Step 1 - Purchase Price Calculation

The first step in purchase price allocation, or PPA, is to determine the purchase price. Note that no acquisition-related costs are included in the purchase price after January 1, 2009, in accordance with FAS 141r.

Equity Purchase Price

Also known as the transaction price/value, this is the price paid for the equity of a company and is calculated as:

Acquisition-Related Costs

Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finder’s fees; advisory, legal, accounting, valuation, and other professional or consulting fees; general administrative costs; and costs of registering and issuing debt and equity securities. With the exception of costs to issue debt or equity, FAS 141 and FAS 141r differ substantially

• FAS 141 – Include in purchase price
• FAS 141r – Do not include in purchase price; expense as incurred

Under both FAS 141r and FAS 141, debt and equity issuance fees are treated differently from other acquisition-related costs as follows:

• Debt – Financing fees capitalized and amortized over cost of the term of the debt
• Equity – Fees netted against proceeds from the offering

After December 15, 2008, acquisition-related costs are no longer included in the purchase price. Instead, the acquirer expenses these charges as incurred and the services received, while debt and equity financing fees continue to receive the same accounting treatment described above.

The FASB is working to remove ambiguity in the accounting rules for debt and equity financing fees in business combinations, and has tentatively decided to require that these costs be expensed as incurred.

Restructuring costs are not considered part of the purchase price under both FAS 141 and 141r.

Compensation for Past Services

Payments to Target's employees for services performed in the past which have no future benefit are added to the purchase price because they are considered assumed liabilities. Examples include severance payments to Target's former managers and stock options that vest upon a change of control. We cover this topic in far more detail in the next lesson.

Purchase Price Allocation

An acquirer allocates the purchase price to the assets acquired and liabilities assumed at fair value (FV) on the acquisition date. Normally, the purchase price exceeds the FV of these assets and liabilities. Why would anyone pay more for something than it is supposedly worth? Perhaps because the acquirer expects to create value through synergies or better management, giving the target's sellers leverage to demand a premium for their business.

Goodwill

To calculate goodwill in a transaction, we allocate the purchase price to the FVs of identifiable assets acquired and liabilities assumed in the following order:

1. Tangible net assets (assets minus liabilities)
2. Identifiable intangible assets
3. Goodwill (the residual after steps 1 and 2)

Goodwill is an indefinite-lived intangible asset recorded on the acquirer's post-combination balance sheet that is not amortized but, rather, tested periodically for impairment. If the acquirer later writes down impaired goodwill, it is usually a sign that the business combination failed to meet expectations (e.g. Time Warner's troubled acquisition of AOL) and, consequently, implies overpayment for the acquired business and error in judgment by the acquirer.

Book Value of Net Assets

Book values of assets and liabilities are often different from their FVs. In allocating the purchase price to these assets and liabilities, we step, or write, them up/down to reflect their FVs.

Identifiable Intangible Assets

Examples of identifiable intangibles may include customer contracts, Internet domain names, patents and trademarks, and brand names, among other things. As much we value our employees, assembled workforces are not considered identifiable intangibles. For book accounting purposes, intangibles with finite lives are amortized over their useful lives, while indefinite-lived intangibles (like goodwill) are not amortized but, rather, tested for impairment. For tax purposes, Section 197 of the IRS tax code requires straight-line amortization of all intangible assets (including goodwill) over 15 years only in an:

• Asset acquisition or a
• Stock acquisition with a Section 338 election.

Intangibles are not amortized for tax purposes in stock acquisitions absent a Section 338 election.

Applied Purchase Price Allocation

Recall that in both asset and stock acquisitions, Tango's net assets are written up/down for book purposes and are recorded on Alpha's balance sheet at FV. However, for tax purposes, the write-ups/downs are treated differently depending on the type of acquisition. In an asset acquisition, as in Example 2.3, Tango's net assets are written up for both book and tax purposes. In a stock acquisition, on the other hand, Tango's net assets are written up for book purposes but not for tax purposes.

Think about what effect differences between the book and tax balance sheets in a stock acquisition might have. In Example 2.3, we wrote up PP&E by $10 for book purposes. However, in a stock acquisition, there is no corresponding write-up for tax purposes. So, if the deal was a stock acquisition, Alpha's post-transaction book balance sheet would record PP&E at its FV of $60, while A's tax balance sheet would record PP&E at its historical, or carryover, value of $50. The incremental depreciation resulting from the write-up of PP&E for book purposes results in taxable income that is lower for book purposes than for tax purposes, giving rise to a deferred tax liability (DTL). This DTL, recorded on Alpha's balance sheet, represents Alpha's liability for the actual cash taxes that Alpha must eventually pay the IRS in excess of the lower taxes Alpha will report on its income statement for accounting purposes. The write-up of identifiable intangibles for book purposes but not for tax purposes also gives rise to a DTL due to the incremental book amortization expense.

From the DTL equation above, it should be clear why there is no DTL created in an asset acquisition; the tax basis is stepped up to FV. In practice, we often use book value as a proxy for tax basis when calculating DTL in the PPA; due diligence would be necessary to discover the actual tax basis. The following example shows how a deferred tax liability figures into the PPA:

Bargain Purchase

In a rare bargain purchase, the excess just defined must be immediately recognized by the acquirer in earnings as a gain that increases goodwill from a would-be negative value to zero after in accordance with FAS 141r. FAS 141 had required that any negative goodwill be allocated pro rata to the acquired assets, reducing their allocated FVs to zero. Any goodwill remaining following the pro rata allocation must then be recorded immediately as an extraordinary gain. However, before recognizing any such gain, the acquirer should check the PPA parameters for accuracy. IFRS 3 requires that all negative goodwill be expensed immediately, similar to FAS 141r.

Asset & Stock Deals

Subsidiary Accounting

Important Accounting Changes

Purchase Price Allocation II

The Equity Method

Noncontrolling (Minority) Interest

Treatment of Options (FIN 44)

Discounted Cash Flow Analysis

Black-Scholes and FIN 44 Calculations

Macabacus Macros

Excel Keyboard Shortcuts

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