Abstract: In mergers and acquisitions, how you divvy up the selling price among acquired assets and liabilities can have important consequences after the deal closes. This article lists five steps required to allocate the purchase price to acquired assets (including goodwill and other identifiable intangibles) as well as liabilities under U.S. Generally Accepted Accounting Principles.
In mergers and acquisitions, how you divvy up the selling price among acquired assets and liabilities can have important consequences after the deal closes. Inaccurate allocations can result in write-offs later on. Here are the five steps required to allocate the purchase price in a business combination under U.S. Generally Accepted Accounting Principles (GAAP).
1. Identify assets and liabilities
Under Accounting Standards Codification Topic 805, Business Combinations, purchase price allocations start with the identification of tangible and “identifiable” intangible assets and liabilities. A seller’s balance sheet tells only part of the story. Various intangible assets and contingencies may be excluded from the financial statements. Examples include internally developed brands, patents and customer lists, along with environmental claims and pending lawsuits. Overlooking identifiable assets and liabilities often results in inaccurate reporting of goodwill from the sale.
Private companies can, however, elect to combine noncompete agreements and customer-related intangibles with goodwill. If this alternative is used, it specifically excludes customer-related intangibles that can be licensed or sold separately from the business.
The buyer should also evaluate the tax implications of the deal, because there may be differences in the book and tax bases of acquired deferred tax assets and assumed tax liabilities. Under GAAP, business combinations may trigger complex rules regarding goodwill and replacement awards classified as equity. For example, goodwill may be taxable in certain jurisdictions, resulting in deferred taxes.
2. Determine the purchase price
When the buyer pays in cash, the purchase price (also called the fair value of consideration transferred) is obvious. But other types of consideration complicate matters. For instance, consideration transferred may include:
- Stock and stock options,
- Replacement awards, and
- Contingent payments.
For example, it can be challenging to assign fair value to earnouts payable only if the acquired entity achieves predetermined financial benchmarks. Contingent consideration may be reported as a liability or equity (if the buyer will be required to pay more if it achieves the benchmark) or as an asset (if the buyer will be reimbursed for consideration already paid). Contingent consideration that’s reported as an asset or liability may need to be measured each period if new facts are obtained during the measurement period or for events that occur after the acquisition date.
The income approach is often used to value contingent consideration. The buyer may, for example, use a discounted cash flow analysis to calculate the amount and timing of contingent consideration. Under this technique, the best estimate of contingent payments is discounted to present value using a rate that reflects the risks that the contingent event won’t happen.
It’s also important to determine whether the terms of the deal include arrangements to compensate the seller (or existing employees) for future services. These payments, along with payments for pre-existing arrangements, aren’t part of the business combination. In addition, acquisition-related costs (such as finder’s fees or professional fees) shouldn’t be capitalized as part of the business combination. Instead, they generally should be accounted for separately and expensed as incurred.
3. Allocate the purchase price
The next step is to split up the fair value of consideration (minus any noncontrolling interests retained by the seller or held by other investors) among the assets acquired and liabilities assumed. This requires you to estimate the fair value of each individual asset and liability.
Under GAAP, fair value is the price an entity would receive to sell an asset — or pay to transfer a liability — in a transaction that’s orderly, takes place between market participants and occurs at the acquisition date.
If quoted market prices and other observable inputs aren’t available, unobservable inputs may be used to estimate fair value. It’s important to use assumptions that a market participant would use — based on an asset’s highest and best use — rather than assumptions based on the buyer’s intended use. Intangible assets are often hard to value because they’re unique and there’s limited comparable market data to support their values.
4. Assign leftover value to goodwill
Once the fair value of consideration has been allocated to the acquired company’s identifiable assets and liabilities, any remainder is assigned to goodwill. Essentially, goodwill is the premium the buyer is willing to pay above the fair value of the net assets acquired for expected synergies and growth opportunities.
Important: While most companies that follow GAAP are required to test goodwill annually for impairment, private companies may instead elect to amortize goodwill over a period not to exceed 10 years. This election doesn’t eliminate the requirement for private companies to test for impairment when a triggering event happens, however.
In rare instances, a buyer negotiates a bargain purchase. Here, the fair value of the net assets exceeds the fair value of consideration transfer (the purchase price). Rather than book negative goodwill, the buyer reports a gain on the purchase.
5. Perform a sanity check
Before settling on an amount for goodwill, step back and ask if the amount makes sense. Large amounts of goodwill relative to the overall purchase price might indicate that the buyer overlooked a key asset or understated the fair value of an identifiable asset. Likewise, bargain purchases typically may occur only when the seller is financially distressed and forced to sell.
Buyer beware
Purchase price allocations can have important financial reporting implications years after the deal closes. After a merger closes, goodwill generally must be tested for impairment annually or whenever a triggering event — such as the loss of a major customer or enactment of unfavorable government regulations — happens. Inaccurate fair value measurements may result in write-offs in subsequent years, which may raise a red flag to investors and lenders.
Do-it-yourself purchase price allocations can be perilous. Work with your CPA to help ensure your fair value measurements are supported by market data and other reliable valuation techniques. Doing so can help minimize the subsequent write-offs and potential lawsuits from stakeholders.
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