Purchase Price Allocation (PPA) is an acquisition accounting process of assigning a fair value to all of the acquired assets and liabilities assumed by the target company.
In practice, purchase price allocation is an integral part of M&A accounting with broad implications on the financial statements of the parties involved in the transaction.
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Once an M&A transaction has closed, purchase price allocation (PPA) is necessary under accounting rules established by IFRS and U.S. GAAP.
The objective of purchase price allocation (PPA) is to allocate the price paid to acquire the target company and to allocate them to the target’s purchased assets and liabilities, which must reflect their fair value.
The steps to performing purchase price allocation (PPA) are the following:
Upon transaction close, the acquirer’s balance sheet will contain the target’s assets, which should carry their adjusted fair values.
The assets most likely to be written up (or written down) are the following:
Moreover, the fair value of the tangible assets – most notably, property, plant & equipment (PP&E) – serves as the new basis for the depreciation schedule (i.e. spreading out the capital expenditure across the useful life assumption).
Likewise, the acquired intangible assets are amortized over their expected useful lives, if applicable.
Both depreciation and amortization can have a major impact on the acquirer’s future net income (and earnings per share) figures.
Following a transaction with increased future depreciation and amortization expenses, the acquirer’s net income tends to fall in the initial periods after the transaction close.
To reiterate from earlier, goodwill is a line item designed to capture the excess purchase price over the fair value of the target company’s assets.
The majority of acquisitions contain a “control premium,” since an incentive is typically needed for the sale to be approved by existing shareholders.
Goodwill functions as a “plug” that ensures the accounting equation remains true post-transaction.
Total Assets = Total Liabilities + Shareholders’ EquityThe goodwill recognized after purchase price allocation is typically tested for impairment on an annual basis but cannot be amortized, although the rules have been modified for private companies.
If an intangible asset meets either or both of the criteria below – i.e. is an “identifiable” intangible asset – it can be recognized separately from goodwill and be measured at fair value.
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Fundamentally, the purchase price allocation (PPA) equation sets the assets acquired and liabilities assumed from the target equal to the purchase price consideration.
Let’s say, for instance, that an acquisition target was acquired for $100 million.
The next step is to calculate the allocatable purchase premium by subtracting the target’s net tangible book value from the purchase price.
Net Tangible Book Value = Assets – Existing Goodwill – LiabilitiesNote the existing goodwill of the target from earlier transactions is wiped out, and the previous carrying value must be excluded.
In addition, the shareholders’ equity account – assuming it is an acquisition of 100% of the target – must also be wiped out.
Here, we’ll assume the net tangible book value is $50 million, so the purchase premium is $50 million.
Moreover, there was also a PP&E write-up adjustment of $10 million post-deal, so the goodwill can be calculated by subtracting the fair value write-up amount from the net tangible book value.
But the tax implications from the write-up must not be forgotten, as deferred tax liabilities (DTLs) are created from the PP&E being written up.
Deferred taxes arise from the temporary timing difference between GAAP book taxes and the cash taxes actually paid to the IRS, which impacts the depreciation expense (and GAAP taxes).
If cash taxes in the future exceed book taxes in the future, a deferred tax liability (DTL) would be created on the balance sheet to offset the temporary tax discrepancy.
While the incremental depreciation stemming from the PP&E write-up (i.e. increased carrying value) is deductible for book purposes, they are NOT deductible for tax reporting purposes.
Assuming a 20% tax rate, we’ll multiply the PP&E write-up amount by the tax rate.
Goodwill Created = Purchase Price – Net Tangible Book Value – Fair Value Write-Up + Deferred Tax Liability (DTL)
Once we input our assumptions into the goodwill formula, we calculate $42 million as the total goodwill created.
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