PURCHASE PRICE ALLOCATION: Definition, Importance & Detailed Guide

Purchase Price Allocation

Purchase price allocation is an acquisition accounting practice in which the acquirer sets aside an appropriate purchase price for several assets and liabilities of the business/company acquired in the transaction.

It is a process in acquisition accounting that allows the acquirer to allocate the purchase price to a company’s assets and liabilities. 

This often occurs when a smaller company is struggling with financial problems or bankruptcy. A larger organization can decide to buy the company off, and that includes the company’s debt. To complete this transaction, a fair value must be assigned to the visible and intangible assets of the target company. 

However, that’s just on the surface. This article will provide more information on the term “purchase price allocation,” including its definition, direct impact, and what you will need to fully comprehend what this entails.

PPA Meaning

Purchase price allocation is a goodwill accounting method in which the buyer of a company divides the price of the purchase among some or all of the company’s assets and liabilities. When a company decides to purchase a company, they go through the required process. 

Allocating purchase prices is more complicated than just signing an agreement and giving resources to the company being bought. It also includes the determination of fair value and goodwill. 

The fair value must be determined before the purchase price can be allocated. And then the remainder will be distributed to goodwill.

PPAs usually operate following the practice of merger and acquisition accounting. A merger or acquisition usually necessitates the necessary tax and financial reporting for price purchase allocation.

Most of the time, the purchase price allocation includes the net identifiable assets, goodwill, and write-up. Here is the importance of each part of the PPA

Identifiable tangible and intangible assets:

For a purchase price allocation process to be in action, a procedure to identify tangible and intangible assets must be in place. Identifiable assets are the total value of the acquired corporation/company. 

A company’s identifiable assets are assets with measurable value. While intangible assets are assets in connection to legal rights and agreements.

During the purchase of a second company, the acquirer can buy off both the tangible and intangible assets of the target company and includes the legal rights of the target company. 

To calculate the tangible book value:

Net Tangible Book Value = Assets – Existing Goodwill – Liabilities

Goodwill:

Goodwill is a financial statement that shows the difference between the allocations’ purchase price and the fair value of the company’s assets. It works as a means to guarantee the accounting equation. 

On an annual basis, goodwill is the amount notable after purchase price allocation is checked for any errors. It is the net value of assets minus liability.

Write-up:

In purchase price allocation, the assets will require a write-up. A write-up is a flexible increase to the book of value of the target company. 

To determine the actual write-up amount, a valuation specialist will be employed to access the fair value of the company.

The assets of the target company can be written up as inventory, intangible assets, or property, plant, and equipment.

Purchase Price Allocation Schedule

The purchase price allocation helps to evaluate the specific value of the target company’s assets. 

This will also include the tangible & intangible assets and liabilities of the company. 

To properly allocate the purchase price, an acquisition schedule must be in place. 

In a purchase price allocation schedule, the agreement will entail the effective date in which the buyer will prepare and deliver to the target company a write-up stating the fourth proposed allocation of the purchase price, which will include both the assets and any assumed liabilities.

Generally, the buyers are often in charge of the costs and fees linked with the purchase allocation schedule. 

With a purchase price allocation schedule, both the acquirer and the target company must agree to allocate the purchase price to the assets and liabilities.

While the purchase price schedule may seem straightforward or easy, this is not always the case. Assuming there is an earn-out clause in the contract, in the event that the target company receives an excess payment in the transaction, 

Then, another valuation must be done to get the real value. This can easily affect the PPA schedule.

Tax Purchase Price Allocation

To buy another company as the CEO, you must understand the tax rules and conditions regarding asset purchase prices. The official tax rule about purchase price allocation is meant to stop taxpayers from putting values on assets that give them better tax results. 

But this tax rule gives the buyer and seller a reason to agree on how to split the total purchase price. There is a need for both parties to the transaction to agree on a price that will yield favorable tax outcomes. 

IRS Form Purchase Price Allocation

According to IRS Form 8594, there are seven (7) asset values to which a purchase price should be equally allocated. However, to abide by these terms, the purchaser must allocate the aggregate purchase price to assets through their fair value. 

Nonetheless, here are the seven asset value classes:

Cash and equivalents (Class I assets):

According to the IRS form, cash and its equivalents are Class I assets. You can reduce the purchase price minus the assets transferred from the target company to the acquirer.

Securities (Class II assets):

For PPAs, securities are important, but if market quotes aren’t easily available, fair value can be used instead. They are readily available instruments, such as foreign currencies and CDs.

Accounts Receivable (Class III ):

This is part of class III of the asset value. It also includes mortgages and credit card receivables.

