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Purchase Price Allocation

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Purchase Price Allocation

We understand the M&A lifecycle

Purchase price allocation is an application of goodwill accounting whereby one company, when purchasing a second company, allocates the purchase price into various assets and liabilities acquired from the transaction.

Signing the deal to buy or sell a company is often the most memorable moment for those involved in an M&A transaction. However, it is only one of the stages within the M&A lifecycle, in which each step impacts the other ones.

One of the steps that should be taken after the deal has been closed is the Purchase Price Allocation (PPA). 

Integration of financial statements

The deal has been closed, the M&A advisors and lawyers have left the scene and the integration of the acquired business has started. Then the external accountant knocks at the proverbial door: the transaction needs to be properly recorded in the financial statements. After all, the consolidated annual report should now represent the acquired company. This may seem trivial – and maybe a bit dull – but this is an activity that needs to be dealt with as soon as possible with as little effort as possible. You only need the balance sheet of the acquired company, right? How hard can that be? Well, at times it’s actually not that simple.

    Alignment of accounting principles

    It may be that the acquired company adopts accounting principles that are different from the acquirer. Therefore, as a first step, the financial statements of the acquired company need to be aligned with the accounting principles of the acquirer. In case the acquired company is to switch from Dutch GAAP (RJ) to IFRS, this could be quite a significant exercise with, for instance, requirements of IFRS 15 (revenue recognition) or IFRS 16 (lease accounting).

      Allocating the purchase price

      Subsequently, the financial reporting standards (RJ and IFRS) require that the purchase price paid (in a business combination) needs to be allocated to the assets acquired and liabilities assumed, a process that is also referred to as a ‘purchase price allocation’ or PPA. This can be a tricky business. For starters, the purchase price may not have been paid exclusively in cash, but also partly in equity, or in deferred or conditional payments like earn-outs, which means that the definitive value of the purchase price might not be entirely clear at the moment the PPA is performed.

        Fair value adjustments

        An accurate and reliable estimate of the purchase price is required to determine the goodwill amount that is paid in the transaction. Goodwill is the difference between the value of the net assets acquired and the price paid for the shares. However, this goodwill amount may not be the figure that will be recognised in the balance sheet. The purpose of the PPA is to evaluate if the fair value of all assets and liabilities on the opening balance sheet is different from the stated book value. If there are material differences between fair value and book value, the asset or liability is revalued in the balance sheet to its fair value, with the goodwill amount as balancing item. The usual suspects for revaluation include real estate, machines and equipment, inventory, investments in associates, but possibly also long-term loans.

          Identification, recognition and valuation of new assets and liabilities

          In addition to potential fair value adjustments for existing items on the opening balance sheet, the acquired entity may also have assets and liabilities that did not meet the criteria for recognition before. For example, if a company has an internally developed reputable brand name for its product sold, this brand would not show on the balance sheet. When this company is acquired, the buyer will certainly have considered the brand in the purchase price he was willing to pay and will in turn have paid ‘goodwill’ for it. In that case, the reporting standards require the valuation and recognition of the brand name in the books. Other examples of such identifiable items are the customer relationships, databases or contracts, intellectual property, favourable or unfavourable contracts and contingent liabilities.