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 assets acquired and its fair value as illustrated by the following chart:

Purchase Price Allocation

The fair value of purchase consideration differs form book value of net assets due to two reasons: First, the book values are based on historical cost in most cases but in a business combination, an acquirer assess them at their fair value. This is represented by the difference represented by the yellow-shaded area. Second, even fair values of net assets do not capture the whole value of a company, for example, accounting standards do not allow companies to recognize many internally-generated intangible assets. Then there is the value which comes from a company's brand name, reputation, culture, management quality, etc. But a potential acquirer must compensate the target company's investors for this undocumented value to convince them to sell their stake in the company. This second component is called goodwill. 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 $250 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 exists an intangible asset 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 (purchase) consideration transferred C 250
Book value of net assets B 190
Total differential D = C - B 60
Intangible asset recognized I 12
Fair value adjustment F 35
Total asset recognition and fair value adjustment T = I + F 47
Goodwill G = D - T 13

The book value of net assets equals the excess of book value of total assets over book value of total liabilities and the fair value adjustment equals the difference between fair value of net assets and their book values as shown below:

USD in million Book Value Fair Value Increase in Fair Value
Property, plant and equipment 220 250 30
Investments 80 80 -
Inventories 40 40 -
Accounts receivable 30 25 (5)
Other current assets 10 10 -
Long-term debt (150) (140) 10
Current liabilities (40) (40) -
Net 190 225 35

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.

by Obaidullah Jan, ACA, CFA and last modified on

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