minus $12,000,000).

The following formula is required to complete the purchase price allocation.

Total Purchase Price – Net Identifiable assets + write-up = Goodwill

This scenario shows how the calculation works:

$20 million – $12 million + $2 million = $6 million

Accordingly, $6 million should be considered goodwill in subsequent tax returns. Once the value has been determined, Company A will need to classify each asset to determine the tax rate and tax basis for each asset acquired in the transaction.

3 Tips For Proper Allocation Of Purchase Prices For Tax Purposes

1. Talk to the appraiser/valuation expert to get the necessary information and ensure that the transaction value is correctly allocated.

Properly allocating purchase prices can result in significant tax savings and cost savings, both during the acquisition year and in the future. As the acquirer and the seller, you know your business well and what is most valuable during the transaction. Communication with the valuation expert performing the PPA will keep everyone on the same side and prevent any negative outcomes.

Management may believe that the transaction’s value is intellectual property or software, but the appraiser puts most of its value on intangible property. This would result in a higher tax liability.

2. Think about the future of your organization.

When companies are completing purchase price allocations, they should think about the future. What is the plan of the acquiring company in terms of tax and transfer pricing? What are the future cash flows expected?

PPAs’ accuracy is dependent on the consistency of future transfer pricing approaches, and forecasts used to value them. Tax consequences can arise from unreliable profit forecasting, which doesn’t consider future operating models or transfer pricing policies.

3. Align yourself with the allocations of other parties.

After an acquisition, both the seller and buyer must report the purchase price allocations to IRS. Both parties must communicate with each other through the purchase price allocation process. They should also engage an appraiser who understands their business and will respect the PPA determination.

Tax authorities can raise red flags and increase the possibility of an audit if they discover that the seller and buyer used different allocations. Aligning on allocations is in the best interests of both the buyer and seller, as it helps them avoid unwanted attention from the IRS and minimizes the risk of a dispute.

We can help you can manage your tax obligations.

One of the many tax implications that a merger or acquisition can have is the purchase price allocation. An experienced valuation consultant can help you to determine the tax implications of a merger or acquisition. Valentia, an independent valuation and transfer pricing consulting firm, comprises industry veterans who have previously held senior positions in Big Four advisory and accounting firms.

The world’s most respected organizations trust our consultants to help reconcile value for income tax and purchase price accounting purposes.

A purchase price allocation (“PPA”) is a valuation analysis required by the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (ASC) Topic 805, Business Combinations when an entity acquires control of a business. This article assumes that this transaction is a business combination. It will be accounted for by using the acquisition method. A PPA is required when an acquisition triggers additional tax and financial reporting requirements.

What exactly is a PPA?

It sounds the same as it sounds. The purchase price, or the consideration paid to buy the business, is taken and used to allocate the consideration to acquired assets and assumed liabilities. Goodwill is the remaining amount after allocating the purchase price. Here is a list of components of a PA:

Take into account. The price that the acquirer paid to take control of the acquired company is called the purchase price. Considerations include:

Net assets

Net assets are the sum of all assets, less total liabilities. ASC 805 states that all assets acquired and liabilities assumed in a PPA must reflect fair value, not just book value. The fair value may require that book values be adjusted to reflect fair value. The fair value may be required for common balance sheet items such as:

Allocation of Purchase Price for Tax Purposes

The consideration for buying a business through an asset deal is usually expressed as a lump amount. A purchase price allocation is necessary to determine the tax basis for the business’s assets. To calculate the appropriate tax deduction and depreciation, the buyer will need to know how much each asset’s purchase price was allocated. To determine the gain or loss, the seller would also like to know the purchase price allocation. The buyer and seller must also disclose the purchase price allocation in their tax returns for the year that the transaction took place.

It is mainly a important to point out that a tax rules for purchasing price allocation differ from the accounting rules under Generally Accepted Accounting Principles. Tax headaches can result from the incorrect rules used to allocate the purchase price, given the importance of this decision.

A purchase price allocation, which is essentially a process that identifies every asset bought, both tangible and intangible, along with any liabilities, assigns the assets a value. It is usually three-step.

Calculating the purchase price (total consideration)

Identify the assets and liabilities that have been acquired.

Calculating the fair value of these assets and liabilities

Total Consideration

The total consideration includes all costs associated with an acquisition and any liabilities assumed by the buyer. An additional valuation may be required to quantify any form of payment other than cash (e.g., stock, debt, cryptocurrency, or another type of payment). Also, the calculation of total consideration may need to take into account earn-outs and covenants-not-to-compete. These may be subject to a specific analysis because they could represent additional consideration and be taxed as capital gain to recipients or compensation subject to ordinary income tax rates (which will also involve the withholding tax obligations and employment tax obligations).

Identifying Assets

Other than tangible assets like personal property and real estate, it is also important to identify intangible assets like customer and business relationships and software and technology. Intellectual property such as trademarks, trade names, and trademarks must also be identified.

After each asset has been identified, the purchase price can be divided up or distributed among the assets. A company producing consumer staples might choose to purchase a toilet paper manufacturer for $5 million. This transaction is known as an asset purchase. The purchase price of all assets would be $5 million. This would then be divided among inventory, machinery, and other assets the consumer staples company chooses to acquire.

Internal Revenue Code Section 1067 allows for the use of the residual method to allocate the purchase price to these assets:

Class I: Cash or cash equivalents

Class II: Foreign currency, personal property, and CDs that are actively traded

Class III: Credit card receivables, mortgages, and accounts receivables

Class IV: Inventory

Class V: Equipment and land, as well as property

Class VI: Intangibles as defined under Internal Revenue Code Code 197, less Goodwill and going concerned

Class VII: Goodwill and going concerned

The residual method involves the parties assigning the purchase price to identifiable assets. Any excess value is then allocated to goodwill (i.e., Class VII).

The seller may be subject to different tax rates depending on the asset type. Gains attributable to Class IV assets (inventory) are treated as ordinary gains. Gains attributable to Class IV (inventory) can be treated as ordinary income or capital gain.

A purchase price allocation agreement between buyer and seller is binding for both parties.

When to do a purchase price allocation ?

Because it is necessary for financial and tax reports, a purchase price allocation should be done immediately after closing a deal. It is mainly a good idea to start working on the allocation soon after a deal has been closed. This is while the target company’s management remains engaged and their information is more easily accessible. It is a common mistake to wait too long after completing a deal. Records can become lost, staff may move, and management might change.

Buyers and sellers can make sure they have a good deal by negotiating a purchase price allocation before the deal is closed. A seller should view a purchase price allocation before the deal to increase their business’ appeal to potential buyers.

A pitch book is a common practice that sellers use to present potential buyers with how they can use each asset. A seller might highlight the potential impact of depreciation and amortization on a particular asset on the buyer’s tax profile or balance sheets.

A neutral third-party assessment can give sellers more credibility and buyers more confidence when entering into a deal. This early, independent, asset-specific valuation by a third party can help to avoid misunderstandings later.

Conclusion

A purchase price allocation is not just for accounting or tax purposes. Investors and buyers will see the details of each piece of the company they just purchased. Management can scale up their business and improve efficiency if they better understand the value drivers.

Future and present investors will want to know the reasons behind this acquisition over other investments or creating dividends. Investors will be particularly interested in the ratio of assets acquired to goodwill, which is an indicator of risk.

The purchase price allocations are a way for sellers to attract buyers. Buyers also benefit from a thorough analysis of the business they wish to buy. Both sides need to consider this when conducting their due diligence. It is also required for financial and tax reports. Both sides will have a better understanding of the long-term implications of the deal.