Purchase Price Allocations: What CFOs need to know to get it right?

Purchase Price Allocation (PPA) is an important component of a merger and acquisition transaction. It entails distribution of the value of the purchase consideration among various tangible and intangible assets (and liabilities) acquired from the target following the merger/acquisition. Residual purchase consideration, if any, is recorded as goodwill in the acquiring company’s books. A fairly complex process, it requires deep domain knowledge, understanding of the business plan, and expertise in intrinsic valuation to ensure all aspects of the analysis have been factored in accurately.

If your organization is contemplating an M&A or has recently completed a transaction to acquire or purchase another business, it is time to lay the groundwork to deal with financial reporting provisions relating to Purchase Price Allocation (PPA). ASC 805 “Business Combinations” under US GAAP and IFRS 3 “Business Combinations” are the most common reporting standards for purchase price accounting.

What is PPA? How it can impact your business, and how Aranca can help you to get it right?

What is PPA?
A PPA exercise basically entails distribution of the value of the purchase consideration among various tangible and intangible assets (and liabilities) acquired from the target following the transaction. Residual purchase consideration, if any, is recorded as goodwill in the acquiring company’s books.

For starters, is it very complicated then? Well, not from the sound of it. Read the purchase agreement and allocate the value to different assets listed in the agreement schedules based on some high level judgment. But, herein lies the catch – simple as it may seem, the actual application often throws up several complex challenges.

What are key issues that often make it complex?
Time to zoom in.

Determining the fair value of purchase consideration

The first step is that the purchase consideration be reported at ‘fair value’. This is not an uphill task in cases where the consideration is wholly discharged in cash. However, with M&A transactions across markets globally increasing in complexity, determining the fair value may turn out to be more than uphill: 

• How do you determine the fair value of the purchase consideration if it involves a contingent element like earn-outs that are payable in future (mostly upon successful achievement of certain financial outcomes or business milestones)?
• What if the purchase consideration in whole or part is discharged by the issuance of equity shares of private company?
• How do you deal with dilutive instruments (like warrants) if they are a part of the purchase consideration?

Allocation of fair value of total purchase consideration to all tangible and intangible assets and liabilities

While identification of tangible assets is often straightforward, identifying intangible assets for allocating value can be challenging. Intangible assets may include diverse classes/groups based on their distinct character and exploitation in the business:

• Technology-related assets (patents, unpatented technology, R&D projects)
• Marketing-related (brands, trademarks, copyrights)
• Customer-related (contracts, customer relationships)
• Human intellectual capital-related (assembled workforce, non-compete agreements)

Intangible assets are recognized separately if they meet one of the following two criteria:

• Control – Arising as result of contractual or other legal rights
• Separability – Capable of being sold, transferred, licensed, rented or exchanged either individually or in combination with other related asset or liability

Why is it important to get PPA accounting right?
Depending upon the size and nature of the transaction, PPA can have significant impact on income statement and balance sheet. The intangible assets recognized at fair value are subject to amortization over their useful life which impacts profits and in turn taxation. The goodwill is subject to an impairment risk in case of downturn in business cycles. An improper allocation of purchase consideration can negatively impact your business in multiple ways:

• Understatement or overstatement of depreciation and amortization leading to volatility and other adverse impact on net reported income
• A lack of sufficient documentation to explain the methodologies, reasonability of data and assumptions used creating year-end audit issues
• Failure to allocate value to intangible assets inflates goodwill which increases the impairment risk on annual testing; in case of public companies, this could significantly impact investors’ sentiment and share price
• Recasting the value of intangible assets causing significant delays; this could happen if your company is planning for an IPO and during due diligence, detects PPA reporting issues related to prior acquisitions

So, as a CFO or financial controller, it is only prudent to not approach this as a paper shuffling exercise. If conducted proactively at pre-deal stage, the exercise can help you support future earnings guidance. A well-performed PPA exercise can act as a catalyst to realize the perceived value and synergies.

Why choose Aranca for PPA valuation services?
Aranca has extensive experience in PPA valuation for mid-market transactions, having conducted it for hundreds of clients across diverse industry verticals. Our engagement experience spans a variety of intangible assets including patents, unpatented technology & knowhow, brands, customer contracts and relationships. Our team of seasoned finance professionals with international accreditations from CFA and ASA provide seamless audit review support even if it is required months after the submission of the valuation report. We often efficiently leverage our firm’s overall capabilities in market research and technology advisory by engaging with in-house sector-focused and technology-domain experts.

Aranca is uniquely positioned with resources of large scale advisory firm and boutique approach to deliver valuation services at cost-effective billing rates.