Last Updated: Mar 5, 2024

Accounting for the acquisition of a business is a complex process that most accounting and finance professionals do not encounter routinely. A lack of in-depth knowledge and experience with this complex area can create new risks, reveal existing risks, increase the likelihood of delays and expose an organization’s susceptibility to errors in financial reporting.

The Purchase Price Allocation (PPA) is an important component of the accounting for a merger or acquisition and requires five key steps.

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 and earnouts. Regardless of the form of the consideration, it must be recorded at its acquisition date fair value. 

In addition to cash consideration, where cash paid at closing is typically considered fair value, common forms of consideration include:

  • Share Consideration: The agreed-upon price in a purchase agreement may or may not represent the fair value of shares issued. For publicly traded equity, the price on the acquisition date is typically the best indicator of fair value. Recent issuances to third parties may indicate fair value for shares not publicly traded. If the shares are not publicly traded and there are no recent arms-length transactions, an independent valuation analysis may be required to support the fair value of the shares issued in the business combination.
  • Deferred Payments and Promissory Notes: Deferred payments occur when a portion of the purchase consideration is paid after the acquisition. The fair value of deferred consideration should reflect a discount for the time value of money and the risk of non-payment. Deferred consideration can also include equity shares—like those placed in escrow for release later. In determining the fair value of deferred equity consideration, one should consider a discount for the deferral length and the underlying stock’s volatility.

Contingent Consideration: Contingent consideration is recorded at its acquisition date fair value, which is determined using a model appropriate to the earnout structure. Subsequent changes in the fair value of contingent consideration are recorded in the profit and loss statement in the post-acquisition period.

Step 2: Revalue Existing Assets Acquired and Liabilities Assumed

Consistent with the requirements of Accounting Standards Codification (“ASC”) 805, existing assets and liabilities acquired in a business combination must be recorded at fair value on the acquisition date, including working capital, fixed assets, intangible assets and goodwill.

  • Working Capital: Working capital recorded in the PPA should reflect the actual working capital delivered on the acquisition date and should also consider working capital adjustments if included in the purchase agreement.
  • Fixed Assets: Depending on the estimated fair value and complexity of the fixed assets acquired, determining the fair value may require the assistance of a qualified third-party appraiser.
  • Intangible Assets and Goodwill: Any existing intangible assets and goodwill recorded on the closing balance sheet of the acquired company are written off in purchase accounting. The intangible assets at the acquisition date will be identified and revalued with the residual amount being recorded as goodwill.

Step 3: Identify Intangible Assets Acquired

The next step is to ensure that all identifiable intangible assets acquired are recorded separately from goodwill. ASC 805 specifies that an intangible asset is identifiable if it arises from a contractual or legal right or is separable.

To be considered separable, the intangible asset must be able to be separated or divided from the enterprise and then sold, transferred, licensed, rented, or exchanged, individually or with a related contract, asset, or liability. Additionally, to be considered contractual, the intangible asset must arise from a contractual or other legal right, even if those rights can’t be transferred or separated from the business. Some of the most common intangible assets acquired include order backlogs, customer relationships, favorable and unfavorable contracts, patents and technology, trademarks and trade names and non-compete agreements.

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, which 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:

  • Market: The market approach starts by gathering data on prices paid for comparable assets. The fair value reflects the price for purchasing comparable assets bought under similar circumstances. The market approach is viewed as straightforward due to its simple application when a comparable asset is available. However, it becomes more complicated when intangible assets are introduced, as comparable transaction information is rarely available as these are seldom sold on a standalone basis. 
  • Cost: The cost approach is based on the premise that a prudent investor would not pay more for an asset than necessary to replace or reproduce it. It is frequently applied to value assets not intended to generate future cash flows. However, the cost approach can create problems as it fails to capture the expected future benefits of an intangible asset. 
  • Income: The income approach measures an asset’s value as the present value of the future economic benefits derived over its life. These benefits may include earnings, cost savings and proceeds from disposal. Applying the income approach requires estimating the expected cash flows attributable to the asset over its life and discounting them to present value. 

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 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 applying 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 historically scrutinized by financial statement auditors and regulators.  

WilliamsMarston’s team of accounting, tax and valuation experts is experienced in preparing complex PPAs and valuing intangible assets and is ready to assist with all financial reporting aspects of business combinations.

Accounting for business combinations, including the related valuations required, is complicated and dependent on the terms and conditions of the transactions and businesses involved.  This whitepaper contains general information only.  By virtue of this whitepaper, WilliamsMarston LLC is not rendering business, accounting, financial, investment, legal, tax, valuation or other professional advice or services. The statements contained in this whitepaper are not intended to be a substitute for any accounting literature or SEC regulations. Companies applying U.S. GAAP or filing financial information with the SEC should apply the relevant laws and regulations and consult a qualified accounting advisor.