When acquiring another company, engaging an appraiser to conduct purchase price allocations as soon as the transaction closes is crucial to avoid rushing the process when trying to complete an audit later.

Purchase price allocations, more formally known as the determination of purchase consideration and recognition of acquired assets and liabilities at fair value under Accounting Standards Codification^® (ASC) Topic 805, Business Combinations, (Topic 805) can require time and specialized knowledge so planning is beneficial.

Learn more about purchase price allocations so you can be in a proactive, rather than reactive, state when you need one.

Common Audit Scenarios Requiring Purchase Price Allocations

Imagine it’s audit season and the process has been progressing smoothly until your auditor asks about the target—a company in which you acquired a majority stake last year—as the financial results of the acquisition will have to be included in your financial statements.

This means that the price paid for the target will need to be allocated among the following:

• Tangible assets
• Intangible assets
• Assumed liabilities
• Goodwill

To accomplish this, your auditor will likely advise you to find a business appraiser to perform the allocation of purchase consideration quickly for you to finalize your audit in time.

What Is a Purchase Price Allocation?

As defined under ASC 805, business combinations, must be accounted for using the acquisition method of accounting. Under the acquisition method of accounting, all identifiable assets acquired, including goodwill, liabilities assumed, and any non-controlling interests, should be stated on the balance sheet at fair value.

Although not an allocation of the purchase price but rather a recognition of assets acquired and liabilities assumed at fair value, it’s still colloquially referred to as a purchase price allocation due to past accounting requirements.

The purpose of the purchase price allocation is to help you identify all the assets that were acquired, tangible and intangible, and the liabilities that were assumed, and recognize them at fair value.

What Does Fair Value Mean and How Is It Determined?

According to paragraph 820-10-35-2 of ASC 820, Fair Value Measurement, fair value is 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—the closing date of the transaction.

The business appraiser determines the fair value of the asset or liability by using valuation methodologies that are generally accepted by valuation experts and auditors, and consistent with the ASC 820 concept of using an exit price that increases the use of observable inputs.

Tangible Assets

Certain tangible assets and liabilities require little effort on the part of the purchase price allocation provider to value, including:

• Cash
• Accounts receivable
• Accounts payable
• Some interest-bearing debt

Examples of tangible assets that require more complex valuation considerations are inventory and fixed assets, discussed in greater detail below.

Intangible Assets

Common examples of intangible assets that need to be considered in a purchase price allocation include:

• Tradenames
• Trademarks
• Patents
• Know-how
• Customer relationships
• Noncompetition agreements
• Assembled workforce

An intangible asset is recognized as an asset apart from goodwill if it arises from contractual or other legal rights—regardless of whether those rights are transferable or separable from the acquired entity or from other rights and obligations.

If an intangible asset doesn’t arise from contractual or other legal rights, it’s recognized as an asset apart from goodwill only if it’s separable. That is, it’s capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged, regardless of whether there’s intent to do so.

An intangible asset that can’t be sold, transferred, licensed, rented, or exchanged individually is considered separable if it can be sold, transferred, licensed, rented, or exchanged in combination with a related contract, asset, or liability.

The below example demonstrates what a summary exhibit for a purchase price allocation may look like.

The example plainly identifies the total purchase consideration and its various components, each intangible and tangible asset or liability, their respective fair values, and life. The buyer will use the fair value figures to recognize the assets and liabilities and prepare the consolidated financial statements.

Why Might My Company Need a Purchase Price Allocation?

Looking back to the discussion on ASC 805, you’ll most likely need a purchase price allocation if you recently completed a business combination and you have audited GAAP-basis financial statements.

In this case, engage a purchase price allocation provider immediately after the closing of the transaction so the work can be completed before your audit begins. If you find yourself needing a purchase price allocation during your audit, it will likely be more difficult to find a provider that has capacity to do the work. Even if you can find one, it’ll likely be more costly.

