A purchase price allocation (“PPA”) is a type of valuation used for financial reporting purposes. The analysis typically allocates the purchase price from a transaction across three main asset categories: net working capital, tangible assets, and intangible assets.
Property, plant, and equipment is the most common tangible asset purchased in a transaction. Examples of intangible assets are brand names, trade names, developed technology, customer relationships, and goodwill.[1]
A PPA analysis falls under the Financial Accounting Standards Board’s (“FASB”) ASC section 805, which relates to business combinations, and usually follows the fair value standard of value 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.”
When is PPA Required?
A PPA is required when a change of control occurs. The analysis gives reporting companies the ability to calculate amortization based on the remaining useful life of the intangible asset. It is important to note that typically goodwill is not amortized unless the accounting alternative election is made (a.k.a. the private company alternative). If that election is not made, goodwill is instead tested for impairment if a triggering event occurs. For more on the private company alternative election, read the article found here.
Business Combination Versus Asset Acquisition
According to FASB, a business “consists of inputs and processes applied to those inputs that have the ability to contribute to the creation of outputs. Although businesses usually have outputs, outputs are not required for an integrated set to qualify as a business.” The three elements of a business are defined as follows:
- Input. Any economic resource that creates, or has the ability to contribute to the creation of, outputs when one or more processes are applied to it. Examples include long-lived assets (including intangible assets or rights to use long-lived assets), intellectual property, the ability to obtain access to necessary materials or rights, and employees.
- Process. Any system, standard, protocol, convention, or rule that when applied to an input or inputs, creates or has the ability to contribute to the creation of outputs. Examples include strategic management processes, operational processes, and resource management processes. These processes typically are documented, but the intellectual capacity of an organized workforce having the necessary skills and experience following rules and conventions may provide the necessary processes that are capable of being applied to inputs to create outputs. Accounting, billing, payroll, and other administrative systems typically are not processes used to create outputs.
- Output. The result of inputs and processes applied to those inputs that provide goods or services to customers, investment income (such as dividends or interest), or other revenues.[2]
In a business combination, identifiable intangible assets are recorded at their fair value, with goodwill being a calculated value representing the difference between: (i) the fair value of the net identifiable tangible and intangible assets acquired and (ii) the purchase price, or consideration paid. In addition, transaction costs are expensed.
In an asset acquisition, assets are recognized based on their cost to the acquiring entity, which generally includes the transaction costs of the asset acquisition.[3]
Acquiring assets in groups requires not only ascertaining the cost of the asset (or net asset) group but also allocating that cost to the individual assets (or individual assets and liabilities) that make up the group. The cost of a group of assets acquired in an asset acquisition shall be allocated to the individual assets acquired or liabilities assumed based on their relative fair values and shall not give rise to goodwill.[4]
[1] The fair value of the assembled workforce is calculated but that value is subsumed into goodwill.
[2] FASB ASC 805-10-55-4.
[3] FASB ASC 805-50-30-1.
[4] FASB ASC 805-50-30-3.
