What Is Purchase Price Accounting and How Does It Work?

Purchase Price Accounting (PPA) is a fundamental accounting method applied when one company acquires another. It ensures adherence to established accounting standards.

Defining Purchase Price Accounting

Purchase Price Accounting (PPA) involves systematically allocating the total price paid for an acquired company to its individual assets and liabilities. This allocation is based on their fair values at the specific date the acquisition occurs. The primary reason for performing PPA is to comply with generally accepted accounting principles (GAAP) in the United States.

PPA is triggered by business combinations, which occur when one entity gains control over another. This involves mergers or acquisitions where the acquiring company obtains decision-making ability over the target business. The process applies whether the acquisition is structured as a stock acquisition, where ownership shares are transferred, or an asset acquisition, focusing on the combination of businesses.

A central concept in PPA is the “acquisition date,” which is the precise point in time when the acquirer obtains control of the acquired company. This date is the closing date when consideration is legally transferred, and assets and liabilities are assumed. All valuations and measurements in the PPA process are performed as of this acquisition date.

Identifying and Measuring Acquired Assets and Liabilities

The initial step in Purchase Price Accounting involves identifying all assets acquired and liabilities assumed from the target company. This goes beyond the historical figures on the acquiree’s balance sheet, encompassing both tangible items like property, plant, and equipment, and intangible assets such as customer relationships, patents, brand names, or proprietary technology. Liabilities assumed, including debt, leases, deferred revenue, and contingent liabilities, are also identified.

Once identified, these assets and liabilities must be measured at their “fair value” as of the acquisition date. Fair value is defined 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.

To determine fair value, various valuation techniques are employed, including the market approach, income approach, and cost approach. The market approach uses prices and other relevant information from market transactions involving similar assets or liabilities. The income approach converts future amounts into a single current amount, while the cost approach considers the cost to replace an asset.

The fair value measurement process also involves a “fair value hierarchy” (ASC 820), which categorizes inputs into three levels based on their observability and reliability. Level 1 inputs are quoted prices in active markets for identical assets, considered the most reliable. Level 2 inputs are observable inputs other than quoted prices, while Level 3 inputs are unobservable inputs, used when active markets do not exist or are illiquid.

The re-measurement of assets and liabilities to their fair values directly impacts the acquirer’s balance sheet immediately following the acquisition. The acquired company’s assets and liabilities are recorded at these new fair values, providing a current market-based representation.

Recognizing Goodwill or Bargain Purchase Gain

After the fair values of identifiable assets and liabilities are determined, the next step in Purchase Price Accounting is the calculation and recognition of goodwill or a bargain purchase gain. This outcome stems from comparing the total purchase price paid for the acquired company to the fair value of its net identifiable assets.

Goodwill arises when the purchase price paid for an acquired company exceeds the fair value of its identifiable net assets. Net identifiable assets are calculated by subtracting the fair value of assumed liabilities from the fair value of acquired identifiable assets. Goodwill represents the premium paid for unidentifiable intangible factors like a strong brand name, loyal customer base, or potential synergies from the combination.

The formula for calculating goodwill is straightforward: Purchase Price – (Fair Value of Identifiable Assets – Fair Value of Liabilities) = Goodwill. For instance, if a company is acquired for $5 million, and the fair value of its identifiable assets is $4 million with $1 million in liabilities, the net identifiable assets are $3 million. The $2 million difference ($5 million purchase price – $3 million net identifiable assets) is recognized as goodwill.

A “bargain purchase gain” can occur when the purchase price is less than the fair value of the identifiable net assets acquired. Such a scenario might arise from a distressed sale, market inefficiencies, or specific factors related to the selling entity. When a bargain purchase occurs, the resulting gain is recognized immediately in the acquirer’s income statement in the period of acquisition.

Goodwill is initially recorded as a non-current, intangible asset on the acquirer’s balance sheet. It is distinct from other intangible assets because it cannot be separately identified or measured apart from the business as a whole.

Impact on Financial Statements and Future Reporting

The completion of Purchase Price Accounting has a lasting impact on the acquirer’s financial statements beyond the initial acquisition date. The re-measured assets and liabilities, along with any newly recognized goodwill, are directly reflected on the acquirer’s consolidated balance sheet.

The income statement is also affected over time due to the revaluation of assets. Higher fair values assigned to tangible assets, such as property, plant, and equipment, will lead to increased depreciation expense in subsequent periods. Similarly, identifiable intangible assets, like patents or customer lists, are amortized over their estimated useful lives, resulting in amortization expense that reduces reported earnings.

Goodwill, unlike other intangible assets, is not amortized for public companies under U.S. GAAP. Instead, it is subject to an annual impairment test, or more frequent testing if indicators of impairment arise. Impairment occurs when the carrying value of goodwill on the balance sheet exceeds its fair value, indicating a loss in its economic benefit.

If goodwill is determined to be impaired, a non-cash charge is recognized on the income statement, reducing reported net income. This impairment charge reflects the diminution in the value of the acquired intangible assets. For private companies, there is an option to amortize goodwill over a period of 10 years or less, which may reduce the complexity and cost of annual impairment testing.

While PPA is primarily an accounting exercise that does not directly involve cash flows, its subsequent effects on depreciation, amortization, and impairment charges influence reported net income. Net income is the starting point for the operating activities section of the cash flow statement, meaning these non-cash expenses will indirectly affect the reported operating cash flows. Companies are also required to provide disclosures in the footnotes to their financial statements regarding business combinations and the PPA process. These disclosures offer transparency to investors and other stakeholders, detailing the valuation methods used and assumptions made during the allocation.