Additional Factors to Consider

There are several factors that can affect the complexity of a purchase price allocation.

The Private Company Alternative—ASU 2014-18

Private companies that choose to adopt the private company alternative will no longer recognize or otherwise consider the fair value of certain customer-related intangible assets or those attributable to noncompetition agreements acquired in business combinations and certain other qualifying transactions.

Instead, these amounts will be included as a part of goodwill. Private companies that adopt the alternative may benefit from cost savings, since it eliminates the need to:

• Separately recognize certain customer-related intangible assets and noncompetition agreements
• Conduct impairment testing of such assets in future periods

It also makes the purchase price allocation less complicated and therefore less costly. If adopted, the alternative would constitute an accounting policy change that requires prospective application to all future transactions after the adoption date.

This alternative also requires that goodwill is amortized over a period of 10 years, or alternative life if supported.

It’s important to note that if a company elects this accounting alternative but then decides to enter the public markets at a later date, it’ll be required to unwind the accounting related to the alternative for any historical periods presented in public filings. This can be a robust effort.

Inventory

Fair value adjustments to inventory have the potential to be material, especially if the target manufactures a product and holds a large quantity.

Discuss materiality level with your auditor and work with your purchase price allocation provider to understand whether determining the fair value for the inventory will be meaningful to the purchase price allocation exercise or not.

The following factors will typically lead to a larger fair value inventory adjustment:

• Margins on the sale of your finished goods inventory are high
• Costs to complete work-in-process inventory as of the measurement date are low
• Inventory can be disposed of quickly once it becomes a finished good
• Costs to dispose of the inventory are low, for example, quantity discounts, sales commissions, freight, and shipping charges

Fixed Assets

Be careful not to overlook the target’s fixed assets as fair value will most likely be different than historic book value, and in some situations significantly different.

Experts generally recommend valuing the fixed assets if any one of the following applies:

• They’re a material percentage of the purchase price.
• The fixed assets are a critical part of the target’s business, such as a manufacturing company.
• You believe historic book value is materially different from fair value.

Your purchase price allocation provider may have the necessary skills and expertise to also perform the valuation of fixed assets, but real estate or asset specific valuations are typically performed when the amounts are likely to be material.

Intangible Assets

Intangible assets may be recognized for the first time on the combined company’s statement of financial position through the application of Topic 805 to the business combination transaction. This can be complex as US GAAP must be applied to elements of the transaction to conclude if recognition criteria have been met.

The governing agreement may not contemplate these assets explicitly. The economic purpose of the transaction can give clues. Many times, this process necessitates management, their technical advisors, and the valuation experts work together to agree on the intangible assets that should be recognized before any modeling of fair value occurs.

What Is Rollover Equity?

Sometimes it’s in the buyer’s or seller’s best interest for the seller to maintain ownership in the combined entity. When this occurs, it’s referred to as rollover equity. When rollover equity is present the purchase price allocation provider will consider whether it needs to be adjusted to fair value.

Below are some examples of circumstances when the rollover equity value could need to be adjusted to fair value:

• The shares received by the seller have different economic rights than the shares held by the majority owner
• The shares received by the seller aren’t allowed to vote on matters requiring a vote
• The shares received by the seller have transfer restrictions

If any of these factors are true, it’s likely additional analysis will have to be performed to determine the fair value of the rollover equity.

Contingent Consideration

When contingent consideration, also known as an earnout, is part of a purchase agreement, its fair value needs to be factored into the purchase price. This can increase goodwill. In the above example, had the contingent consideration been ignored, the purchase consideration and goodwill would have been understated by $10 million.

The valuation of contingent consideration is often complex requiring the use of sophisticated methodologies including option-pricing modeling or Monte Carlo simulation.

We’re Here to Help

To learn more about purchase price allocations or to begin the process, contact your Moss Adams professional.

Additional Resources

• Valuations Services
• Technical Accounting Services