Purchase Price Allocation
Purchase price allocation (PPA) is a market or fair value analysis made by a buying company to let its investors know what assets were obtained in any merger or acquisition.
Purchase price allocations are a crucial element of the financial reporting of a merger or acquisition and play a significant part in income tax filings to the Internal Revenue Service (IRS).
Purchase Price Allocation (PPA)
The first part of calculating the purchase price allocation is finding the purchase price or the transaction price which is what the company was bought for. In the case of a listed company, it is how much per share the buying company paid for the acquired company.
Mergers and acquisitions (M&As) offer good chances for businesses to expand in competitive markets, but they come with their own set of challenges and issues. Most mergers and acquisitions are subject to intense screening and a thorough assessment of the workings of the merger to ensure that there is no illegal activity being conducted or any investor's or business’s rights are being violated.
Mergers are also subject to new tax and financial reporting parameters to ensure proper analysis is possible such as the Purchase Price Allocation. It helps let the company’s investors know what was acquired in a merger and for how much.
Purpose of Purchase Price Allocation
When buying a company through a merger or acquisition, the amount for sale is usually discussed in totality. However, in order to know how much the amount is worth in tax dollars, the tax basis of the assets included in the deal is needed, which makes a purchase price allocation mandatory.
The buyer should know how much their purchase price is allotted to each asset which is necessary to report the correct tax, depreciation, and amortization of assets. You can read about what is a prepaid amortization schedule? here.
The seller also wants to know the gain or loss on all assets included in the deal. The buyer and the seller must disclose the gains and losses on assets on their financial statements and tax returns for the transaction year.
Bear in mind that the tax requirements for the purchase price allocation differ from the Generally Accepted Accounting Principles (GAAP) requirements.
Calculating the purchase price allocation is an accounting process that lists every asset bought and liabilities and gives the assets a value and is usually a three-step process:
Find the total purchase price (total price paid)
Listing the correct assets bought and liabilities acquired
finding the fair market worth of these assets and liabilities
Total Price Paid
Total price lists cover everything used to pay for a merger, added to the liabilities the buyer takes on. If shares, loans, cryptocurrency, or another payment category are used instead of cash, a further valuation could be needed to measure the specific payment type.
This calculation of the total price paid also needs to consider any earn-outs and covenants-not-to-compete. This requires a detailed analysis as these items also represent additional consideration taxed as capital gains for the recipients.
Together with the tangible assets like personal and real property, intangible assets like customer and business relationships, goodwill, software and licenses, and copyrighted property like trademarks and trade names should also be listed.
After all the assets are identified, the purchase price is divided or allocated between all the listed assets.
For instance, a company specializing in consumer goods decides to buy a potato chip maker for $10 million in a deal designed as an asset purchase. The $10 million is the purchase price for all the assets of the chip maker. This price is then distributed between the different types of machinery, inventory, and any other assets the chip maker brought into the deal.
In the IRS issues the Internal Revenue Code Section 1067, there are provisions for using the residual method to distribute the purchase price amongst the following assets:
Class I: Cash and cash equivalents
Class II: easily tradable property, Certificates of Deposits and foreign currency
Class III: real estate mortgages, accounts receivables and credit card receivables
Class IV: Inventory
Class V: Equipment, land and property
Class VI: Intangible assets as described in Internal Revenue Code 197, less Goodwill or going concern items
Class VII: Goodwill and going concerned
Using the residual method for calculating the purchase price requires both sides of a transaction to use the valuation method and then distribute the purchase price to all identified assets.
If there is any extra value leftover after distribution, it is assigned to goodwill (i.e., Class VII).
The tax treatment of the gains and losses will vary according to the asset class, and the rates will also vary. For example, gains assigned to assets in inventory (Class IV) are taxed as ordinary gains, on the other hand, gains assigned to certain intangibles (Class VI) can be treated as ordinary income or capital gains.
When is a Purchase Price Allocation Necessary?
A purchase price allocation is usually needed after a buyout deal is executed for both tax purposes and financial reporting.
The standard practice is to work on the price distribution as soon as a deal is finalized (and values are final) as the acquired business’s management is usually still available, and it is easier to get information about the new business from them.
Delaying until after the deal is finalized is not a good idea as people move on to other jobs, and information is lost, misplaced, or forgotten. Records can be misplaced, and management team members are shuffled about or leave.
Many businesses set themselves up for success by doing the purchase price allocation at the initial stages of the negotiation. This is an opportunity to get a better overview of what the business they are acquiring is worth.
The buyer gets to know how much they are paying and for what and sellers use the purchase price allocation at an early stage to make their business more attractive. In cases where the seller is looking for buyers, it is the norm to build a pitchbook and “sell” their assets by showing other features such as additional financing and tax benefits they may have.
Many others opt to get the purchase price allocation exercise done by an independent third party which adds credibility to the transaction for both the buyer and seller.
Regardless of when it is done, the assessment or allocation by an independent third party can execute the deal quicker as there is an explicit sharing of information.
The objective of doing a purchase price allocation is not just limited to the accounting and tax purposes people usually assume. Buyers and investors assessing balance sheets will get a clear picture of the piece of business that they have invested in.
Management can plan out their strategy with more information at their disposal as the PPA gives them a deep understanding of the asset values. They can also better justify their decision to invest in this particular business. Goodwill is significant in purchase price allocation as it shows how much or little risk exists for the new business.
Purchase price allocation is a process that both sides should opt for when starting the due diligence. The objective is a more apparent end result for both sides about the long-term impacts of the deal.