5 Key Steps to Prepare a Purchase Price Allocation After A Business Combination

Completing the acquisition of an operating business, including due diligence, negotiations and closing procedures, often spans many months. Amid closing a transaction and navigating the operational logistics of merging two companies, accounting for the acquisition is often the last thought on the mind of the acquirer.

Accounting for the acquisition of an operating business (also know as a business combination) is a complex process which accounting and finance personnel typically do not encounter on a daily basis. The lack of familiarity with accounting for business combinations can lead to challenges in the year-end financial reporting process.

International Financial Reporting Standards (IFRS) 3 Business Combinations and Accounting Standards for Private Enterprises (ASPE) 1582 Business Combinations, require that upon completion of a business combination, the consideration transferred as well as the assets and liabilities acquired must be recorded at their acquisition date fair values.¹

Upon identification of the acquirer and determination of the acquisition date, business combinations are accounted for through the preparation of a Purchase Price Allocation (PPA). The following five steps should be considered when completing a PPA:
Step 1: Determine the fair value of consideration paid;
Step 2: Revalue all existing assets and liabilities (excluding intangible assets and goodwill which are addressed in step 3 to 5 below) to their acquisition date fair values;
Step 3: Identify the intangible assets acquired;
Step 4: Determine the fair value of identifiable intangible assets acquired; and,
Step 5: Allocate the remaining consideration to goodwill and assess the reasonableness of the overall conclusion.

Step 1: Determine the Fair Value of Consideration Paid

Consideration paid in a business combination can take many forms, including, but not limited to, cash, shares, promissory notes, contingent payments, earnouts, etc. Regardless of the form or timing of the consideration, it must be recorded at its acquisition date fair value. Examples include:

• Cash consideration - Cash consideration payable on the closing date is typically considered to be representative of acquisition date fair value.
• Share consideration - Purchase and sale agreements often detail a deemed price for share consideration. However, for the purposes of completing a PPA, this deemed price may or may not represent the fair value of the shares issued. For companies with shares trading in an active market, such as public companies, the trading price on the acquisition date is typically the best indicator of fair value. For companies whose shares are not traded in an active market, recent third-party transactions or issuances of the company’s shares can sometimes be referred to as an indication of fair value. If the shares are not actively traded and recent transactions are not available, a valuation analysis may be required to support the fair value of the shares issued in the business combination.
• Deferred payments and promissory notes - Deferred payments occur when all or a portion of the purchase consideration will be paid to the vendor at a date subsequent to the acquisition date. The fair value of deferred cash consideration should reflect a discount for the passage of time over the deferral period as well as the risk of non-payment. Deferred consideration can also relate to share consideration, such as when consideration shares are placed in escrow and scheduled for release at a later date. In determining the fair value of deferred share consideration, one may consider a discount related to the length of the deferral period as well as the volatility of the underlying stock.
• Contingent consideration – Contingent payments are common in business combinations as they often allow vendors and purchasers to navigate pricing disparities. Contingent consideration can take various forms; a common form involves the acquirer agreeing to transfer additional consideration upon achievement of certain financial or operational milestones within a defined time period. However, contingent consideration may also give the acquirer the right to return previously transferred consideration if specified conditions are/are not met. Contingent consideration is recorded at its acquisition date fair value, which is determined using a model appropriate to the earnout structure.

Step 2: Revalue all Existing Assets and Liabilities to their Acquisition Date Fair Values

Consistent with the requirements of IFRS 3 and ASPE 1582, existing assets and liabilities acquired in a business combination must be recorded at fair value on the acquisition date. Examples include:

• Working capital – Working capital recorded in the PPA should reflect the actual working capital transferred on the acquisition date and should also consider working capital adjustments if included in the purchase and sale agreement.
• Property, plant and equipment - Depending on the estimated fair value and complexity of the property, plant and equipment acquired, determining the fair value of property, plant and equipment may require the assistance of a machinery and equipment or real estate appraiser.
• Intangible assets and goodwill - Any existing intangible assets and goodwill recorded on the closing balance sheet of the acquired company, are revalued to nil on a preliminary basis. The intangible assets in existence at the acquisition date will be identified and revalued in Steps 3 and 4 below.

Step 3: Identify Intangible Assets Acquired

The next step in completing a PPA is to ensure all identifiable intangible assets acquired in the business combination are recorded separately from goodwill. IFRS 3 and ASPE 1582 both specify that an intangible asset is considered identifiable if it arises from a contractual or legal right or is separable. That is: an intangible asset is considered separable if it is capable of being separated or divided from the enterprise and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability regardless of whether the enterprise intends to do so. An intangible asset is contractual if it arises from a contractual or other legal right, regardless of whether those rights are transferable or separable from the enterprise.

