Purchase Price Allocation: Key points to note

Purchase Price Allocation (PPA) is an important component of a merger and acquisition transaction. It entails distribution of the value of the purchase consideration among various tangible and intangible assets (and liabilities) acquired from the target following the merger/acquisition. Residual purchase consideration, if any, is recorded as goodwill in the acquiring company’s books. A fairly complex process, it requires deep domain knowledge, understanding of the business plan, and expertise in intrinsic valuation to ensure all aspects of the analysis have been factored in accurately.

If your organization is contemplating an M&A or has recently completed a transaction to acquire or purchase another business, it is time to lay the groundwork to deal with financial reporting provisions relating to Purchase Price Allocation (PPA). ASC 805 “Business Combinations” under US GAAP and IFRS 3 “Business Combinations” are the most common reporting standards for purchase price accounting. For Indian companies, AS 14 or Ind AS 103 is applicable which is based on IFRS.

What is PPA?
A PPA exercise basically entails distribution of the value of the purchase consideration among various tangible and intangible assets (and liabilities) acquired from the target following the transaction. Residual purchase consideration, if any, is recorded as goodwill in the acquiring company’s books.

For starters, is it very complicated then? Well, not from the sound of it. Read the purchase agreement and allocate the value to different assets listed in the agreement schedules based on some high level judgment. But, herein lies the catch – simple as it may seem, the actual application often throws up several complex challenges.

What are the key issues that often make it complex?
Time to zoom in.

Determining the fair value of purchase consideration

The first step is that the purchase consideration be reported at ‘fair value’. This is not an uphill task in cases where the consideration is wholly discharged in cash. However, with M&A transactions across markets globally increasing in complexity, determining the fair value may turn out to be more than uphill:  

• How do you determine the fair value of the purchase consideration if it involves a contingent element like earn-outs that are payable in future (mostly upon successful achievement of certain financial outcomes or business milestones)? 
• What if the purchase consideration in whole or part is discharged by the issuance of equity shares of private company?
• How do you deal with dilutive instruments (like warrants) if they are a part of the purchase consideration?

Allocation of fair value of total purchase consideration to all tangible and intangible assets and liabilities

While identification of tangible assets is often straightforward, identifying intangible assets for allocating value can be challenging. Intangible assets may include diverse classes/groups based on their distinct character and exploitation in the business:

• Technology-related assets (patents, unpatented technology, R&D projects)
• Marketing-related (brands, trademarks, copyrights)
• Customer-related (contracts, customer relationships)
• Human intellectual capital-related (assembled workforce, non-compete agreements)

Intangible assets are recognized separately if they meet one of the following two criteria:

• Control – Arising as result of contractual or other legal rights
• Separability – Capable of being sold, transferred, licensed, rented or exchanged either individually or in combination with other related asset or liability

Why is it important to get PPA accounting right?
Depending upon the size and nature of the transaction, PPA can have significant impact on income statement and balance sheet. The intangible assets recognized at fair value are subject to amortization over their useful life which impacts profits and in turn taxation. The goodwill is subject to an impairment risk in case of downturn in business cycles. An improper allocation of purchase consideration can negatively impact your business in multiple ways: 

• Understatement or overstatement of depreciation and amortization leading to volatility and other adverse impact on net reported income
• A lack of sufficient documentation to explain the methodologies, reasonability of data and assumptions used creating year-end audit issues
• Failure to allocate value to intangible assets inflates goodwill which increases the impairment risk on annual testing; in case of public companies, this could significantly impact investors’ sentiment and share price
• Recasting the value of intangible assets causing significant delays; this could happen if your company is planning for an IPO and during due diligence, detects PPA reporting issues related to prior acquisitions

So, as a CFO or financial controller, it is only prudent to not approach this as a paper shuffling exercise. If conducted proactively at pre-deal stage, the exercise can help you support future earnings guidance. A well-performed PPA exercise can act as a catalyst to realize the perceived value and synergies.

