Purchase Price Allocation (PPA): How It Works and Why Companies Need PPA?

Did you know that when a company acquires another business, it’s not just a simple exchange of assets and liabilities? — it’s a transformation from end to end. To get it done effectively, a proper calculation of the acquired (target) company’s assets and liabilities will help clarify financial reporting for stakeholders after business acquisitions.

A detailed analysis of setting prices to the target company’s total assets and liabilities is called Purchase Price Allocation (PPA). When a company buys another, PPA helps break down the price tag, showing how much goes to assets and debts. It’s a way of ensuring everyone gets a fair price for the assets.

Let’s discuss how PPA works, its importance, and the common challenges a company faces.

What is Purchase Price Allocation (PPA)?

Purchase Price Allocation is like breaking down costs when buying a company. Imagine you buy a house; you’d allocate the price to rooms, kitchen, and garden. Similarly, when one company buys another, the total cost is divided among its parts, like buildings, machines, or brand value.

In the Financial Institutions sector, the PPA study revealed intriguing shifts in PC allocation over the years.

Within the Healthcare industry, the PPA study showcased notable changes in PC allocation.

In the Industrials sector, the PPA study indicated distinct changes in the allocation of PC.

The Infrastructure Services and Materials industry displayed significant changes in PC allocation.

The Technology sector witnessed distinctive changes in PC allocations:

The overall analysis of Goodwill in the PPA study reveals the following insights:

It involves experts and fair value assessments and impacts financial statements, showing investors and others where the money went.

What are the components Of PPA?

Purchase Price Allocation (PPA) allocates purchase price to assets, liabilities, and goodwill in a business acquisition for accurate accounting. The components of it typically include:

Fair Value Assessment

• Tangible Assets — include property, plants, equipment, and inventory.
• Intangible Assets — Identifiable intangible assets such as patents, trademarks, customer relationships, and technology.
• Liabilities: Recognition of assumed liabilities, including contingent liabilities. This includes outstanding debts, legal obligations, and other liabilities.

Goodwill — represents the excess of the purchase price over the fair value of the net assets acquired. It is an intangible asset that reflects the value of the collaborative benefits, brand recognition, customer relationships, and other factors that are not separately identifiable.

Identifiable Intangible Assets — This includes patents, copyrights, trademarks, customer relationships, technology, and other intangibles that can be separately identified and valued.

Contingent Consideration — If there’s an agreement for additional payments based on certain future events, we consider these in the purchase price allocation.

Deferred Tax Liabilities or Assets — Recognition of deferred tax liabilities or assets arising from the differences between the book value and tax value of assets and liabilities.

Transaction Costs — Direct costs associated with the acquisition, such as legal fees, accounting fees, and other professional fees, are considered in the purchase price allocation.

Equity Consideration — If the purchase involves issuing equity securities, include their fair value in the allocation.

Example for Purchase Price Allocation using different approaches;

In the acquisition journey of Sole Inc. by Lee Corp., understanding Purchase Price Allocation (PPA) becomes pivotal. The following examples illustrate PPA Valuation using different approaches for accurately assigning values to acquired assets.

Income Approach:

• Lee Corp. values Sole Inc.’s customer relationships using the Discounted Cash Flow (DCF) method.
• Sole Inc.’s customer relationships are projected to generate annual cash flows of $1 million for the next 5 years.
• The discount rate is determined to be 8%.
• Using the DCF formula, the present value of the future cash flows is calculated, resulting in a fair value of $4.111 million for Sole Inc.’s customer relationships.

Market Approach:

• Lee Corp. assesses the fair value of Sole Inc.’s trademarks by comparing them to similar trademarks recently sold in the market.
• Comparable trademarks in the market were sold for an average of $2 million.
• Lee Corp. determines that Sole Inc.’s trademarks are comparable, and thus assigns a fair value of $2 million to Sole Inc.’s trademarks .

Cost Approach:

• Lee Corp. values Sole Inc.’s manufacturing equipment using the Cost Approach.
• Sole Inc.’s manufacturing equipment has a book value of $500,000, but a market appraisal reveals that it would cost $700,000 to replace the equipment with new ones.
• The fair value of Sole Inc.’s manufacturing equipment under the Cost Approach is determined to be $700,000.

After completing these approaches, Lee Corp. would allocate the total purchase price to the various assets acquired, including customer relationships, trademarks, and manufacturing equipment. Goodwill would be calculated as the excess of the total purchase price allocation over the fair values assigned to identifiable assets and liabilities.

Why is PPA important and How It Works for Companies?

Accurate purchase price allocation is important for transparent financial reporting when a company acquires another. It involves breaking down the purchase price to assign values to acquired assets and liabilities.

Consider a scenario where Company A acquires Company B for $100 million. Accurate allocation attributes $80 million to identifiable assets and $20 million to liabilities. This means no goodwill is generated ($100 million — $80 million — $20 million = $0). When a company buys another, accurate purchase price allocation is like dividing money into different categories, such as assets and debts. This helps create clear and trustworthy reports about where the money went.

This clarity is vital for stakeholders as it reflects the economic reality of the acquisition.

It decides how we value things like brand names and special relationships the company gained. It also determines how we spread the cost of these things over time and influences taxes, ensuring the company follows the rules.

What are the Challenges in PPA?

Purchase Price Allocation ensures everyone knows what we bought and at what cost.As you now know, PPA is important for determining the accurate value for the total assets; below are the common challenges a company might face:

• Paying attention to the acquisition numbers can mess up financial statements and meeting deadlines.
• Sorting out purchase prices takes a lot of people and time — financial analysts, valuation experts, and legal advisors.
• Getting the right financial details is necessary; otherwise, mistakes might happen in the allocation process.
• Figuring out how to merge the acquisition with existing systems and processes adds another layer of complexity.
• Due to market volatility, what you thought was worth a lot today might be worth less tomorrow.
• There are accounting standards and rules to follow, like IFRS or GAAP, which impact how you do the allocation.
• It’s not a one-and-done deal; you must also keep an eye on things after the acquisition.

Get your PPA Valuation support from EQVISTA!

It’s hard to put a price on intangible things like brand reputation, making valuation subjective and challenging. How you allocate the purchase price can affect legal and tax matters; aligning them is essential. Eqvista is highly skilled at evaluating prices for mid-market transactions.

Our experienced finance professionals, accredited by global organizations like CFA and ASA, have assisted hundreds of clients in various industries. We excel in providing seamless support for audit reviews. For more details, contact us now!