Common intangible assets acquired in business combinations include:

• Order backlog – Identified based on review of open purchase orders and / or in-progress projects as at the acquisition date and represents an intangible asset due to its contractual nature.
• Customer relationships – A contract does not have to be in place with a particular customer in order for the relationship to have value. Recurring revenue is often a strong indication of customer relationship value.
• Non-compete agreements - Typically included as a separate clause in the purchase and sale agreement for shareholders that are either exiting the acquired company or continuing their employment with the acquirer.
• Above or below market contracts - Long-term contracts executed above, or below current market rates may meet the criteria of an identifiable intangible asset. A common example is a long-term facility lease secured at a rate which is now above or below current market rates.
• Patents and proprietary technology - Each patent and piece of technology should be considered separately. The existence of a patent does not necessarily indicate value and conversely acquired technology does not have to be patented to have value.
• Trademarks and tradenames – Trademarks and tradenames used by the acquired company and listed in the purchase and sale agreement should be reviewed to determine if they have value in the market. Trademarks and tradenames may have value regardless of whether the acquirer intends to use the name going forward.

Step 4: Determine the Fair Value of Identifiable Intangible Assets Acquired

Preparing a PPA typically starts with a review of the acquirer’s acquisition model. The Internal Rate of Return (IRR) of the acquisition is then calculated by solving for the rate that equates the net present value of the after-tax forecast cash flows of the acquired business to the purchase price. The acquisition IRR represents the weighted average rate of return of all the assets and liabilities of the acquired business. The acquisition IRR is then compared to an independently calculated weighted average cost of capital in order to determine if the consideration represents fair value.

Once the acquired intangible assets are identified and the acquisition IRR is determined, the next step is to value the identifiable intangible assets. There are three generally-accepted approaches for valuing intangible assets:

• Market Approach
• Cost Approach
• Income Approach

Market Approach
Under the market approach, the fair value of an asset reflects the price at which comparable assets are purchased under similar circumstances. When the market approach is applied, data is gathered on prices paid for reasonably comparable assets.

The appeal of the market approach is its simple application when a comparable asset is available. However, the market approach is difficult to apply to the valuation of intangible assets as intangible assets are seldom sold on a standalone basis and therefore public transaction information is rarely available.

Cost Approach
The cost approach is based on the premise that a prudent investor would not pay more for an asset than the amount necessary to replace or reproduce the asset. The cost should reflect physical deterioration, functional obsolescence and economic obsolescence as appropriate.

The cost approach is often applied to value assets that are not intended to generate future cash flows, such as internal-use software. The cost approach is often not applicable in other circumstances as it fails to capture the expected future benefits of the intangible asset.

Income Approach
The income approach is the most common technique used to value intangible assets. The income approach measures the value of an asset as the present value of the future economic benefits to be derived over the life of the asset. These benefits may include earnings, cost savings, and proceeds from disposition. Applying the income approach involves estimating the expected cash flows attributable to the asset over its life and converting these cash flows to present value through discounting.

Step 5: Allocate the Remaining Consideration to Goodwill and Assess the Reasonableness of the Overall Conclusion

Any consideration that is not allocated to the fair value of the assets (including identifiable intangible assets) and liabilities is allocated to goodwill. The reasonableness of the overall conclusion and quantum of goodwill can be assessed through an analysis of the Weighted Average Return on Assets (WARA). This analysis reconciles the estimated returns on all assets (excluding goodwill) and liabilities acquired to the acquisition IRR with the difference being the implied rate of return on goodwill. This implied rate of return on goodwill is then assessed for reasonableness in the context of the rate of return on the other assets and liabilities acquired.

The preparation of a PPA is an involved and complex process. It requires an in-depth knowledge of the acquired business as well as knowledge and experience in the application of various fair value methodologies. Ongoing communication between accounting and operational personnel is required. The valuation of intangible assets involves estimates and is therefore an area of scrutiny from financial statement auditors and regulatory bodies. MNP’s business valuation team is experienced in the preparation of PPAs and the valuation of intangible assets and can provide assistance in business combination related matters.

Contact Amanda Salvatori, CPA, CA, CBV, at 416-515-3852 or [email protected].

This article was authored by Brittany Dela Rosa, CPA, CA, CBV , MNP Valuation and Litigation Support.

¹Fair Value is defined in IFRS 13 Fair Value Measurement 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.”
Fair Value is defined in ASPE 1582 Business Combinations as “the amount of the consideration that would be agreed upon in an arm's length transaction between knowledgeable, willing parties who are under no compulsion to act.”