Purchase Price Allocation can represent a signification challenge for an organization, given the changes and complexities in modern accounting. In a Purchase Price Allocation, the equation is squared off when the purchase consideration is equal to the fair value of the assets and liabilities to be recognized. Hence on the one side there is the amount paid – Cash, Shares, Preference Shares or such other forms of consideration and the other side there is Net Working Capital, Tangible Assets, Intangible Assets and Goodwill.

Goodwill is essentially the residual value of purchase consideration less fair value of assets and liabilities (Net Assets).

In order to arrive at the value of assets and liabilities, there are three accepted approaches – Cost Approach, Market Approach and Income Approach. Depending on the type of asset the most appropriate approach or a combination of approaches is chosen.

Tangible Assets

In a business, tangible assets comprise of Land, Building, Plant and Machinery, Furniture and Fixtures, Computers, and other industry specific assets. The fair value of tangible assets is established using the market approach when market data is available as in the case of land and building, Whereas, the replacement cost approach is generally employed in the case of plant and machinery. To arrive at the fair value of tangible assets a valuer needs to be aware of the market and the cost of assets prevailing in the market or the market value that an asset may fetch as of the valuation date.

Intangible Assets

Most intangible assets can only be recognized after the company has made an acquisition. So, there may be inherent intangible assets in a business which have not been recognized in the financial statements of the seller, however contribute to the business of the seller. For example, a company may not have recognized its brand in its financial statements, which could well be a contributing factor to sales and one of the motives behind the acquisition.

Hence, Intangible Assets that are identifiable, separable and can be valued are carved out of the purchase price and recognized in the financial statements of the acquirer. Goodwill as a component is reduced to the extent of Intangible Assets that are recognized. However, key considerations are – at what value should an Intangible Asset be recognized and what are the methods of valuation?

Cost Approach

The Cost Approach is based on the economic principle of substitution. Essentially, the premise is that acquirers will pay no more for an asset than it would cost them to develop or obtain that same or similar asset. The Cost Approach determines the value of Intangible Assets by aggregating the costs involved in their development. There are two distinct Cost Approach Methods: Reproduction Cost and Replacement Cost.

“Reproduction Cost” measures the expenditure necessary to reproduce the exact same asset. Alternatively, the “Replacement Cost” method measures the expenditure necessary to develop an asset with similar utility. In either method, it is essential that costs which are directly related to the development of the Intangible and no other. Another consideration is the valuation date – hence only those costs should be considered which have been or are expected to be incurred up to the valuation date.

Market Approach

Under the market approach, Intangible Assets are valued by benchmarking transactions to actual market transactions or sale, license or transfer of similar intangibles in the market. Although this approach is most practical and logical in its reasoning – the market delivers the best indication of price between a willing buyer and willing seller – the method suffers from the lack of adequate information that may be available in the market, especially for intangibles as they are not frequently traded in the market. Also, since most intangibles are considered unique, it may be difficult to find a transaction that is truly comparable. Nevertheless, when reliable and comparable market data is available, this approach is considered the most direct and systematic approach to determine the value of Intangible Assets.

Income Approach

Under this approach, the value of the intangible asset is derived from estimating the future income stream expected from the use of the intellectual property or intangible asset and then discounting it to its present value to arrive at the value of the intangible asset. This is one of the most widely used methods for valuing intangible assets as the inputs required for this method are relatively easily available and to a large extent fairly commensurate with business activities.

One commonly made error while using this method is that often valuers do not differentiate between the business enterprise value and the value of the intellectual property that supports the business.

There are two most commonly used methods under income approach – Relief from Royalty Method and Multi-period Excess Earnings Method (MEEM).

Relief from Royalty Method

As the name suggests, the value of the intangible is calculated as the present value of royalties that a company is relieved from paying as a result of ownership of the assets. The Relief from Royalty Method measures value by estimating future revenue associated with the asset over its remaining economic life and then applying an appropriate royalty rate to the revenue estimate.

