Have you recently purchased or acquired another business? Congratulations! Did you know that a merger or acquisition (“M&A”) often initiates additional tax and financial reporting requirements? One of the most common reporting requirement is a Purchase Price Allocation (“PPA”). What then, is a PPA, why is it important to get it right and how can Economics Partners help you with it?
The basic idea behind Purchase Price Allocation, whether for tax or financial reporting purposes, is that the value of the consideration given in a transaction must be allocated to the acquired assets and liabilities, with the residual value being allocated to goodwill.
This exercise may sound easy, right? I read the contract and allocate. Not so fast. It can become complex fairly quickly. If a portion of the consideration is contingent upon achieving certain milestones (i.e. earn-outs), then an analysis must be performed to determine the value of that consideration. What is the additional consideration isn’t cash but a right to certain IP, or equity in a private company? What is the future right to receive equity in a private company? What if the transaction grants the buyer or the seller an ability to unwind the transaction? As you can see, the value of the consideration isn’t all that easy to determine.
After the value of the consideration is determined, then that value must be allocated among all tangible and intangible assets and liabilities with the residual value being allocated to goodwill. Examples of tangible assets include property, plant and equipment. Intangible assets include software, licensing agreements, patents, assembled workforce, non-compete agreements, customer relationships, trademarks, tradenames, copyrights and more. The appraiser needs to determine the value of each asset category and to allocate the overall value of the consideration to those assets groups. The appraiser needs to determine how much a non-compete agreement is worth, how much an assembled workforce is worth, the value market participant will place on a patent and more.
The rules governing Purchase Price Allocation for financial reporting are found in Accounting Standards Codification (“ASC”) Topic 805. The rules governing Purchase Price Allocation for U.S. tax reporting are found in Internal Revenue Code Sections 1060 and 338. There are also some important differences between the two; however, the concept is generally the same between financial reporting and tax reporting. Your specific transaction may or may not require a Purchase Price Allocation report. As such, it is always a good idea to consult a competent professional to ensure you are complying with the applicable regulations.
Bottom line, if you have gone through a merger or acquisition (stock or equity), then find out if you need a PPA.
Purchase Price Allocation impacts the balance sheet (the beginning balance of the assets), the income statement through depreciation and amortization and ultimately profits which impact taxes paid and returns to owners / investors. There are several ways that your business can be negatively impacted by a poorly performed PPA:
- Depreciation and Amortization could be over or understated – which artificially decreases or increases net income
- It could trigger future impairment of intangibles leading to losses on the financial statements
- The miscalculation of contingent consideration could cause over/understated liability on the books
- All the above could negatively impact investors’ perception of the business
Whether it is now or 5-10 years down the road, the impact of these effects could ripple through the business, hurting future earnings and prospects. At first glance, it would seem that having depreciation, for instance, understated, which in turn implies that Net Income would be overstated, would be great – after all, what business wouldn’t want their performance to look better than it truly was? In the interim, it may seem this way, but indulge me in a thought exercise:
Company A is interested in acquiring Company B, for whatever reason. Say the acquisition goes through and the two companies merge. Six months down the road Company A uncovers that Company B has been understating their depreciation expense because their purchase price from a previous transaction had been incorrectly allocated between tangible and intangible assets and goodwill. This also means that they have been overstating their Net Income. If Company B’s Net Income has been overstated for years, this likely means that Company A overpaid to acquire Company B. Company A now discovers that Company B’s assets aren’t worth anything near what they paid for them in the acquisition. Company A now has to record impairment to the goodwill associated with the purchase of Company B, which effectively means that Company A purchased Company B for far more than it was worth in an absolute waste of resources.
For this reason, anytime a triggering event in a company happens, a business is required to have intangibles and goodwill tested for impairment. If it is determined that either the intangibles or goodwill are impaired, the business will have to report a loss, which is generally substantial and has a large impact on the company’s bottom line. It seems counterintuitive then, to go through a merger or acquisition with the intention of expanding operations or becoming more profitable only to end up with investors having a negative outlook of the business simply because the PPA was not performed or it was performed incorrectly. Professionals at Economics Partners (“EP”) have vast experience and expertise with Purchase Price Allocation and have the resources at their disposal to deliver top-quality products with efficiency.
Economics Partners has substantial experience with Purchase Price Allocation valuations. EP has valued tangible and intangible assets and performed Purchase Price Allocations for a wide variety of firms (public and private) across a number of different industries. Our clients have ranged from top global Fortune 500 businesses with billions of dollars in assets to smaller businesses experiencing consistent, rapid growth. Our team includes accomplished professionals who have worked for firms such as PWC, KPMG, Deloitte, EY, Grant Thornton, Duff & Phelps, Anderson Tax, and others. With some of the most accomplished professionals in the world and decades of experience, we provide a high-level of service and strive to do it better than anyone.
Disclaimer: This information piece should not be construed as tax advice or financial reporting advice. Please consult a competent professional for advice on your specific situation.