Accounting for the acquisition of a business is a complex process that most accounting and finance professionals do not encounter routinely. The lack of in-depth knowledge and experience with this complex area can create risks, delays and errors in the financial reporting process. This article will outline the key steps in completing a Purchase Price Allocation (PPA), including some of the key accounting and valuation considerations.
Step 1: Determine the Fair Value of Consideration Transferred
Consideration transferred in a business combination can take many forms, including cash, shares, promissory notes, contingent payments, earnouts, etc. Regardless of the form of the consideration, it must be recorded at its acquisition date fair value.
Common forms of consideration include:
Step 2: Revalue Existing Assets Acquired and Liabilities Assumed
Consistent with the requirements of ASC 805, existing assets and liabilities acquired in a business combination must be recorded at fair value on the acquisition date, including the following:
Step 3: Identify Intangible Assets Acquired
The next step is to ensure all identifiable intangible assets acquired are recorded separately from goodwill. ASC 805 specifies that an intangible asset is considered identifiable if it arises from a contractual or legal right or is separable. An intangible asset is considered separable if it is capable of being separated or divided from the enterprise and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability regardless of whether the enterprise intends to do so. An intangible asset is contractual if it arises from a contractual or other legal right, regardless of whether those rights are transferable or separable from the enterprise.
The most common intangible assets acquired include:
Step 4: Determine the Fair Value of Intangible Assets Acquired
Preparing a PPA begins with a review of the acquirer’s acquisition model. The Internal Rate of Return (IRR) is determined by calculating the rate where the net present value of the after-tax forecast cash flows of the acquired business equals the purchase price. The acquisition IRR represents the weighted average rate of return of all the assets and liabilities of the acquired business. The acquisition IRR is then compared to an independently calculated weighted average cost of capital to determine whether the consideration approximates fair value.
The next step is to value the identifiable intangible assets using one of the following three approaches:
Step 5: Allocate Remaining Consideration to Goodwill
Any remaining consideration after allocation to assets acquired and liabilities assumed is allocated to goodwill. The reasonableness of the resulting goodwill can be assessed through an analysis of the Weighted Average Return on Assets, which compares the estimated returns on all assets acquired (excluding goodwill) and liabilities assumed to the acquisition IRR with the difference being the implied rate of return on goodwill. The implied rate of return on goodwill is then assessed for reasonableness as compared to the rate of return on the other assets and liabilities acquired.
How We Can Help
PPA is inherently complex, requiring in-depth knowledge of the acquired business, industry and accounting rules as well as knowledge and experience in the application of acceptable fair value methodologies. Ongoing communication between accounting and operational personnel is required throughout the process. The valuation of intangible assets involves estimates and is, therefore, an area of scrutiny by financial statement auditors and regulators.
WilliamsMarston’s seasoned team of accounting, reporting, tax and valuation experts are experienced in the preparation of complex PPAs and the valuation of intangible assets and can provide assistance with all financial reporting aspects of business combinations.
Please contact one of our valuation leaders for more information on WilliamsMarston’s market-leading valuation expertise:
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