At Redwood Valuation we perform independent business valuations and purchase price allocation valuation to help companies comply with the requirements of ASC 805 (previously SFAS No. 141R), which includes determining the fair value of the transaction consideration, intangible assets, liabilities, and certain tangible assets as of the date of acquisition, and to allocate the value of the purchase consideration to the identifiable tangible and intangible assets acquired. If you’ve never taken a dive into this part of business transactions, strap on and let’s take a look at what all of these “big” terms really mean for you and your business. It’s really not that complicated, so don’t worry.

What Is Purchase Price Allocation?

The rules governing PPAs (ASC 805 valuations) are intended to provide users of these financial statements with useful investment information. The goal is to have the fair value of acquired assets and liabilities accurately reflected in the balance sheet of the buyer or surviving entity.

Most often, an allocation of purchase price, or purchase price allocation (PPA), occurs after an acquisition or, occasionally, when one company desires to or is attempting to acquire another company. When one company purchases another, the procedure divides the price of the purchase into assets and liabilities. Some professionals refer to a PPA as a form of “goodwill accounting” owing to the inclusion of a financial consideration of intangible assets.

Although the procedure sounds – and in fact is – more than a little confusing, it is nevertheless an essential element of certain business transactions, especially business combinations and acquisitions and change in control transactions. An allocation of purchase price is a financial statement necessary to meet Generally Accepted Financial Principles (GAAP) and to be in conformance with standards set forth by the Financial Accounting Standards Board, a standard-setting board implemented by the Securities and Exchange Commission (SEC).

The PPA valuation has as its logical starting point (with respect to an ASC 805 PPA appraisal that will satisfy GAAP-guided auditors) a determination of the appropriate total purchase price amount to be allocated. Basically, this is a determination of value of the company being purchased. While it is easy to state the definition, the actual valuation can be highly complex with many interlocking parts.

Notes on financial and legal factors to consider:

  • Appraisers must take into account cash, stock, contingent consideration, milestone payments, and other factors when determining the purchase consideration.
  • Acquisition-related costs costs are not typically included in the purchase consideration pursuant to ASC 805.
  • Compensation for future services may not be part of the purchase consideration depending on the nature of the contract.

An appraiser, then, in arriving at a fair and reasonable PPA has to employ a purchase price allocation model that weighs and considers and factors in all these multiple sources of value. The appraiser has to be experienced and have impeccable integrity- not everyone can handle business transactions and valuations, so be wise about who you allow to enter the deal. Having done that, your purchase price allocation valuation professionals can then give you a good idea of the fair value of the business.

PPA for Merger and Acquisition Financial Reporting

For financial reporting pursuant to mergers and acquisitions, the most common reason for a PPA, the main goal is to create the opening balance sheet.

The first step is to determine the fair value of the purchase consideration and the second is to determine the fair value of the individual assets acquires and liabilities assumed.

The difference between the purchase consideration and the fair value of the total net assets acquired (other than goodwill) is the value of goodwill recorded on the opening balance sheet.

PPA Model for Intangible Assets

The accounting rules governing intangible assets (including intellectual property) lay out two conditions for an asset to fall under this heading: 1) it must arise from a legal or contractual right, and 2) it must be separable from the business – that is it could be sold, licensed, or rented separately. The five broad categories of intangible assets are:

  1. Marketing related (examples: trademarks, logos, domain names)
  2. Customer related ( examples: lists, profiles, customer relationships)
  3. Artistic related (examples: books, songs, photos, films, mostly intellectual property)
  4. Contract based
  5. Technology based

Typically, marketing-related intangible assets include the following: trademarks, trade names, trade dress (which includes logos, color schemes, packaging design, and the like), service marks, domain names, and noncompetition agreements. Of course, the importance of such intangible assets depends on the industry, so the valuation is made on the basis of comparable assets in similar markets. Noncompetition agreements, however, are assessed according to the detrimental effects their absence would cause, often employing a with-and-without method.

Customer-related assets are generally more static than marketing assets and comprise lists, purchase/order backlogs, and customer relationships (both contractual and non-contractual). Typically, the most significant of these is non-contractual customer relationships. A wasting asset, it is appraised by means of identifying projected income benefits while also taking into account other income generated from other necessary assets through a method known as the excess earnings method.

Artistic assets, which are generally within the intellectual property category, may be more difficult to value. For they include books, films, musical compositions, and photographs.

Contractual assets, while important, are not as common in PPAs as the name would seem to imply. To be of PPA value, these assets must represent an intrinsic benefit to the company, and, generally, these benefits reach into the future. Suppose, for example, a company has a facility lease under which it pays less than the market rental rate, and 10 years remain on the lease with no contractual provision for the rental rate to be reset to market rates. That would be an example of a beneficial contractual asset.

