Purchase Price Allocation

Purchase price allocation is the process through which purchase consideration paid in a business combination is allocated between the assets of the acquiree and goodwill, if any.

A business combination is a transaction in which the acquirer transfers cash or its own stock to the acquiree or its shareholders in return of the acquiree’s net assets or its stock. The consideration (cash or stock) transferred to the acquiree is called purchase consideration. The purchase consideration differs from the book value of the net assts acquired and its fair value as illustrated by the following chart:

Purchase Price Allocation

The first component of the difference between book value of the acquiree’s asset and purchase consideration is represented by the difference between the fair value and book value of those assets and liabilities. This difference arises because accounting information for many assets are based on historical cost. The second component arises due to difference between the purchase consideration and the fair value of net assets. This represents goodwill, the x-factor, which represents the company’s reputation, culture, management quality, etc. which is not captured by the sum of fair values of the acquiree’s assets minus fair values of its liabilities, but which must be compensated to convince the acquiree’s investors to sell their stake in the company. These components can be negative.

Purchase price allocation is all about identifying assets and liabilities of the acquiree, correctly assigning fair values to each identifiable asset and identifying whether there is a goodwill or bargain purchase. One important consideration is to identify intangible assets which are not recognized in the acquiree’s business, but which nonetheless exist due to contractual and legal rights.

Example

Company A has offered $150 million to purchase 100% stake in Company B. Following are the book values and the fair values of the acquiree’s assets and liabilities:

USD in million Book Value Fair Value
Property, plant and equipment 220 250
Investments 80 80
Inventories 40 40
Accounts receivable 30 25
Other current assets 10 10
Long-term debt 150 140
Current liabilities 40 40

There exist intangible assets worth $12 million which are not recognized by Company B in its books.

Following is the allocation schedule which shows how the purchase consideration is allocated between different assets and goodwill:

Fair value of consideration transferred C 150
Book value of net assets B 80
Total differential D = C - B 70
Intangible asset recognized I 12
Increase in fair value recognized F 25
Total asset recognition and fair value adjustment T = I + F 37
Goodwill G = D - T 33

The purchase consideration allocation is recognized through a journal entry when the acquiree ceases to exist as a separate entity, otherwise this journal entry is used in the consolidation worksheet to simulate business combination.

Written by Obaidullah Jan, ACA, CFA and last modified on