Purchase Price Allocation Reviewed by Momizat on . Analyze early and avoid earnings surprises The purchase price allocation (PPA) process is often treated as an afterthought in mergers and acquisitions (M&A) Analyze early and avoid earnings surprises The purchase price allocation (PPA) process is often treated as an afterthought in mergers and acquisitions (M&A) Rating: 0
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Purchase Price Allocation

Analyze early and avoid earnings surprises

The purchase price allocation (PPA) process is often treated as an afterthought in mergers and acquisitions (M&A). Thinking about PPA can help guide a deal to a more predictable conclusion. In the most rewarding deals, a prompt PPA process helps acquirers analyze, from a financial reporting point of view, the primary drivers or intangible values associated with the transactions.

PPA-AnalysisAccounting Standards Codification (ASC) Topic 805 establishes the accounting standards for determining and reporting the assets and liabilities acquired in a business combination for financial reporting purposes. ASC 805 requires that “as of the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable intangible assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree.” The acquirer is required to measure the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree at their acquisition-date fair values.

“Fair value” is defined in ASC 820 as the price that would be received to sell an asset or paid to transfer a liability in a transaction between market participants at the measurement date. Under ASC 805, the fair value of the business interest or assets acquired is determined, and the fair value of the consideration paid in the acquisition is allocated to the identifiable tangible and intangible assets acquired at the reporting unit level.

“Getting an early start on PPAs can add value. Incorporating the PPA process into M&A diligence can serve as a ‘sanity check’, forcing a rigorous exploration of what besides tangible assets is being purchased.”

The purchase price allocation (PPA) process is often treated as an afterthought in mergers and acquisitions (M&A). The PPA can help guide a deal to a more predictable conclusion. In the most rewarding deals, a prompt PPA process helps acquirers analyze, from a financial reporting point of view, the primary drivers or intangible values associated with the transactions. A well-considered and well-executed PPA process can also prevent the so-called “Day-Two” earnings surprises due to unanticipated dilutive (or accretive) effects from larger- (or smaller-) than-anticipated accretion, depreciation, and amortization expenses of the acquired assets and liabilities.

The PPA process often is not a priority until after a deal has closed. The principle driver is the acquisition or the deal. However, for companies that integrate it into their M&A procedures early in the deal and have the help of valuation experts, the PPA process tends to run more smoothly. Early valuation involvement also is likely to produce more consistency between due diligence expectations and post-closing realities.

Managing the process well can help an acquiring company understand the financial accounting aspects of the assets and liabilities it is acquiring. Good process management also provides the opportunity for early exposure of the buyer and its auditor to the acquisition’s effect on the buyer’s financial statements after the deal.

Determining how to express an acquisition’s value in accounting terms might seem academic to deal makers who have studied a purchase inside and out and view the target as an integrated whole. It could be tempting, therefore, to treat the PPA process as an exercise in post-deal rationalization.

However, the PPA can affect companies’ earnings. The acquired fixed assets are adjusted to fair value and depreciated at different rates depending on the estimated useful lives of the fixed assets. With respect to intangible assets, distinctions must be made among the separately identified intangible assets. Liabilities need to be adjusted to current market expectations for assuming those liabilities.

Separately identified intangible assets, such as patents, copyrights, and licenses, are amortized at different rates, depending on each asset’s estimated useful life, including an indefinite life if appropriate, and other circumstances specific to the asset. Goodwill, on the other hand, is not amortized by public business entities for book purposes but is tested annually for impairment instead. (There is an alternative to amortize goodwill available to non-public business entities.) Therefore, if these separately identified intangible assets are not identified and valued appropriately, the amortization expenses might be overstated or understated. This, in turn, can affect future earnings, which is an important financial indicator to investors—especially for public companies—for which stock prices are often assessed by short-term performance indicators such as earnings per share.

A proper PPA process benefits from a regimented structure. The foundational first steps are determining the rationale behind the acquisition and studying the consideration transferred, including the buyer’s anticipated internal rate of return. These steps help an acquirer and its auditor understand, from an accounting perspective, the assets being purchased and liabilities being assumed.

After the fair value of the tangible assets is identified, the next step is to identify the intangible assets. To do that, it helps to understand the transaction’s main driver, which in most cases will serve as the primary income-generating asset. Other intangible assets also need to be identified and valued separately. An assessment of how these intangible assets create value and how long these assets are expected to generate value provides the basis for value.

Given the varying lives and consumption patterns of tangible and intangible assets, a methodical approach is vital. Depending on the nature of the intangible assets, different valuation methods are applied to value those assets.

Because of the inherent complexity of the process, companies new to M&A often have an understandable desire to delay a PPA until after a deal has been established. However, the process’s importance has led acquirers to incorporate PPAs more frequently into earlier-stage diligence efforts. A benefit of moving up the work is that it facilitates earlier interaction with the auditors and valuation appraisers, thereby inducing buyer, appraiser, and audit teams to be on the same level of understanding and minimizing unnecessary post-deal accounting surprises.

Getting an early start on PPAs can add value. Incorporating the PPA process into M&A diligence can serve as a “sanity check,” forcing a rigorous exploration of what besides tangible assets is being purchased.

A well-run PPA process that produces a significant allocation to goodwill might also indicate that an acquirer’s internal rate of return is below that of the market participants, which could signify an overpayment. Therefore the PPA process can help acquirers to re-evaluate the assumptions used in determining the consideration transferred. However, if the acquirer expects important synergies that other market participants don’t, then a high level of goodwill might be appropriate.

A prompt PPA process can provide an opportunity for a closer look at a deal. Often based on rules of thumb, valuations that investment bankers and other consultants give during the diligence process frequently lack the specificity that a PPA requires. In instances where valuations might be contested, a PPA can inject authority and clear metrics into the process. In a negotiation environment, the view of an independent party not involved in the deal can be invaluable.

There are clear benefits to taking a proactive, rigorous approach to the PPA process. Armed with the right expertise and a vigorous method, an acquiring company can manage the M&A process to include the PPA considerations sooner and avoid any post-deal earnings or other surprises.

Gautam Anumukonda, CPA, CA (Ind), CVA, MFP, RFS, is a practicing Certified Public Accountant. He has two decades of diversified professional accounting, auditing, management and consulting knowledge and experience. Mr. Anumukonda’s experience includes numerous special assignments performed for businesses ranging from start-up ventures to major public corporations. Special assignments performed include public offerings, merger and acquisition buy-side and sell-side due diligence reviews, technical accounting assistance and advisory services, Securities and Exchange Commission (SEC) consulting and advisory services, CFO and controller advisory services, Sarbanes-Oxley assistance and advisory services, International Financial Reporting Standards conversions and advisory services, accounting system reviews, corporate governance advisory services and tax advisory services. Mr. Anumukonda can be reached at ganumukonda@consultingsgc.com or at (646)207-7725.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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