Purchase price allocation (PPA): how it works
CapitalQuarter - Spring 2023
Read time: 2 mins
PPA is an important methodology during business acquisition. What are its stages and benefits?
When a business is acquired, the acquisition rationale is hardly ever the book value of assets. Typically, intangible assets make up 75% of deal values. But these would largely remain off balance sheet without the application of a purchase price allocation (PPA).
From an accounting perspective, this process is covered by three accounting standards: IFRS 3, IAS 38, and IFRS 13).
Under IFRS 3, intangible assets acquired in a business combination must be recognised separately from goodwill. Should the assets meet the IAS 38 recognition criteria, they are required to be recognised within twelve months of acquisition.
So what does this mean? IAS 38 defines an intangible asset as “an identifiable non-monetary asset without physical substance.” An intangible asset is identifiable if it is either:
- separable: can be separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, regardless of whether the entity intends to do so; or
- arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.
And the identified intangible asset will be recognised if, and only if:
- it is probable that future economic benefits will flow to the entity; and
- the cost of the asset can be measured reliably.
The most commonly recognised intangible assets derived from the PPA process that exist off-balance sheet before acquisition, are:
- customer-related – relationships, contracts or order-backlogs
- marketing-related – brands, trademarks and tradenames; and
- technology-related – internally developed software and patents.
The PPA approach differs slightly between practitioners when it comes to detail, but usually progresses as follows:
- Identify the acquired assets and liabilities – this includes both tangible and intangible items.
- Determine fair value of those assets and liabilities – IFRS 13 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.
- Calculate unallocated goodwill – if the purchase price is greater than the fair value of the identifiable net assets acquired, the difference is recognised as goodwill.
- Test the results for reasonableness – by calculating the weighted average return on assets (WARA) for the post-PPA balance sheet. Logically, the unallocated goodwill should have the highest expected returns.
Unallocated goodwill is typically made up of:
- the future economic benefits that the acquirer expects to receive from the business combination; and
- the assembled workforce that does not meet either the separability or contractual requirements under IAS 38.
The benefits of the PPA process are discussed less frequently than the methodology. But representing the value of the assets acquired accurately is important and beneficial. It allows for better management decisions in relation to future investments and operations, and also provides stakeholders with improved information to support their own investment decisions.
For more guidance on PPAs, please contact Matthew Willetts.