Contract signing purchase price allocation

What you need to know about purchase price allocation

Learn what a PPA is, common challenges, business considerations, and why it is important in a business transaction.

In many deals, the purchase price allocation (PPA) is an afterthought to the transaction. However, completing the PPA timely is important and necessary to start providing monthly financial statements and ensure necessary activities are completed before an audit.

What is a PPA?

A PPA is a requirement under ASC 805 Business Combinations and how an acquisition is accounted for. The primary purpose is allocating the purchase price or consideration to the fair value of tangible and intangible assets acquired, assumed liabilities, and non-controlling interest.

How is fair value determined?

Fair value is defined in ASC 820 Fair Value Measurement 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/closing date of the transaction.

What are some common challenges?

Receivables – Many buyers want to carry over the allowance for uncollectible accounts. However, GAAP requires receivables to be at fair value. So if any reserve exists, it will need to be allocated to specific receivable accounts (i.e., recorded net of any allowance).

Inventory – Similar to the allowance for receivables, any allowance for inventory must be allocated to specific inventory items. In addition, if the acquiree carried a large amount of finished goods or work-in-process inventory, fair value measurements may be needed in determining the value.

Fixed assets – In many cases, the fair value of fixed assets will vary from historical book value. We typically recommend a third-party valuation specialist to appraise items and real estate to assess that difference. Another key consideration is that historically accumulated depreciation does not carry over, and the assets acquired will need a new life assigned to each asset. Determining the value before closing is also a best practice so buyer and seller can agree on the value for the purchase agreement, as buyers and sellers may have competing interests for what the value should be.

Contingent consideration – Transactions involving contingent consideration or what is commonly referred to as an earnout should also be recorded at fair value. Fair value represents the amount the reporting entity/buyer would pay a hypothetical counterparty to transfer responsibility for paying the contingent liability. This amount is basically the present value of the probability-weighted expected amount of the future payment.

Other amounts – Read the purchase agreement thoroughly; many agreements have other provisions that can trigger liability recognition (compensation-related liabilities, lease obligation liabilities, etc.) Be mindful of other possible accruals, such as recording items a seller may not have had on the balance sheet (for example, warranty or vacation accruals).

Other considerations

Tax treatment – The purchase price allocation is also important from a tax perspective, as the buyer and seller must include Form 8594 when filing tax returns, and the amounts reported must be the same.

Private company alternative - ASC 805 requires intangible assets to be broken out into separately identifiable assets. However, for private entities, the Private Company Council (PCC) provided relief for those who qualify and choose to aggregate certain customer-related intangibles into one amount and include them as part of goodwill. Electing this alternative does require the resulting goodwill to be amortized over 10 years (15 years for tax purposes).

Step acquisition - Step acquisitions can also create complexities when allocating consideration. A step acquisition occurs when a buyer or shareholder obtains control over an entity by acquiring an additional interest in the equity that results in a total value of over 50%. For example, a buyer holds a 25% interest in an entity and accounts for the investment using the equity method. A purchase allocation is required if an additional 75% is acquired and control is now with the buyer. The allocation starts by valuing the previously held minority interest with any adjustment impacting earnings. The fair value of the minority interest is then added to the consideration paid for the remaining portion of the business for allocation to its underlying assets and liabilities.

In summary

The key to a smooth PPA starts in the due diligence process, leading to a clear purchase agreement. A clear purchase agreement can avoid surprises in values or recognition if done properly. Other keys are to get any third-party appraisals done early and discuss the allocation before the deal closes.

While it takes a team of advisors, there are benefits working with one firm that can provide the necessary resources, expertise, and services. If you would like to learn more about how AGH’s transaction team can help, contact Mark Schmelzle using the information below.

Mark Schmelzle

Senior Vice President
Assurance Services

Mark Schmelzle leads the firm’s financial services industry team. His practice focuses primarily on financial institutions, manufacturing/wholesale/distribution entities and private equity groups.

In the financial services and manufacturing industries, his experience includes financial statement audits, fraud investigations and other types of attest services.

In the private equity area, Mark provides a wide range of merger and acquisition services for private equity groups and their portfolio companies, including due diligence, cash flow analysis, quality of earnings review, and potential cost-savings analysis.

Schmelzle is a certified public accountant and a member of the American Institute of Certified Public Accountants, the Kansas Society of Certified Public Accountants and Young Bank Officers of Kansas. He is an alumnus of Leadership Wichita and was named one of the Wichita Business Journal’s “40 Under 40” young leaders in the community. He also serves in leadership positions for community organizations including Youth Entrepreneurs and the Wichita Aero Club.

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