Inventory (class IV assets):

Inventories are parts of the class four assets value. In a scenario where the purchaser and the seller agree to the purchase price allocation, they will most likely receive attributes that may be capital gains to the assets.

Fixed Assets (class V assets):

The class five assets usually include land, properties, equipment, and others.

Intangibles assets (class VI assets):

Class six assets are intangible assets. They are frequently calculated by subtracting a going concern or goodwill from a going concern or goodwill. 

Intangible assets are trademarks, customer contracts, patents, domain names, and others,

Goodwill (Class VII assets):

The class seven assets are goodwill. Goodwill is the remaining purchase price of the allocations over the fair value of the corporation’s assets.

Purchase Price Allocation Example

Here is an example of purchase price allocation:

A corporation wants to buy a second company for another branch. The corporation then bought the second company for $50 million. Afterward, the corporation as the purchaser must fulfill purchase price allocation to the official accounting criterion. 

The target company must estimate the assets and assumed liabilities. They will also complete the acquisition. 

The target company’s book value asset is $20 million, while its book value liability is $5 million. That is, the value of the identifiable assets of the second company is $15 ($20 million – $5 million).

The purchaser will record goodwill because the price paid for the acquisition of $50 million is more than the amount of the identifiable assets, the assumed liabilities, and the write-up. The goodwill of $5 million must be acknowledged.

How do you allocate purchase price? 

Most people often believe that allocating purchase prices is complex. 

This is not correct because allocating the purchase price is straightforward. 

Here is an easy step to how you can allocate purchase price:

Attribute the fair value (FV):

The first step in allocating the purchase price is to assign the fair value to the tangible and intangible assets purchased.

Allocate the unexpended difference:

Write up the book value of the assets. You should allocate the unexpended difference between the fair values of the assets and the purchase price into goodwill. 

Effectively manage the assets and liabilities:

You should sort the net assets of the target company and its liabilities to fair value. 

Calculations:

You should proceed to calculate the balances of the purchaser. 

What is a purchase price allocation used for? 

The major purpose of a purchase price allocation is to allocate the purchase price of assets and liabilities. 

This is often done after a merger and acquisition agreement is at its final stage.

Both the acquirer and the target company will get to sort out the assets and assumed liabilities before the completion of the transaction. And in terms of tax, they will have a clear view of what to pay or expect during the transaction.

However, it is no secret that PPA has larger tax implications. And that is why both the acquirer and the target company must choose a better option on how they allocate assets to avoid most of its implications.

Why is purchase price allocation important?

The importance of purchase price allocation cannot be undermined during the buying and selling of a company. However, here is the importance of purchase price allocation:

  1. The purchase price allocation clarifies the contract between the buyer and the sell-on means in which the assets and assumed liabilities of the target company should be allocated,
  2. Generally, PPAs have higher tax problems, if both parties in the contract agree to lower base going concern, this will most likely reduce the exposure of tax. 
  3. Another importance of purchase price allocation is that the allocation process helps to define the assets of the seller. In most cases, the seller may not be aware of the actual value of the company, but with the help of PPA, assets and liabilities will be clearly defined. 

Is a purchase price allocation required? 

Yes. Purchase price allocation is an essential requirement for both the seller and the buyer. During the transaction, a PPA process will be required for tax and financial reporting on the income tax of the target company to the IRS.

Who is responsible for purchase price allocation? 

Purchase price allocation is the job of both the company doing the buying and the company doing the selling. The buyer and the seller must have an accurate purchase price allocation of assets. If the case is reversed and they both contradict one another, this may lead to tax implications for the seller. Hence, both parties must agree on a purchase price allocation before finalizing the acquisition.

What is a fair value allocation? 

A fair value allocation is a price receivable used to sell an asset and to transfer a liability during an acquisition. Fair value is the valuation price at which an asset is bought when the acquirer and the seller agree on a set price. 

Fair values are account receivables, cash, securities, and others.

To calculate fair value, the assets and liabilities of a target company will be measured on market value. That is,

Fair Value = C×(1+r×( 360 x ))−D

Where:

D= Number of dividends investor would receive before the expiration date

C = Current value of security

r = Interest rate charged by a broker

x = Number of days remaining in the contract

Dividends = Number of dividends an acquirer would receive before the scheduled date

Conclusion

Purchase price allocation is a method of applying goodwill accounting in which the acquirer, in means of buying another company, distributes the purchase price into all or some parts of the company’s assets and liabilities. 

Both the acquirer and the target company (buyer and seller) are responsible for purchase price allocation. It is an essential requirement for both buyer and seller because it reduces the power of taxpayers to allocate asset values in a means that would project better tax results during the acquisition. We hope this overview is a helpful guide to your search.

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