Purchase Price Allocation (PPA)
One of the financial valuation services provided by Appraisal Economics is the appraisal of assets for financial reporting, U.S. federal tax reporting, and international tax reporting. The acquisition of one entity by another gives rise to the need for compliance with the relevant reporting requirements.
When does a purchase price need to be allocated?
To comply with generally accepted accounting principles (GAAP) for financial reporting purposes, an acquirer needs to report the specific types and associated fair values of the acquired tangible (monetary and non-monetary), and intangible assets. These fair values are included on the opening post-acquisition balance sheet and are periodically adjusted to reflect depreciation and amortization charges, which reduce the carrying value of the associated asset (carrying value is calculated as the difference between original fair value, less cumulative depreciation and amortization charges). Intangible assets that are not amortized, such as goodwill, must be tested for impairment on at least an annual basis. Impairment is indicated when fair value is less than carrying value as of a given impairment testing date, or when other circumstances suggest the presence of impairment, such as a downturn in the entity’s business that is not considered to be temporary.
To report earnings on the income statement in compliance with GAAP, an acquirer must accurately compute depreciation and amortization charges based on an asset’s fair value and estimated remaining life. An asset’s fair value and estimated remaining life are interdependent, as fair value is a function of the estimated cash flows to be realized through use of the asset over its remaining life. Thus, the estimation of remaining life is a crucial step in the valuation of an asset, and can be particularly problematic for certain types of intangible assets, such as technology and non-contractual customer relationships, where an entity’s current and anticipated competitive environment can have a significant impact on remaining life.
Where assets are either directly acquired, or indirectly acquired in conjunction with an Internal Revenue Code (IRC) Section 338 (h)10 election to treat an acquisition of stock as an asset acquisition, the acquisition date fair market values of the acquired assets must be determined. These fair market values are included on the opening post-acquisition tax balance sheet and become the basis for annual tax depreciation and amortization charges in accordance with the provisions of the IRC and associated U.S. Treasury regulations.
Appraisal Economics seasoned staff including former engineers, CPAs, and financial analysts, has the expertise to undertake business and asset valuations and asset lifing studies with the requisite level of rigor to satisfy relevant regulatory authorities, including the entity’s auditors, the SEC, and the Internal Revenue Service (IRS). As Appraisal Economics counts the IRS among its regular clients, we have a deep understanding, developed over many years of working closely with the IRS, of the reporting requirements that will ultimately withstand IRS scrutiny.
What are the steps in a purchase price allocation?
There are three basic steps in a purchase price allocation, whether for financial or tax reporting purposes. First, the total purchase price must be determined, inclusive of cash and non-cash consideration. To the degree that the acquirer is assuming certain liabilities, whether stated or contingent, these must be properly taken into account in the calculation of the effective price paid for the acquired assets.
The second step is to identify the types of tangible and intangible assets acquired that meet the criteria for recognition under the relevant accounting and tax reporting guidelines. In the case of intangible assets, the main criterion is whether it is to be recognized as an asset separate and apart from goodwill.
The third step is to value the identified assets that meet the relevant reporting criteria, using, as appropriate, the cost, market, and income approaches.
What guidance exists for allocating the purchase price?
The Financial Accounting Standards Board (FASB) has promulgated the Accounting Standards Codification (ASC) as the source of the generally accepted accounting principles bearing upon allocation of purchase price for non-governmental entities. ASC Topic 805, Business Combinations, provides guidance on accounting for the acquired assets. For tax reporting, IRC Section 1060 provides the relevant guidance. Similar regulations apply in jurisdictions outside the United States. International Accounting Standards typically govern in foreign locales.
What standard of value is required?
The standard of value depends on the reporting requirements. For financial reporting, the standard of value is fair value, defined as, “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”1 Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are independent, knowledgeable, able to transact, and willing to transact.
The standard of value for tax reporting is fair market value, which is defined as, “the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”2
As a practical matter, there is usually little if no difference between fair value and fair market value. However, in the purchase price allocation arena, there are specific differences that can have a material impact on the allocation of purchase price. These include:
Contingent consideration– for financial reporting, any element of contingent consideration must be valued and included as part of the aggregate purchase price to be allocated. For example, there may be additional payments from the buyer to the seller should specific performance thresholds be achieved within a certain time frame subsequent to acquisition. Typical performance metrics include specific revenue, and/or EBITDA targets, with additional payments to be made based on meeting or exceeding such targets. For tax reporting, such contingent consideration would not be included in the total purchase price to be allocated.
