What Is a Purchase Price Allocation in Accounting?

Purchase Price Allocation (PPA) is an accounting procedure required when one company acquires another business. This process distributes the total cost of the acquisition, or “consideration transferred,” among the identifiable assets acquired and liabilities assumed of the acquired entity. Its fundamental purpose is to record the acquired business’s assets and liabilities at their fair values on the acquirer’s financial statements. This allocation ensures the combined entity’s financial position accurately reflects the value obtained from the business combination, aligning with accounting standard ASC 805.

Core Principles of Purchase Price Allocation

PPA involves allocating the consideration transferred to the identifiable assets acquired and liabilities assumed of the acquired entity. This consideration can include cash, other assets, stock, assumed debt, or contingent consideration, all measured at fair value as of the acquisition date.

Fair value, as defined by accounting standard ASC 820, is 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. This is considered an “exit price” and reflects a market-based measurement. Assets and liabilities are categorized into tangible and intangible for allocation purposes.

After allocating the purchase price to all identifiable tangible and intangible assets and assumed liabilities at their fair values, any residual amount is recognized as goodwill. Goodwill represents future economic benefits from assets not individually identified and separately recognized, such as brand reputation or customer loyalty. If the fair value of the net identifiable assets acquired exceeds the consideration paid, it results in a “bargain purchase,” recognized as a gain by the acquirer.

Key Assets and Liabilities in Purchase Price Allocation

PPA involves identifying and valuing various assets and liabilities. Tangible assets include physical items such as property, plant, and equipment, revalued to their current market prices. Inventory, including raw materials, work-in-process, and finished goods, is valued at fair value, often considering its selling price less costs to complete and sell. Cash and cash equivalents are straightforward to value; accounts receivable are assessed based on their collectibility.

Identifiable intangible assets are a substantial portion of the acquired value. These assets must be separable (meaning they can be sold, transferred, licensed, rented, or exchanged) or arise from contractual or legal rights. Examples include:
Customer-related intangibles: Customer lists, contracts, and relationships.
Contract-based intangibles: Operating lease agreements, supply contracts, or licensing agreements.
Technology-based intangibles: Patents, proprietary software, unpatented technology, and in-process research and development.
Marketing-related intangibles: Trademarks, trade names, brand names, and internet domain names.
Artistic-related intangibles: Literary works, musical compositions, and theatrical plays.

Liabilities assumed by the acquirer are also recorded at their fair values. Common liabilities include accounts payable, various forms of debt like loans or bonds, and deferred revenue, representing payments received for goods or services not yet delivered.

Steps in a Purchase Price Allocation Process

The purchase price allocation process begins with determining the acquisition date, which is the date the acquirer obtains control of the acquired business. This date is crucial because it sets the point in time for all subsequent valuations. Next, the total purchase consideration must be calculated. This involves summing all forms of payment made by the acquirer, including cash, equity instruments issued (like common stock or preferred stock), contingent consideration, and assumed liabilities.

The next step involves identifying all assets acquired and liabilities assumed from the target company. This detailed process goes beyond the acquired company’s historical balance sheet, as some intangible assets may not have been previously recognized. Once identified, these assets and liabilities must be measured at their fair values as of the acquisition date. This valuation often requires independent valuation specialists due to the complexity of assessing tangible and intangible assets.

After the fair values of all identifiable assets and liabilities are determined, goodwill is calculated as the residual amount. This represents the excess of the total purchase consideration over the fair value of the net identifiable assets acquired.

Financial Reporting Implications

Purchase Price Allocation impacts the acquirer’s financial statements following the acquisition. On the balance sheet, acquired assets and liabilities are recorded at their newly allocated fair values, rather than historical carrying amounts. This revaluation can substantially change the acquirer’s asset and liability balances, often increasing the recorded value of assets, particularly intangible ones. The recognition of goodwill as a separate intangible asset also directly affects the total asset base.

The income statement is also affected by PPA over subsequent periods. Revalued tangible assets, such as property, plant, and equipment, are depreciated based on their new fair values over their remaining useful lives, potentially leading to higher depreciation expense. Identifiable intangible assets, like customer relationships or technology, are amortized over their estimated useful lives, resulting in an amortization expense recognized on the income statement. This systematically reduces the carrying value of these assets over time.

Goodwill, however, is treated differently under accounting standard ASC 350; it is not amortized. Instead, goodwill is subject to annual impairment testing, or more frequently if certain indicators suggest a potential loss in value. If the carrying value of goodwill exceeds its fair value as determined by this testing, an impairment loss is recognized on the income statement, reducing reported earnings. This impairment charge reflects a decline in the expected future economic benefits associated with the goodwill.