Once a company has been acquired, the price paid for it must be assigned to relevant identified assets and liabilities within the acquired business for reporting within consolidated financial statements. This process is known as a Purchase Price Allocation (PPA).

The purpose of the PPA is to assess the ‘fair value’ (or market value) of the tangible and intangible assets acquired in a transaction, along with the acquired liabilities of the target business, for disclosure in the post-acquisition combined accounts. 

This requirement, as required by International Financial Reporting Standards in IFRS 3 Business Combinations and by UK GAAP within FRS 102, seeks to enhance the accuracy of consolidated financial statements (particularly around the recognition of intangible assets) and ensure greater comparability in financial reporting. With it having been reported that intangible assets account for almost 85% of the enterprise value of US companies within the S&P 500, the desire to provide greater transparency as to acquired intellectual property in this time of the ‘knowledge economy’ is understandable.

The PPA process

There are a number of steps necessary to perform a PPA;

• Firstly, the purchase consideration should be accurately reflected. This will naturally be straightforward in a simple cash deal, however a fair value assessment may be necessary for components of the consideration that are settled by way of deferred consideration, share-for-share exchanges, and so on.

• It is then necessary to identify what cash generating units (CGUs) exist in the acquired entity and determine an appropriate allocation of the purchase price to each CGU. A CGU itself is essentially the smallest part of a business (such as a division operating within a specific geography) which is able to generate its own income in a way that is largely independent of the rest of the business – and given this definition, there is obviously some work to do in terms of making this assessment.

• The value of any tangible assets then must be assessed, as at the date of the acquisition. This may be very straightforward (e.g. cash and highly liquid assets), but for certain assets such as large plant & machinery or property (which may be on the books at historical cost) a revaluation may be appropriate,

• The fair value of liabilities also needs to be assessed as at the acquisition date. It is possible for the value of loan instruments to differ from their book value – for example with related party loans on favourable terms, or where interest rates were set at a level which was commercial at the time but would no longer be realistic.

• The difference between the fair value of the purchase consideration, and the fair value of the acquired balance sheet with reference to their tangible asset values, must then be allocated to the acquired identifiable intangible assets (IIAs) – the identity of which must first be established.

The process of trying to determine which IIAs have been acquired will be subjective, as no recognition of their existence (at least in the financial statements) may have been made previously. There exist certain criteria (which vary between IFRS 3 and FRS 102) as to what assets can, or must, be recognised given the circumstances, but assets which are frequently recognised in a business combination include:

• Brands and trademarks

• Patents

• Software

• Customer contracts and customer relationships

• Copyrights

• Non-compete agreements

• Recipes and formulations

Even upon recognising the above assets there may be a degree of ‘residual goodwill’ (there may even be ‘negative goodwill’ if it can be proven that the deal was a bargain purchase – the accounting treatment for which will differ). This residual goodwill is to be expected and will reflect other acquired benefits which cannot be separately recognised as assets on the balance sheet – such as the value to the business of the embedded workforce, or the synergies projected to arise from the transaction.

Valuing intangible assets

The determination of the value of each intangible asset may vary between assets and asset types, and involves rigorous valuation techniques including market comparisons, income approaches, and cost methods, to estimate the value of each asset and liability accurately.

Whilst these approaches can be reasonably technical, a simplified outline of some of the key approaches is shown below:

• Replacement Cost method: conceptually the easiest approach to understand, this requires an estimation of the cost involved to recreate an identical asset (including labour costs). There are obvious limitations of this method however, including the subjectivity involved in determining appropriate costs, the benefits associated with any existing property right protections, and the omittance of any assessment of the future profits the asset may be used to generate. 

• Relief-from-Royalty method: for asset types where it is theoretically possible to license the asset, and an active market in similar assets exists (such as patent royalties), this approach attempts to capture the value of ownership of the asset by estimating the present value of the theoretical saving the entity is able to make by avoiding the need to pay for a licence to use this asset.

• With or Without method: very much doing as it says on the tin, this approach requires a valuation of the enterprise in total and then hypothesises what the enterprise value would be without the IP being valued – the difference between the two being attributed to the IP itself.

• Multi-Period Excess Earnings Method: somehow even more complicated than even its mealy-mouthed moniker might suggest. In essence this models the future cash flows attributable to the acquired business, but then strips out the upside from future enhancements of the asset (such as software updates or new business, which is done by factoring in the natural ‘attrition’ of the asset) and the deemed ‘contribution’ to earnings from other assets, before discounting those residual cash flows back to their present value.

There also exists a final step that allows valuers to cross-check their outcomes, which is to consider the appropriateness of returns implied on each asset from the final valuations, called the weighted average return on assets (WARA). 

Conclusion

Purchase Price Allocation is a fundamental part of the post-M&A process, enabling businesses to not only comply with accounting standards but also assess the value of acquired assets and liabilities with a reasonable degree of accuracy. Whilst this process may be complex and challenging, it is nonetheless useful as it provides insights for financial reporting, decision-making, and even tax planning in the wake of an acquisition.