Is a critical process in the private equity market and is most prevalent in the mergers and acquisitions (M&A) process. It involves allocating the purchase price of an acquired company to its identifiable assets and liabilities. This process ensures that the financial statements of the acquiring and acquired company accurately reflect the fair value of the acquired assets and liabilities.
What Are Purchase Price Allocations?
Purchase Price Allocation is a valuation exercise required by the Accounting Standards Codification (ASC) 805 in the United States. It is performed when a company acquires another business, and it involves assigning the purchase price to the acquired company’s tangible and intangible assets and liabilities.
The goal of the PPA and purchase accounting process is to determine the fair value of these assets and liabilities at the acquisition date. PPAs are essential because they impact the financial statements of the acquiring and acquired company (if push down accounting is elected) and are often both a complex and time-consuming exercise to complete.
The Process and Best Practices
The typical PPA and purchase accounting process involves the following steps:
- Identifying the Acquirer: The first step is to identify the acquiring entity in the transaction. While typically straightforward, this step can be complex in cases in which the acquirer for accounting purposes may not be the same as the legal acquirer. In the majority of cases, the acquirer will be the entity transferring cash or other assets, assuming liabilities or issuing equity interests. Refer to ASC 805-10-55 for more complex cases.
- Determining the Acquisition Date: The acquisition date is the date on which the acquirer obtains control of the acquiree. This date is crucial as it determines the point at which fair value measurements are made.
- Calculating the Purchase Price: The purchase price in a business combination typically involves one or a combination of the following:
- Cash: Typically outlined in what is commonly referred to as the funds flow, the cash portion of the purchase price generally includes the cash wired to the sellers, seller expenses if paid for by the buyer on behalf of the seller or any other shared expenses agreed upon by both parties.
- Contingent Consideration: Contingent consideration involves additional payments to the seller based on the future performance of the acquired business. It is common for management to retain a valuation specialist to determine the fair value of this portion of the consideration at the acquisition date under the guidelines of ASC 820.
- Equity Interests: In the private equity space, issuing rollover equity interests or options to purchase interests in the acquirer is a common mechanism to keep former owners or executives engaged post-acquisition. Management must consider the fair value guidelines under ASC 820 when calculating this portion of the purchase price.
- Other Applicable: Other aspects of the purchase price may include but are not limited to: Debt of the acquiree assumed by the acquirer, Debt issued by the acquirer payable to the acquiree and non-cash consideration (intellectual property, real estate, business units, etc.).
Recognizing and Measuring Identifiable Assets and Liabilities
The acquirer must recognize and measure the identifiable assets acquired and liabilities assumed at their fair values. This includes both tangible assets (like cash, inventory and property, plant and equipment) and intangible assets (such as customer relationships, trademarks, and patents).
- Tangible Assets: While in most cases fair value will equal book value, there are certain assets such as property, plant and equipment that if material, could require additional consideration.
- Intangible Assets: It is typical for management to engage a specialist to perform a PPA valuation to determine the fair value of separately identifiable intangible assets. Management should be prepared to provide various historical and projected financial information to the engaged specialist. In addition, management may elect the private company alternative in which customer related intangibles and noncompete agreements are subsumed into goodwill unless they can be sold separately.
- Calculating Goodwill: Goodwill is calculated as the excess of the purchase price over the fair value of the net identifiable assets and liabilities obtained. If the fair value of the net assets acquired exceeds the purchase price, the acquirer recognizes a gain from a bargain purchase.
Auditing Purchase Accounting and Purchase Price Allocations: Preparing for Your Annual Financial Statement Audit
Auditing PPAs is a complex task that requires a deep understanding of both the purchase agreement and the financial aspects of the transaction. Management should be prepared for the following:
- Gathering Documentation: As always, document retention is paramount. An audit firm will start by obtaining and reviewing key documents such as the purchase agreement, operating agreements, credit agreements, working capital adjustments and the funds flow to first understand the transaction and second, form an audit plan. It’s recommended management maintain all documents associated with an acquisition in a centrally located finance folder as a lack of documentation could lead to material adjustments.
- Verifying the Purchase Price: Management should be prepared to provide bank statements or other wire documentation, vendor invoices related to seller and buyer transaction expenses and answer various fair value inquiries related to any contingent consideration or equity issued to the sellers.
- Opening Balance Sheet Testing: Similar to testing performed at the end of the fiscal year, an audit firm will assess the opening balance sheet and perform audit procedures according to their materiality thresholds. In order to be best prepared for the audit process, a reconciliation process that mimics the month end financial close should be performed. Some common areas of emphasis are as follows:
- Contract Assets/Liabilities – If the acquired business operates in an industry in which revenue is recognized over a period of time, management should meet with project managers and perform appropriate percentage of completion cutoff procedures of all open projects to calculate the opening contract asset and liability amounts.
- Unrecorded Liabilities – Management should evaluate vendor invoices received, and cash disbursements made subsequent to the acquisition date for proper cutoff. Unidentified liabilities are one of the most common working capital adjustments.
- Inventory – Management should perform an inventory count on or around the acquisition date to ensure proper cutoff. In addition, management should evaluate inventory on hand for any slow moving or obsolete inventory and record a reserve accordingly.
Takeaways
Purchase accounting and PPA valuations are a fundamental aspect of private equity transactions, ensuring that the financial statements of the acquiring and acquired companies accurately reflect the fair value of the acquired assets and liabilities. The process involves several steps and requires management to have an in-depth understanding of the historical and future expected performance of the acquired company. Its important for management to be both prepared and organized when navigating acquisitions as it will best prepare them for subsequent audit scrutiny.
Author: Michael Tiplady, CPA | [email protected]
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