Purchase Price Allocation - An Overview and Update

By Mark Gehrig, Managing Director

Companies that need to have financial statements issued in conformance with GAAP know that there are a lot of rules to follow.  One of the many areas for which adherence to GAAP requires special attention is business combinations and acquisitions.  Over the past 15 years, the GAAP rules governing this area have been known by a variety of names and abbreviations (FAS 141, FAS 141r, and the current ASC 805) but can be more generically referred to as purchase price allocation (“PPA”) standards.  Purportedly, the PPA rules are intended to provide the users of financial statements with useful investment information. While this contention is often debated, the rules themselves remain, and GAAP requires that the fair value of the assets and liabilities acquired in a business combination must be reflected in the balance sheet of the buyer/surviving entity.

Within the last two years, in response to an assessment of the costs and benefits of performing a PPA analysis, the Financial Accounting Standards Board offered a simplification alternative that provided some options to GAAP-reporting private companies (not currently available to public companies).  These options are discussed below, after a brief review of what a typical PPA entails.

The logical starting point in performing an ASC 805 PPA appraisal that will satisfy your GAAP-loving auditors is to determine the appropriate total purchase price amount that needs to be allocated.  Sounds simple, and in some cases it may be.   However, in many instances the answer is not so straightforward.

If the Buyer paid cash at the time of close for acquiring the stock or the assets of the Target in a clear-cut transaction, then maybe the answer is easy.  However, if the Buyer and Seller negotiate that some consideration will be paid now and some will be paid in the future based on a specified event or achievement of a financial milestone, then the answer is much less clear.  Estimation of the fair value of contingent consideration is often surprisingly difficult.  To make things trickier, it is also a highly contested area of valuation with no consensus of treatment.  Nonetheless, getting this element of the PPA correct is necessary to assure the process gets off on the right foot.

Once the first appraisal hurdle is cleared, and allocable purchase price is determined, it’s time to consider how, and on what valuation basis, to allocate the purchase price.

One way to think of purchase price is in terms of the balance sheet.  The amount paid to acquire assets that will generate revenues and cash flow for the buyer consists of two potential components:  cash paid for the equity, and the assumption of any interest bearing debt capital.  These two components (along with those spontaneous financing components of current liabilities that are considered part of net working capital, such as accounts payable, accrued expenses, etc.) comprise all of the right hand side of the balance sheet.  So, because of the equality inherent in the balance sheet, the purchase price should equal the left hand side of the balance sheet (reduced by the “spontaneous financing” components), namely, net working capital, fixed assets, and all intellectual property and intangible assets including goodwill.

Net working capital is usually the easiest component of the acquired assets for which to determine fair value.  Cash is a separate item in most transactions.  Occasionally inventory will require appraisal, which means determining the price for which the inventory could be sold, less the necessary costs incurred to sell the inventory and a reasonable profit for that effort.    The accounting book value of all remaining current assets is typically a reasonable proxy for fair value.  The same is true of most non-debt current liabilities.  One exception is deferred revenue.  This liability often lurks in software development companies where payment has been made in advance for services not yet provided.  The task in this case is to determine the costs still to be incurred in order to satisfy the obligation and the portion of total profit attributable to that effort.  These exceptions aside, less effort is typically required to determine fair value of net working capital.

If the real estate is owned and acquired it will likely need to be separately appraised, unless a recent arm’s length transaction exists that can serve as a gauge for fair value.  For personal property fixed assets, the fair value determination will depend on several factors: type of property, magnitude of difference between accounting/tax depreciable life and economic useful life, the cost basis (i.e., original cost or based on previous acquisition allocation of fair value), and other factors that cause accounting net book value to deviate from fair value.  We have found that the accounting net book value of relatively short-lived assets (such as computer equipment, office furniture and devices, etc.) is often accepted as a proxy for fair value, as long as the cost basis is the original acquisition cost.  Final judgement regarding these factors will ultimately rest with your auditors.

So, once contingent consideration has been appraised and the tangible assets have been addressed, the primary effort associated with the PPA is the valuation of intellectual property and intangible assets that are identifiable and separable from goodwill.

The accounting rules provide notable assistance in this regard.  First, fair value appraisal should be performed of intellectual property and intangible assets that either (1) arise from a legal or contractual right and/or (2) are separable from the business (i.e., could be separately sold, licensed, rented, etc.).  While not an exhaustive listing, five “buckets” of intangible assets are set forth in the accounting literature:

  • marketing-related intangible assets
  • customer-related intangible assets
  • artistic-related intangible assets
  • contract-based intangible assets, and
  • technology-based intangible assets

Marketing assets typically include trademarks, trade names, service marks, trade dress (i.e., logos, color, package design, etc.), internet domain names, and noncompetition agreements.  The importance of these assets will vary depending on industry, and assets are often appraised based on a comparison of actual licensing in similar markets.  Noncompetition agreements, in contrast, are typically appraised based on the detrimental effects on the value of the business that could be caused by the absence of the competition prohibition.

Customer-related intangible assets can include relatively static assets, such as lists (catalog mail order), as well as backlog (actual purchase orders from existing customers) and contractual and non-contractual customer relationships.  The typical asset within this group is non-contractual customer relationships. Normally very significant, this continually wasting asset is appraised by identifying the income benefits projected to be derived while at the same time considering the claim on income generated by the business from all other requisite assets that cause a business to be an operating going concern (in contrast to an uncoordinated group of assets).

As the name suggests, artistic assets include works such as operas, books, musical compositions, photographs, and films, to name a few examples.  Fittingly, the appraisal of such assets involves—no pun intended— truly more art than science.

While one might think contractual assets enter into the PPA picture frequently, our experience has not found that to be true.  Typically, to represent a value element the contract in question must reflect an intrinsic benefit to the company (e.g., rates charged to the company are lower than market rates charged to everyone else).  It is also usually the case that these benefits extend into the distant future.  An example would be a beneficial facility lease in which the company pays a lower than market rental rate, and the lease has 10 years remaining with no contractual provision to reset the rent to market rates.

Finally, the technology assets employed by a company are typically critical and varied.  The valuation approaches employed to appraise such assets can be as varied but, as one might expect, are typically based on the economic benefits a hypothetical buyer would expect to enjoy as a result of ownership.  This asset group can include patents, patent applications, trade secrets and unpatented technology, internally developed software, a library of critical designs or drawings, formulas and recipes, and so on.

As mentioned earlier, private companies do have some options regarding the reporting of business combinations in conformity with GAAP.  These simplification rules arose in response to feedback from private companies that the process of adhering to the GAAP requirements of business combination reporting is time consuming, expensive, and in some instances, of questionable decisional value to users of the financial statements.

Currently, private companies can elect either to not amortize goodwill for book purposes (status quo and public company treatment) or amortize over 10 years (or a shorter period if a shorter economic life can be substantiated).  Further, under simplification rules a private company can include the value of customer relationships and noncompetition agreements in goodwill through the residual computation, rather than appraising these assets separately and reflecting them on the balance sheet. These assets can be significant in many acquisitions.    However, it should be noted that if simplification is elected for reporting acquired intangible assets then goodwill must be amortized for financial reporting purposes.  If a private company believes it will ever consider an IPO or for any other reasons need to adhere to public company reporting rules, the effort associated with restating the results of business combinations to eliminate the simplification effects would likely lobby for the use of the non-simplified reporting rules in the first place.

Chartwell has significant experience assisting both private and public clients with fair value estimation related to financial statement reporting.  Our work has successfully withstood reviews by each of the Big Four accounting firms, as well as most second tier and regional accounting organizations.