Purchase price allocation (PPA)

The Carta Team

Read time: 15 minutes

Published date: December 20, 2018

A Purchase Price Allocation (PPA) is often required for tax and financial reporting following a merger or acquisition. Learn more about how PPA works.

What is a purchase price allocation?

A purchase price allocation (PPA) is an exercise intended to identify what was actually purchased—all of the assets, both tangible and intangible, as well as any liabilities—and assigning a Fair (or Fair Market) Value to these various components. Note that the Fair Value of any asset is the value that a hypothetical market participant would pay for the assets (and not necessarily the value that any one specific acquirer would be willing to pay).

The purchase price paid for the business is then allocated among the Fair Values of the identifiable assets (and liabilities, if any).

Once the allocation of purchase price to each asset (and liability) in a business sale has been accomplished, the residual is known as goodwill. Goodwill in accounting represents the amount an acquirer has paid above the Fair Value of the identifiable assets.

Why is a purchase price allocation necessary?

The main reason purchase accounting is necessary is for financial reporting purposes. The goal of the accountant for the transaction is to reflect the proper values of the assets and liabilities on the opening balance sheet.

So is a purchase price allocation just another compliance hoop for me to jump through?

Far from it. Yes, it is required for compliance, but you should view a PPA valuation exercise less as a burden and more as an opportunity. Doing a PPA will provide insights into many aspects of the business that you might otherwise not have had.

When do we need to do a purchase price allocation?

A PPA is generally done soon after the close of the transaction while management of the target company and information related to the historical and prospective prospects of the business are still readily accessible.

Why would anyone want a purchase price allocation pre-transaction?

From the sell side, it can be very useful to perform a hypothetical purchase price allocation as a way of dressing the company up for sale. From the buy side, it’s helpful to have an objective third party offer an independent assessment of the value of the individual components of a business.

Why do investors demand a purchase price allocation?

Investors want a clear understanding of what you are doing with their money. After allocating the purchase price, they want to know how much goodwill was left over, which they hope is not going to be subject to impairment down the road.

Why do accounting and taxes require a purchase price allocation?

While financial accounting for an acquisition requires a PPA, you may also require one for tax purposes. The PPA may often be used for both financial and tax reporting, and in the latter case, essential for both sides.

PPA process

Who will we need to get involved in this process?

• Seller’s management (to understand what drives the business)
• Buyer’s management (to discuss what the buyer thinks it is acquiring)
• Buyer’s external accountants and/or tax advisors
• Other relevant parties (as required)

What steps do you take in performing a purchase price allocation?

The acquisition of a business requires an allocation of the purchase price for tax and/or financial reporting purposes. This process consists of:

1. Calculating the purchase price (total consideration paid)
2. Identifying the correct assets acquired and liabilities assumed
3. Calculating the fair value of those assets and liabilities

What is a Replacement Cost New method?

The Replacement Cost New method establishes the highest amount a prudent investor would pay for an asset based on the cost to replace it using current material and labor rates.

What is a Relief from Royalty Method?

In estimating the Fair Value of certain intangible assets, the Relief from Royalty Method estimates the Fair Value based on the present value of the royalties saved because the company owns the intangible asset.

What is an Excess Earnings Method?

The Excess Earnings Method measures the value of an intangible asset by calculating the residual profit after subtracting the appropriate returns for all other complementary assets that benefit the business.

What assets are required to be bifurcated?

All assets apart from goodwill need to be identified and separately allocated a purchase price.

Special circumstances

What is an Asset Deal?

An asset deal means you’re basically just buying the left-hand side of the balance sheet, and the seller is responsible for discharging all liabilities.

What is a Stock Deal?

In a stock deal, you’re exchanging some form of security for equity, and you are generally responsible for the assumption of liabilities.

Should I be worried about a relatively high Goodwill?

You are required to test it at least annually for “impairment of long-lived assets.”

How do Non-Competes work in a Purchase Price Allocation?

Non-Competes are payments for protection to the buyer from activities of the seller which may detract from the value of the acquired business.

What is a remaining useful life and why do I need to know it?

Most acquired assets, except goodwill, are usually finite lived, and it is important to determine the remaining useful life to calculate the period of time over which the asset will be depreciated or amortized on the buyer’s financial statements.