The application of an appropriate royalty rate isolates the portion of value that is attributable to the intangible assets from the value of the overall business operations. Royalty rates used in this method are usually market driven rates and hence lends additional credibility to the value conclusions. The present value of the estimated royalty payments is then calculated using a discount rate that best represents the risks involved in achieving the revenue forecasts and royalty streams.

Identification of an appropriate royalty rate is most essential to this method. The royalty rate should be of transactions that are comparable to the intangible asset being valued. Several parameters have a bearing on determining what is a comparable transaction – the type of asset, industry, geography, exclusivity, time-frame etc. The key to a reasonable valuation is to utilize the correct royalty rate in the calculation. A relative strength analysis of the assets will help to narrow the range of royalty rates to one which is most appropriate.

Multi-period Excess Earnings Method (MEEM)

MEEM is commonly used method for measuring the fair value of intangible assets such as Customer relationships and enabling technology. The method estimates revenues and cash flows derived from the intangible asset and then deduct portions of the cash flow that can be attributed to Supporting Assets or Contributory Assets that contributed to the generation of the cash flows. Contributory Asset charges could be assumed/economic rentals on account of use of operating capital, machinery and equipment, other rights, labour and land and buildings. The net amount so derived is the isolated excess cash flow generated from the use of the intangibles. From this amount tax costs are deducted.

These excess cash flows are then discounted to their present value using an appropriate discount rate to arrive at the value of the intangible asset.

Conclusion

Allocating the right values to the rights assets is imperative to any purchase transaction. It holds all the more importance in a transaction such as a Slump Sale where individual assets and liabilities are not allocated values in the sale transaction with the purchaser having to recognize individual assets and liabilities in its financial statements.

Valuation is a subjective exercise but is governed by certain methods, guiding principle and practices. While it may not be an exact science, it offers a reasonable basis to arrive at the fair value of assets and liabilities. One of the most important considerations in a Purchase Price Allocation is the recognition of Goodwill and Intangible Assets which have formed part of the acquisition and allocating fair values to such brands, trademark, knowhow, non compete agreements, software, technology, customer relationships and other intellectual property is imperative to a reasonable Purchase Price Allocation. The concept of Purchase Price Allocation has also assumed greater significance with evolving accounting regulations and other regulatory guidance.

Equity value and enterprise value are two common ways that a business may be evaluated from a marketing and sales standpoint. The both value may be used in business valuation or sale of a business, however each offers a different view. While equity value offers a snapshot of current and potential future value, the enterprise value provides an accurate calculation of the overall current value of a business which is similar to balance sheet.

Valuation is an integral part in the field of finance and has significance in different areas such as merger and acquisitions, corporate finance, financial reporting etc. The value of a firm is a reflection of its operating, financing and investing decisions. When a valuation analyst values a company, the terms equity value and enterprise value are first to come in mind, where equity value is the market capitalization of the company i.e. the portion available to its shareholders and enterprise value is a measure of company’s total value that is attributable to all its investors. In other words equity value is the number which public at large sees while enterprise value represents its true value. In terms of formula:

Equity Value = Common Shares Outstanding * Share Price 

Enterprise Value = Equity Value + Debt – Cash + Minority Interest + Preferred Stock

Equity value tells you at a glance how much a company is worth, whereas enterprise value tells you more accurately how much it would really cost to acquire the company. When you buy a house, there are all sorts of hidden costs like required repairs, unpaid bills, obligations, and more, but you might also benefit from, for example, getting furniture for free with the house. Enterprise value works the same way, it takes into account the obligations that you need to repay, like debt, and also the “free gifts” you get, like cash, and gives you the true cost to acquire a company.

Before investing in a company, investors would like to know the worth of the company. But the question arises which value to look for, Equity or Enterprise? Enterprise value and equity value are the basic foundation for an investor. Many investors get confused in different valuation metrics that represent the total value of a company. A company with more cash than debt will have an enterprise value less than its equity value and a company with more debt than cash will have an enterprise value greater than its equity value. Therefore an investor should always be cautious of his needs and preferences with respect to these two values and accordingly use appropriate valuation metrics.