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What does purchase price allocation mean?
What are the essential elements you should know!
In this article, I will break down the meaning of Purchase Price Allocation so you know all there is to know about it!
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Table of Contents
What Is Purchase Price Allocation
In mergers and acquisitions, purchase price allocation is the amount an acquiring company allocates to the purchase of assets and liabilities of a target company.
The process of allocating a price to the assets and liabilities acquired is an important accounting step organizations must consider when making a purchase.
When making an acquisition, a company will pay a lump sum to acquire a pool of assets and liabilities from the target company.
However, for tax purposes, the acquiring company must establish the tax basis for the individual assets being purchased.
Once the buyer identifies the purchase price allocation for the assets, it will then be able to calculate things like tax depreciation, amortization deductions, and other implications.
The seller of the asset will also have a proper determination of how much capital gains or capital losses it will need to report.
According to the International Financial Reporting Standards, or IFRS, companies must use the purchase price allocation method to report on the assets and liabilities purchased in the context of a merger or acquisition.
Internal Revenue Code
Section 1067 of the Internal Revenue Code provides for the “residual method” to allocate purchase price in a transaction.
Section 1067 IRC provides for seven different classes of assets:
- Class I: Cash and cash equivalents
- Class II: Actively traded personal property, CDs and foreign currency
- Class III: Mortgages, accounts receivables and credit card receivables
- Class IV: Inventory
- Class V: Equipment, land and property
- Class VI: Intangibles described under Internal Revenue Code 197, less Goodwill or going concern
- Class VII: Goodwill and going concer
Further to the residual method, once you’ve allocated a purchase price to all your identifiable assets, you will then allocate the excess to goodwill.
When To Do A Purchase Price Allocation
When should you perform a purchase price allocation?
Typically, purchase price allocations are done after a mergers and acquisitions deal is completed.
However, it’s very practical to start the purchase price allocation during the acquisition process so both the buyer and seller can have a better understanding of what to expect and the tax implications of the transaction.
Considering the purchase price allocation will have an impact on both the buyer and seller, it’s a good idea to have this aspect sorted out before concluding the transaction.
In some cases, the purchase price allocation can also help in the negotiation of the asset purchase where the buyer or seller may point out the advantages or drawbacks of structuring the purchase price allocation in a certain way.
Purchase Price Allocation Components
What are the elements of purchase price allocation?
The main components of purchase price allocation are:
- Total consideration paid
- Net identifiable assets
The total consideration paid includes anything of value used to purchase the assets or liabilities, such as cash, stock, debt, cryptocurrency, or other forms of payment in lieu of cash.
Net identifiable assets represent the total amount of assets purchased, tangible or intangible, by a company less its liabilities.
In essence, you’re looking at the book value of the target company’s assets on its balance sheet.
Write-up refers to the increase in an asset’s book value if the asset’s carrying value is less than its fair market value.
Goodwill refers to an amount paid over and above the target company’s net asset value calculated by taking the difference between the total fair market value of the assets less the liabilities.
How To Allocate Purchase Price
How do you allocate the purchase price to assets and liabilities in the context of a sale?
Any company going through with an acquisition or merger must perform a purchase price allocation to ensure it complies with the proper accounting rules and guidelines.
Here are the steps you will need to take to allocate your purchase price:
- Identify the target company’s book value of assets
- Identify the target company’s book value of liabilities
- Determine the company’s net asset value on its balance sheet
- Assign a fair market value to the assets and liabilities for tangible assets and intangible assets
- Write up the book value of the assets if the market value of those assets exceeds their book value
- Take the difference between the fair market value paid for the assets and the addition of the net book value of the assets and the write-up and recognize that as goodwill
Purchase Price Allocation Example
Let’s look at an example of purchase price allocation to better understand how it works.
Let’s assume the following acquisition parameters:
- Company A acquires Company B for $50,000,000
- Company B’s book value of assets are $30,000,000 with $20,000,000 in liabilities
- Company B’s net book value of its assets is $10,000,000
- Company B’s fair market value of its assets and liabilities is $40,000,000
In this example, Company A’s purchase price allocation will look like the following:
- There must be a write-up of $30,000,000 ($40M fair market value – $10M net book value), adjusting the company’s net book value to the fair market value
- There must be goodwill of $10,000,000 to be recorded ($10M book value of the assets + $30M write-up), representing the amount paid exceeding the net book value of the assets and the write-up
Allocation of Purchase Price Takeaways
So there you have it folks!
What Does Purchase Price Allocation Mean
Purchase price allocation is an accounting process where a company allocates a fair value to assets and liabilities purchased in the context of a merger or acquisition.
The main purpose of “purchase price allocation” is to ensure that your acquisition is properly recorded from an accounting perspective and to ensure proper tax treatment of the assets sold.
The buyer will be able to better define the book value of its assets, amortization, depreciation, and what number to put on its balance sheet.
The seller will know how much capital gain or loss to report to the tax authorities.
The M&A purchase price allocation is also a great way to understand the implications of the acquisition, its financial, and tax implications as well.
Investors are curious to know how much they are paying for the actual assets being purchased and how much is going to goodwill.
Now that you know what purchase price allocation means, why it’s done, and how it works, good luck with your acquisition!
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