Tax amortization benefits– the value of tax amortization benefits stemming from the deduction of the fair value of an asset over its statutory tax life (15 years for most intangible assets) is always included as part of fair value. In contrast, for tax reporting purposes, such tax benefits are only included if the actual transaction structure is such that a step up in the tax basis of the assets will be realized, that is, if the deal is structured as a direct purchase of assets, or a stock acquisition where an IRC Section 338 h(10) election is made.
Deferred income taxes– are usually included as part of the total purchase price for financial reporting purposes, but are excluded for tax reporting purposes.
Goodwill allocation– for financial reporting, goodwill and other acquired assets can be added to the acquirer’s existing reporting units. For tax reporting, the allocation is limited to the acquired legal entities that owned the assets; no commingling of assets is permitted.
Bargain purchases– where the aggregate fair value of the acquired assets exceeds the purchase price, a gain is recognized for financial reporting purposes. For tax reporting, there is no recognition of gain. Instead, the purchase price is allocated sequentially to the various categories of assets under a seven class hierarchy pursuant to IRC Section 1060, using a residual methodology, whereby the purchase price is first allocated to Class I assets (cash and cash equivalents), then sequentially to Class II -Class VII assets until the entire purchase price is allocated. To the extent there is residual purchase price remaining that exceeds the aggregate fair market value of assets in a particular class, each asset in that class is allocated a portion of the remaining purchase price in proportion to its value as a percentage of the aggregate value of all assets in that particular class.
What types of tangible assets need to be appraised?
Tangible assets generally fall into one of two categories: personal property and real property. Personal property encompasses plant machinery and equipment, office equipment (including computers), furniture and fixtures, and motor vehicles.
What types of intangible assets need to be appraised?
The types, and associated values, of intangible assets largely depend on the nature of the business and the competitive environment in which it operates. Typical categories include:
(i) Marketing-related intangible assets
- trademarks and trade names
- internet domain names
- non-compete agreements (NCAs, covenants not to compete, non-competition agreements)
(ii) Customer-related intangible assets
- customer contracts
- non-contractual customer relationships
- customer lists
(iii) Artistic-related intangible assets
- copyrights for books, comic books, newspapers, and music
- rights to plays, operas, and ballets
- television, movie, and audio-visual rights
(iv) Contract-based intangible assets
- licensing and royalty agreements
- leases (where the acquirer is either the lessor or lessee)
- franchise agreements and use rights
- power purchase agreements
(v) Technology-based intangible assets
- patented and unpatented technology and know-how
- trade secrets, such as proprietary formulae and production processes
- custom-built software and databases
What are some sample examples of Appraisal Economics’ PPA projects?
- $10 billion publicly traded conglomerate’s acquisition of the maker of medical devices that continuously monitor of at-risk patients.
- $5 billion acquisition of a specialty chemical manufacturer serving a wide range of commercial end users.
- $2 billion sale of a leading maker of highly engineered building products between two private equity firms.
- $400 million sale between two private equity firms of a solar panel manufacturer, prior to the company’s IPO.
- $300 million sale of a France-based global construction materials maker.
- $300 million acquisition of a leading provider of automated voice portal communication systems and services.
- $200 million sale of a food storage company with 150 million cubic feet of refrigerated warehouse space.
- $200 million acquisition of a defense contractor providing construction, facility maintenance, equipment and critical supply chain networks in challenging environments around the world.
- $60 million acquisition of a fully integrated internet service company specializing in dedicated managed website hosting.
- $50 million acquisition for a contract manufacturer of complex precision parts for commercial and military aircraft.
- $10 million acquisition of a reseller of homecare medical equipment.
- $5 million acquisition of a home healthcare provider.
Whether a purchase price allocation is needed for a small private company with a single reporting unit, or an appraisal of a publicly traded international conglomerate with multiple reporting units, Appraisal Economics has the requisite expertise to provide the rigorous analysis and comprehensive documentation needed to withstand the ever increasing level of third party scrutiny from financial auditors and the IRS.
1 Financial Accounting Standards Board Accounting Standards Codification Topic 820.
2 Treasury Regulation §20.2031-1(b).