What is Purchase Price Allocation (PPA) and Why It Matters in M&A

You see the headlines in the news all the time: Company A just acquired Company B for billions of dollars. While you recognize that the acquired company may be large and/or popular in the news, you still might ask yourself some basic questions. Was it worth that much? What did the buyer get for their money?

The business world asks those same questions. Any time a business combination or asset purchase occurs, relevant parties want to know what they are paying for. To help with this, the concept of purchase price allocation, or PPA for short, is commonly used by companies for their accounting in the world of mergers and acquisitions (M&A) today.

Understanding Purchase Price Allocation

When a business is purchased, whether as the purchase of a legal entity or as a group of assets, a common requirement for the deal to close is for the seller to provide a listing of all the assets and liabilities that are part of the purchase.

Since this accounting is difficult to do in real-time, the seller often provides an estimated balance sheet at the closing date. That balance sheet is commonly used for certain adjustments to the purchase price and is later updated with more accurate numbers as of the closing date, which is a part of business combination accounting.

Purchase Price Allocation Example

To stay simple in this article, we can assume the balance sheet stays the same. Consider the following example:

On January 1, 2024, Company A acquires Company B. In return for the purchase price of $100 million in cash, Company A receives all the assets and liabilities of Company B as of the acquisition date.

On the acquisition date, Company B’s balance sheet is as follows:

When you look at what was purchased on the acquisition date, Company A received $70 million in assets, but also incurred liabilities of $30 million in liabilities. The net assets received are only $40 million. If that is the case, then… Why did Company A pay $100 million?

Purchase Price Allocation is the answer to that question. There are factors beyond what is simply shown on a company’s closing balance sheet that make them attractive to buyers. For example, consider the following:

• While the Fixed Assets on Company B’s Balance Sheet are recorded at $50 million, they are in great shape and could easily be sold for $60 million. That updated fair value of $60 million should be what gets recorded for Fixed Assets upon acquisition.

• Company B has various intangible assets not recorded on its balance sheet that make it highly attractive. This includes $20 million of future revenues from current customers, commonly referred to as customer relationships, and $10 million of internally-developed technology. These newly identified assets get recorded onto the acquired balance sheet as well.

Assuming the above, we can take another look at the updated balance sheet based on these purchase price adjustments:

Now we can get a better glimpse of what Company A was looking for: $110 million in assets, and $30 million in liabilities. Net assets received are now $80 million, but still do not reach the total purchase price of $100 million. What’s left?

For a business combination, any amount of purchase price in excess of the identified assets and liabilities is recorded as an asset called Goodwill. Goodwill can be many things to different buyers, but the general idea is that it represents the uncertain/unknown factors that the buyer believes will result in a return on their investment. This can be things like synergies between the buyer and the acquired company, such as reduced costs due to operating together or new revenue opportunities that can be sold to customers between the two companies.

So by taking the purchase price, and allocating that purchase price over all the assets and liabilities of a company, companies can see what they clearly received, and what is less certain (such as intangible assets and Goodwill). That, in a nutshell, is purchase price allocation.

Why PPA is Important

The concept of purchase price allocation, while based on estimates and assumptions, is important in helping parties understand what a business pays for with their acquisitions. So important, in fact, that it’s required in accounting.

Remember that quick overview on US GAAP and what it is? If not, you can read more in our other article here. But simply put, US GAAP stands for Generally Accepted Accounting Principles in the United States. It is a comprehensive and complex set of accounting rules, and there is a specific Topic within those rules that governs the accounting for business combinations; we commonly refer to that Topic as “ASC 805.” To see all of these rules and regulations, you can visit the official US GAAP Accounting Standard Codification (“ASC”) here.

If you are a smaller or closely held business without much outside investment or debt, then chances are you don’t need to follow all the rules of US GAAP, and it can be overly burdensome to do so. However, when growing to a point where you take on major external stakeholders, that will change:

• Large equity investors, such as venture capital or private equity, commonly require their portfolio companies to report their financial statements under US GAAP, so that they can understand the overall financial condition of the business.

• Large lenders also require businesses to provide financial reporting under US GAAP to understand their borrowers’ financial condition, as well as, any underlying assets that can help secure the business.

• Any company that is publicly traded on the US stock exchange must file with the SEC (e.g., through an IPO or SPAC) and present US GAAP financial statements on a quarterly to annual basis.

Information on acquisitions is important for others too. Investors and analysts look to see the purchase price allocation of significant acquisitions in a company’s financial statements, and cases where a company needs to write off its recorded Goodwill can lead to warning signs and a lower stock price.

To comply with US GAAP, you must account for your acquisitions under the rules of ASC 805, which requires purchase price allocation and other accounting guidance. And this accounting isn’t easy; it requires a thorough knowledge of the accounting rules, as well as, specialized expertise in areas like valuation to make sure you have the right numbers for your balance sheet.

Not sure where to start? See our other articles, including an overall introduction to business combination accounting here.

Or, schedule a discovery call with our team of technical accounting experts to help you navigate every step of the process.