In my first blog post on the value of intangible assets, I explained what a purchase price allocation is and why they matter. This time I will be looking at the process involved in a purchase price allocation.
The purchase price allocation process
As part of accounting for a business combination, both FRS 102 and IFRS mandate a purchase price allocation process with these key steps:
- Determine the fair value of consideration paid, including the present value of any deferred and contingent consideration.
- Identify and measure the fair value of assets acquired and liabilities assumed (including any “reset” elements for areas such as leases under IFRS 16 which are accounted for as if new leases on the business combination date).
- Recognise and measure identifiable intangible assets separately from goodwill where the applicable standard requires separation. These can include customer relationships, trademarks, patents, in-process R&D, etc. The process also requires some other asset valuations which will not ultimately be separated.
- Recognise deferred taxes for differences between assigned fair values and tax bases.
- Recognise goodwill only after identifying all other acquired assets and liabilities. Goodwill is a residual representing the excess purchase price.
- Disclose information about the amount allocated to each major class of assets and liabilities.
FRS 102 vs. IFRS
While FRS 102 and IFRS take similar approaches to purchase price allocation, a few key differences exist:
- Goodwill amortisation – FRS 102 allows goodwill amortisation over useful life, whereas IFRS prohibits it.
- Impairment testing – IFRS requires more frequent testing if impairment indicators arise.
- Disclosures – IFRS has more extensive disclosure requirements surrounding valuations.
- Negative goodwill – the treatment of negative goodwill (excess of net assets over purchase price) differs.
Despite these differences, both frameworks aim to recognise the fair values of all acquired assets and liabilities, and it is a common misconception that FRS 102 does not require the separation of any intangible assets.
Reflecting value inherent in a business
The purchase price allocation leads to acquired goodwill and other intangible assets reflecting the inherent value within a business not captured on its balance sheet. For example:
- Customer relationships – the fair values represent expected cash flows from future customer business.
- Patents and technology – the fair values capture the discounted future cash flows related to these assets.
- Trademarks and brands – the fair values reveal the earnings capacity of brands based on royalties saved.
- Assembled workforce – the fair values indicate the increased earnings capacity from having a workforce in place.
Only by identifying and valuing them separately from goodwill can financial statements capture the true economic reality after an acquisition.
Goodwill is not a direct representation of value inherent in the business because it does not represent a physical or financial asset. Instead, it reflects the ability of a business to earn higher returns on its other assets due to these unidentifiable intangible factors. So, goodwill represents the growth potential paid for, and synergies that can be generated on an expanded group perspective.
The market participant context
One challenging concept is that a purchase price allocation must be performed from the perspective of a market participant rather than a specific buyer. This means that the fair values assigned should represent the assumptions and inputs that typical market participants would use in valuing the assets and liabilities acquired, and therefore ignore the actual planned use of those assets by the acquirer.
For example, in valuing acquired intangible assets like customer relationships or technology, assumptions about useful lives, cash flow projections, and discount rates should reflect those that other buyers and sellers would reasonably use. Not just the specific acquiring company’s perspectives. This market participant approach prevents the purchase price allocation from being skewed to the unique qualities of the acquirer.
This is why goodwill represents planned synergies and hope value; the amount paid by an acquirer often incorporates the acquirer’s expected use and plans for the acquiree. The market participant perspective, therefore, supports the comparability of financial statements and why goodwill can offer insights into how an acquisition has been commercially decided upon.
Conclusion
Purchase price allocation under FRS 102 and IFRS results in financial statements that better reflect the underlying economics of an acquisition and is critical for faithfully representing the value exchanged in a business combination.
Next steps
There’s no simple answer to performing a purchase price allocation and you’ll likely need to seek support from our specialist Financial Reporting Advisory and Valuations team. If you have any questions or require any advice, please get in touch with a member of the team or call 0333 123 7171.
