Purchase Price Allocation
The Crucial Role of Purchase Price Allocation in Mergers and Acquisitions Purchase Price Allocation (PPA) is crucial in mergers and acquisitions, dissecting acquisition costs into identifiable segments to assign fair values to assets and liabilities. Beyond historical book values, PPA offers a comprehensive view of a target company’s worth, covering tangible and intangible assets. PPA involves rigorous evaluation using diverse valuation techniques for assets like property, plant, and equipment (PPE), alongside intangibles such as intellectual property rights and customer relationships. This meticulous approach ensures compliance with International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP) and enhances financial reporting reliability, fostering stakeholder trust. Compliance with IFRS and U.S. GAAP highlights PPA’s significance in mergers, regardless of scale or industry. Detailed disclosures bolster transparency, mitigating risks associated with discrepancies. PPA influences acquirers’ financial statements, offering insights into transaction economics. Ultimately, PPA’s disciplined execution serves as a beacon of financial prudence and accountability in navigating business combinations, fostering trust and confidence. Illustrative Example Using a Restaurant Analogy: Simplifying Purchase Price Allocation (PPA) To help simplify the concept of Purchase Price Allocation (PPA) for those without a deep financial background, let’s use a relatable analogy: purchasing a high-end restaurant. This example will clarify how PPA allocates fair values to assets and liabilities, adjusts them, accounts for goodwill, and addresses the concept of impairment. Step 1: Evaluating the Menu (Assigning Fair Values) Imagine you decide to buy a popular high-end restaurant. The first step in PPA is to evaluate all the components of the restaurant at their fair market values: By assessing these items at their fair market value, you can determine the true worth of each asset and liability, rather than relying on their historical costs. Step 2: Allocating to Goodwill (Chef’s Charm) After assigning fair values to the identifiable assets and liabilities, the remaining difference between the purchase price and the total fair value of these items is allocated to goodwill. In our restaurant analogy, this excess amount represents the restaurant’s reputation, customer loyalty, and the unique culinary skills of the head chef. This “chef’s charm” is what makes the restaurant special and is valued above the tangible and intangible assets. Step 3: Adjusting the Kitchen (Fair Value Adjustments) Next, PPA involves adjusting the values of all acquired assets and liabilities to their real market worth. For instance: These adjustments ensure that the assets and liabilities on your financial statements reflect their true economic value. Step 4: Recording the Restaurant Ledger (Balance Sheet Adjustments) Finally, all these new values are recorded on your financial statements, providing an accurate picture of the restaurant’s worth: Impairment Concept Impairment occurs when the carrying amount of an asset exceeds its recoverable amount. For goodwill, this means assessing whether the restaurant’s reputation and customer loyalty still hold the same value over time. Inference Using this restaurant analogy, we’ve simplified the concept of PPA by illustrating how fair values are assigned, goodwill is calculated, assets and liabilities are adjusted, and the importance of impairment testing. By understanding these steps, you can appreciate how PPA provides a clearer financial picture, aiding in informed decision-making for investors, creditors, and analysts. Recognition of Identifiable Intangible Assets In the realm of Purchase Price Allocation (PPA), distinguishing and recognizing identifiable intangible assets separately from goodwill is crucial for accurate financial reporting. To recognize intangible assets separately from goodwill, they must meet certain criteria. These assets must be: Examples of Common Identifiable Intangible Assets EY PURCHASE PRICE ALLOCATION STUDY (28TH MARCH 2024) Ind AS 103 applies to most business combinations, including amalgamations and acquisitions. EY has undertaken a study of business combination accounting for transactions that were disclosed in annual reports of the top 500+ listed companies in India by market capitalization and over 80 private companies (covering over 700 transactions) since implementation of Ind AS till 31 March 2023. This study presents the results of assets (primarily intangible assets) that are typically recognized and reported by a company during an acquisition. However, the results of this study cannot be viewed in isolation, as each deal would have specific nuances. Key findings of the PPA Study The sector-wise allocation trends of purchase consideration among Goodwill, intangible assets and tangible assets are as follows: Accounting Implications of Lump Sum Treatment for Intangible Assets in Goodwill Lumping all intangible assets in goodwill can potentially overstate reported profits and increases the volatility of reported profit especially if a significant portion of the identified intangible assets (not recognized in the books of the target company) have a limited economic life and are therefore subject to amortization. For example: Assuming Company A purchased Company B for Rs.100. Company B has Rs.50 of net assets recorded on its balance sheet as at the acquisition date. There is Rs.40 of customer intangible assets that would be identified if a PPA was carried out. The Goodwill booked in the accounts would be Rs.50 if no PPA was carried out and Rs.10 in the opposite situation. Assuming the combined EBITDA is Rs.100, under a scenario where no PPA is carried out; there would be no amortization of the customer intangibles (10 year straight-line). However, the goodwill will be reassessed for impairment annually and may flag up for impairment. Under the assumption, that impairment occurs in Year 5 and 10. Year 5 and Year 10 PAT would be significantly lower in that year. Although the total PAT over the 10 years in both cases would be the same (assuming no claim for tax allowance is made for the customer intangibles), the potential impairment may flag up concerns to investors and other stakeholders that Company A overpaid for Company B and/or PAT is now more volatile (dividends at risk). CIT vs Smif Securities case (October 2023): The problem was, Indian tax law wasn’t clear on whether companies could claim depreciation on goodwill, which reduces its value on the books over time (similar to how a machine depreciates). This became a dispute in the “CIT vs. Smif Securities” case (October 2023). Here’s
