Purchase price allocation (PPA) categorizes how much a buyer paid for a business into the assets and liabilities they purchased. The remainder of the purchase price is allocated to goodwill.
Mergers and acquisitions often result in additional tax and financial reporting requirements, including purchase price allocation. The purpose of PPA is to identify a fair market value for the business’s assets and liabilities. PPA is valuable because it identifies both a business’s tangible assets, like machinery, as well as its intangible assets, like patents.
Why is purchase price allocation important?
While buyers should do their due diligence before any business transaction, PPA is required post-transaction. This figure can affect your business for years down the line, so it’s important to get it right.
Purchase price allocation matters for:
- Taxes: The PPA figure you report will affect the taxes your business pays.
- Depreciation and amortization: You don’t want to over- or under-shoot this. Otherwise, you’ll artificially adjust your net income and throw off your financial calculations.
- Regulatory requirements: PPA is required by FASB (Financial Accounting Standards Board), GAAP (Generally Accepted Accounting Principles), IFRS (International Financial Reporting Standards), and many other regulatory bodies. Your business will be audited on your PPA, and there’s a potential for fines if you get it wrong.
How purchase price allocation works
Purchase price allocation happens when a buyer itemizes what they bought so they can understand the true value of the business. PPA is usually done post-acquisition for accounting and tax reasons, but sometimes a seller will do a PPA to attract more buyers. This is helpful if you’re selling a business with a lot of intangible assets and you want to reflect the value of your business.
Several components go into a PPA, including:
- Net identifiable assets: This is the total value of the assets of the company you bought minus all of its liabilities. This includes both tangible and intangible assets.
- Consideration: Consideration is the price the buyer paid to acquire the company. For example, if they paid $50M to buy a business, the consideration would be $50M.
- Write-up: This happens when you adjust the book value of an asset when its real value is less than fair market value. Businesses typically hire a third-party valuation specialist to assess the market value and write-up.
- Goodwill: This is the difference between what a buyer paid for a business and the total fair market value of the business’s assets and liabilities.
In practice, you conduct a PPA by:
- Determining the assets and liabilities in the business.
- Assigning a fair market value to all assets and liabilities.
- Estimating the rate of return on the price you paid for the business, as well as the business’s financial forecasts.
- Assessing the value of the business and ensuring that the goodwill is reasonable based on what you paid for the business.
For example, if Company A acquires Company B for $10M, Company A would do a purchase price allocation.
On paper, Company B has $7M in assets and $4M in liabilities. The value of Company B would be:
$7M (assets) - $4M (liabilities) = $3M
Next, Company A brings in a business valuation specialist to assess the fair value of the business. The valuation specialist might find that the fair market value of the assets and liabilities is actually $8M, not $10M:
$8M (fair market value for assets) - $3M (liabilities) = $5M
This means Company A gets a $5M write-up to adjust the book value of its assets to fair market value. From there, Company A records its goodwill.
Because Company A paid $10M and that sum exceeds the $8M fair market value, it has $2M in goodwill that it needs to report.
