Purchase Price Alloc.

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David Hahn, CVA, ASA, MAFF, CM&AA, CCIM, MBA

Purchase Price Allocation
(Business Combinations Valuation)







Purchase Price Allocation is the process of allocating the Purchase Price Paid for Acquired Company to its Tangible Assets, Intangible Assets, and Assumed Liabilities.

Tangible Assets
Real Property: Land, Land Improvements, Buildings, Leasehold Interests
Personal Property and Related Assets: Machinery and equipment, Furniture and fixtures,
Computer equipment, Vehicles, Construction in progress,
Leasehold improvements
Intangible Assets:
Trademarks, Patented and unpatented technology, Internal-use software, Customer relationships,
Favorable supply agreements, Noncompete agreements, Licensing agreements

Liabilities: Deferred revenue, Contingent considerations, Contingent liabilities


Pursuant to ASC 805, (formerly SFAS 141 R), a transaction or other event is a business combination if assets acquired and liabilities assumed constitute a business. A business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants.

In the case of a merger or acquisition involving a business combination, the assets and liabilities of the acquiree must be consolidated into those of the acquirer at their acquisition date fair values, pursuant to specific accounting rules presented in ASC 805.


Tax Implications:
Purchase price allocations performed for US tax purposes are done under the standard of fair market value, which is similar to fair value, but which also amy differ in certain cases. IRS Section 1060 and Regulation under IRC Section 338 further indentify the following seven classes of assets for tax purposes:

Class 1 Cash
Class 2 Marketable Securities
Class 3 Market-to-Market Assets and Accounts Receivable
Class 4 Inventory
Class 5 Assets not Otherwise Classified
Class 6 Section 197 (intangible) Assets other than Class 7 Assets
Class 7 Goodwill and Residual Going Concern Value

These classifications are extremely important if a company is contemplating a like-kind exchange, a tax-free exchange of stock, or other corporate tax planning transactions.



Purpose of Purchase Price Allocation - Financial Reporting: ASC 805, Formerly SFAS 141r and 142

  • It accurately reflect Components of a Company's Worth
  • Most Intangible Assets are Amortized over their expected lives; This Expense can have a major impact on reported earnings

Valuation Process - Summary

  • Determine purchase price and total asset base
  • Identify components of total asset base including tangible assets, intangible assets, and remainder as goodwill
  • Allocate Value to Company's Asset Components - Ultimately to the Intangible Asset Valuation

Identification of Intangible Assets

  • Identification is dictated by Industry
  • Trademarks/names
  • Customer contracts & relationships
  • Technology
  • Workforce
  • Patents
  • Databases such as customer mailing lists
  • Non-compete agreements
  • In-process Research and Development ("IPRD")
  • Goodwill

Classifications into Categories:

  • Intangible Assets Seprable from Goodwill
  • Intangible Assets Not Seprable from Goodwill

The first step in purchase price allocation, or PPA, is to determine the purchase price.

Equity Purchase Price

Also known as the transaction price/value, this is the price paid for the equity of a company and is calculated as:

Acquisition-Related Costs

Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finder’s fees; advisory, legal, accounting, valuation, and other professional or consulting fees; general administrative costs; and costs of registering and issuing debt and equity securities. With the exception of costs to issue debt or equity, FAS 141 and FAS 141r differ substantially

  • FAS 141 – Include in purchase price
  • FAS 141r – Do not include in purchase price; expense as incurred

Under both FAS 141r and FAS 141, debt and equity issuance fees are treated differently from other acquisition-related costs as follows:

  • Debt – Financing fees capitalized and amortized over cost of the term of the debt
  • Equity – Fees netted against proceeds from the offering

After December 15, 2008, acquisition-related costs are no longer included in the purchase price. Instead, the acquirer expenses these charges as incurred and the services received, while debt and equity financing fees continue to receive the same accounting treatment described above.

The FASB is working to remove ambiguity in the accounting rules for debt and equity financing fees in business combinations, and has tentatively decided to require that these costs be expensed as incurred.

Restructuring costs are not considered part of the purchase price under both FAS 141 and 141r.

Compensation for Past Services

Payments to Target's employees for services performed in the past which have no future benefit are added to the purchase price because they are considered assumed liabilities. Examples include severance payments to Target's former managers and stock options that vest upon a change of control.

An acquirer allocates the purchase price to the assets acquired and liabilities assumed at fair value (FV) on the acquisition date. Normally, the purchase price exceeds the FV of these assets and liabilities. Why would anyone pay more for something than it is supposedly worth? Perhaps because the acquirer expects to create value through synergies or better management, giving the target's sellers leverage to demand a premium for their business.

