When one company acquires another company, the purchase price paid generally exceeds the fair value of the acquiree’s net assets on its balance sheet, with this value historically being known as “goodwill”. However, this “goodwill” could represent a multitude of assets that are off-balance sheet from the acquiree’s perspective, but which are critical in how that acquiree generates cash and runs its business. This therefore explains why an acquirer might pay more for the business than just its net asset value.
Under FRS 102 (UK Financial Reporting Standard) and IFRS (International Financial Reporting Standard), these no longer assume a default position of “goodwill”. Instead, a purchase price allocation is required, being the process of assigning the excess purchase price to the fair value of the acquiree’s net assets, including identifiable intangible assets. A proper purchase price allocation is critical for recognising the true value inherent in an acquired business under both FRS 102 and IFRS.
In this, the first of two blogs on the value of intangible assets, I will explain what a purchase price allocation is and why they matter.
What is a purchase price allocation?
Under purchase price allocation, the excess of the purchase price over the fair value of the acquiree’s net identifiable assets gets allocated to:
- Any assets where a market value differs to carrying value (most commonly properties).
- Identifiable intangible assets – assets that meet the relevant accounting standard’s recognition criteria; these are often items such as customer relationships, patents, trademarks, brand names.
- Any contingent liabilities of the acquiree often need to be recognised in the acquisition numbers, which differs from the acquiree’s own treatment.
- Deferred taxes – needed to account for differences between assigned fair values and tax bases.
- Goodwill – the residual value. This then represents future economic benefits from assets that cannot be individually identified or separately recognised, from synergies, and from “hope value” inherent in the price paid.
Why does a purchase price allocation matter?
The allocation into these components is crucial for financial reporting and an efficient audit process but, more widely, it can really help users of the financial statements to understand the commercial rationale for the business combination. Without a purchase price allocation, intangible assets would not get recognised and the value of these would remain hidden, while goodwill would be overstated and suggest an excessive premium was paid. As a result:
- Balance sheets would understate the true net assets and value acquired.
- Future earnings would be overstated (especially when reporting under IFRS) since finite-lived intangibles would not be amortised.
- Impairment testing could be flawed since goodwill balances would be over-inflated.
- Reported profits would be different.
- Financial analysis using book value, ratios etc. could be misleading.
- And, of course, your accounts would not be compliant with accounting standards.
So, proper purchase price allocation is needed to reflect the economic reality of an acquisition. It leads to balance sheets that better indicate the resources and future profit potential within a business. This profit potential may even help to inform and maximise any future sale value for the group.
In my next blog, I’ll be looking at the process involved in performing a purchase price allocation. In the meantime, if you have any questions or require any advice, get in touch with a member of our specialist Financial Reporting Advisory and Valuations team or call 0333 123 7171.