Typically, critical and multi-form, technology assets are approached with varying appraisal methodologies, but foremost in all of them are economic benefits a potential buyer could expect to receive as a result of ownership. The category of technology assets includes patents and patent applications, trade secrets (including unpatented technology), internally developed software, business-critical designs and/or drawings, formulas and recipes, and many similar assets.

Goodwill as Part of Purchase Price Allocations

Goodwill is a unique intangible asset. Under current GAAP guidelines, private businesses do have some options with respect to reporting business combinations, and this includes goodwill.

Currently, private companies can choose not to amortize goodwill (either for status quo or for public-company treatment), or they can choose to amortize it over a 10-year (or shorter under certain condition) period. Another option for private companies is to include the value of customer relationships and noncompetition agreements in goodwill through the residual computation, rather valuing these assets separately and then having them reflected in the balance sheet.

However, this may not simplify the ASC 805 valuation treatment as customer relationships and non-compete agreements may still need to be valued in order to properly perform excess earnings methods for other assets.

Goodwill can typically be considered the difference between purchase consideration and fair value of net assets, as shown in the table below:

Purchase consideration << Goodwill
<< Fair value adjustment >> Fair value of net assets
<< Book value of net assets >>

PPA for Tax Purposes

Also, there are some fairly significant differences in PPA valuations for financial-reporting and tax-reporting purposes. The main differences here lie in the computed purchase price, the standard of value, and the valuation treatment and analysis procedures deployed.

The difference in computed purchase price arises owing to the inclusion and exclusion of certain specified costs, for example, certain transaction costs, deferred taxes, and accrued liabilities. Further, tax reporting excludes contingent consideration and liabilities and measures assumed debt at “face value” rather than “fair value.”

(Necessary Procedures For All Parties Involved: Financial Reporting, Tax Reporting, and Valuation Analyses, Oh My!)

(Purchase Price Allocation Procedures: Financial Reporting, Tax Reporting, and Valuation Analyses, Oh My!)

The standard of value for financial reporting is “fair value.” This is 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” (FASB ASC 820-10-20).

For tax reporting, however, the standard of value is “fair market value” – which is “the price at which property would exchange between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both having reasonable knowledge of the relevant facts” (Treas. Regs. §20.2031-1(b) and §25.2512-1; Rev. Rul. 59-60, 1959-1 C.B. 237). Although these two values may often wind up fairly close, there may be a difference.

Finally, the main differences in valuation treatment and procedures reside in the valuation analyses. This can be seen in the assigning of goodwill and other asset values, how bargain-purchase transactions are treated, and determination of tax benefits for intangible-asset amortization.

(Financial reporting, tax reporting, and valuation analyses are an essential part of the PPA procedure)

IRS Concerns On PPA – Financial Reporting

Foremost of the IRS purchase price allocation concerns is that it must be done in accordance with Section 1060 of the Internal Revenue Code. The buyer and the seller each have to file separately with the IRS using Form 8594, “Asset Acquisition Statement’,” with respect to allocation of the purchase price. Generally, both buyer and seller have to file federal and other tax returns reflecting the identical allocation.

The problem here, though, is that the buyer and the seller have opposing interests in making of the allocation.

Takeaways – buyer and seller balance:

  • A buyer’s goal, obviously, is to recover the greatest amount of the purchase price over the shortest period possible by means of depreciating, expensing, or amortizing the assets.
  • A seller’s goal, on the other hand, is to allocate as much of the purchase price as possible to the capital assets in order to produce favorable capital gains conditions. And these differing goals can create IRS issues.

If the allocations in the IRS Forms 8594 filed by buyer and seller are not the same, there exists then the possibility of an audit. And in that case, the Treasury Department retains the right to review and challenge the allocation. To decrease the likelihood of an audit by the IRS, many asset-purchase agreements include a provision requiring buyer and seller to file identical Forms 8594.

If, however, the buyer and seller cannot agree on the purchase price allocation, a third party may be deputized to make the allocation and break the stalemate.

Another way to handle it is to include a pertinent provision in the purchase agreement. Such a provision would state that when buyer and seller cannot agree on the allocation, they are both then free to go their own ways absolved of any responsibility.

How We Can Help Simplify the Process

Purchase price allocation valuation for tax purposes, for financial reporting, for strategic consulting, for fresh start accounting, or for whatever reason is an intricate, complex process consisting of many interrelated and interlocking components. But Redwood Valuation can make the whole process much more manageable. And our valuations are custom tailored for your particular needs and regulator expectations.

Teamwork is one key element that has gained us a respected status in this industry. For over a decade, our partners and directors, along with our team of experienced valuation associates and analysts, have been meeting the needs of both established companies and startups.

Our professionals have expert knowledge in the areas of finance, tax, venture capital, and the audit process. Our experience also allows us to understand the unique challenges and pressures startups face.

Simply put . . . value is our passion. To discover more about our valuable valuation services, contact us today.