Goodwill

To calculate goodwill in a transaction, we allocate the purchase price to the FVs of identifiable assets acquired and liabilities assumed in the following order:

  1. Tangible net assets (assets minus liabilities)
  2. Identifiable intangible assets
  3. Goodwill (the residual after steps 1 and 2)

Goodwill is an indefinite-lived intangible asset recorded on the acquirer's post-combination balance sheet that is not amortized but, rather, tested periodically for impairment. If the acquirer later writes down impaired goodwill, it is usually a sign that the business combination failed to meet expectations (e.g. Time Warner's troubled acquisition of AOL) and, consequently, implies overpayment for the acquired business and error in judgment by the acquirer.


Book Value of Net Assets

Book values of assets and liabilities are often different from their FVs. In allocating the purchase price to these assets and liabilities, we step, or write, them up/down to reflect their FVs.


Identifiable Intangible Assets

Examples of identifiable intangibles may include customer contracts, Internet domain names, patents and trademarks, and brand names, among other things. As much we value our employees, assembled workforces are not considered identifiable intangibles. For book accounting purposes, intangibles with finite lives are amortized over their useful lives, while indefinite-lived intangibles (like goodwill) are not amortized but, rather, tested for impairment. For tax purposes, Section 197 of the IRS tax code requires straight-line amortization of all intangible assets (including goodwill) over 15 years only in an:

  • Asset acquisition or a
  • Stock acquisition with a Section 338 election.

Intangibles are not amortized for tax purposes in stock acquisitions absent a Section 338 election.

Bargain Purchase

In a rare bargain purchase, the excess just defined must be immediately recognized by the acquirer in earnings as a gain that increases goodwill from a would-be negative value to zero after in accordance with FAS 141r. FAS 141 had required that any negative goodwill be allocated pro rata to the acquired assets, reducing their allocated FVs to zero. Any goodwill remaining following the pro rata allocation must then be recorded immediately as an extraordinary gain. However, before recognizing any such gain, the acquirer should check the PPA parameters for accuracy. IFRS 3 requires that all negative goodwill be expensed immediately, similar to FAS 141r.

Existing Goodwill and Deferred Tax Items

Any goodwill or deferred tax items existing on the target's balance sheet at the time of acquisition are written off in the purchase price allocation (PPA) since their fair values (FVs) are zero.

In-Process Research & Development (IPR&D)

A portion of the purchase price may be allocated to acquired IPR&D. FAS 141 and 141r differ significantly in their treatment of acquired IPR&D as follows:

  • FAS 141 – Expense immediately upon completion of the transaction if the acquired IPR&D has no alternate future use
  • FAS 141r – Do not expense, regardless of whether or not the acquired IPR&D has an alternate future use

Under FAS 141r, acquired IPR&D is an intangible asset classified as an indefinite-lived until the completion or abandonment of the associated R&D effort. Intangible IPR&D is not amortized during the period that it is considered indefinite-lived but rather tested for impairment.

Tax and FAS 141r accounting methods for acquired IPR&D are similar in that the asset is not expensed.

Contingent Consideration

Contingent consideration is usually an obligation of an acquirer to transfer assets or equity interests to the target's sellers conditioned on the outcome of future events, such as achieving specific performance benchmarks. FAS 141 and 141r differ in their treatment of contingent consideration as follows:

  • FAS 141 – Usually recognize when the contingency is resolved and the consideration is issued or becomes issuable
  • FAS 141r – Recognize as a liability or equity on the acquisition date at FV on such date

Contingent consideration arrangements can also be structured to give the acquirer the right to the return of previously transferred consideration if specified conditions are met. For example, an acquisition agreement may require the sellers to forfeit some proceeds from the sale of their business if a pending lawsuit against the target is later ruled unfavorably. In such cases, FAS 141r requires the contingent consideration to be recognized as an asset, rather than a liability or equity, at the acquisition date. As you can imagine, structuring contingent consideration arrangements in this manner is rare when the target is a public company with many shareholders from whom it would be difficult to reclaim the contingent consideration.


ASC 805 indicates that an entity shall account for each business combination by applying the acquisition method. Applying the acquisition method requires:

  • Identifying the acquirer
  • Determining the acquisition date
  • Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, measured at their fair value as of the acquisition date.
  • Recognizing and measuring goodwill or a gain from a bargain purchase.

ASC 805 provides that an intangible asset will be recognized as an asset apart from goodwill if (a) it arises from contractual or other legal rights, or (b) it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so). Categories of intangible assets that meet the criteria for recognition as assets apart from goodwill include:

  • Marketing-related intangible assets such as trademarks and trade names;
  • Customer-related intangible assets such as customer contracts and related customer relationships;
  • Artistic-related intangible assets;
  • Contract-based intangible assets such as licensing, royalty and standstill agreements; and
  • Technology-based intangible assets such as patented technology.

ASC 820, (formerly SFAS No. 157), provides guidance as to the definition of fair value, valuation techniques to be applied in fair value measurement, the “fair value hierarchy” and required disclosures. Fair Value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Various valuation techniques are employed in deriving the fair value of intangible assets acquired in a business combination which generally fall under the three principal approaches to value: income approach, market approach and cost approach. Specific methodologies include the Multi-Period Excess Earnings Method, Relief from Royalty Method and others.

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