For individuals involved in an M&A transaction, the moment when the contract to buy or sell a firm is signed is frequently the most memorable. It is only one of the stages in the M&A lifecycle where each stage has an effect on the others. This post will focus on the Purchase Price Allocation, one of the actions that should be conducted after the sale has been completed (PPA).
Who is in charge of determining the purchase price?
Both purchasers and sellers must file a purchase price allocation on form 8594 in accordance with the Internal Revenue Code. The idea that buyers and sellers must provide consistent purchase price allocations is a prevalent one.
The IRS may, however, contest one or both purchase price allocations if a buyer and a seller provide conflicting purchase price allocations. Therefore, prior to closing, it is preferable for buyers and sellers to come to an understanding regarding the purchase price allocation. A clause requiring agreement on purchase price allocation is present in the majority of asset purchase agreements.
What is an asset's fair market value?
The seven asset classes specified in IRS Form 8594 must receive the full purchase price. Buyers must allocate the purchase price to assets according to their "fair value" in order to comply with GAAP. The amount that would be paid to transfer a liability or received to sell an asset in an orderly transaction between market participants at the measurement date is what is referred to as fair value. The numbers on sellers' balance sheets typically represent the assets' fair values, making it simple to determine a fair value for the smaller and more liquid asset classes like cash, securities, and accounts receivable.
Hard assets that are less liquid, such property, plant, and equipment, may have a fair value that is different from the carrying value on the balance sheets of the sellers. As a result, buyers and sellers typically commission an appraisal to ascertain the true market value of tangible assets.
Combined financial statements
The transaction has been completed, the M&A advisors and attorneys have departed, and the integration of the purchased company has begun. The external accountant then appears at the figurative door, demanding that the transaction be accurately reflected in the financial statements.
After all, the purchased company should now be represented in the consolidated annual report. This task needs to be completed as soon as possible with the least amount of effort possible, even though it may seem trivial and a little dull. You simply require the acquired company's balance sheet, correct? How difficult can that be? Actually, it's not always so easy...
Standardization of accounting practices
It's possible that the acquired company will adopt different accounting standards from the acquirer.
The financial statements of the acquired company must therefore be in line with the accounting principles of the acquirer as a first step. This could be a big undertaking if the acquired firm needs to transition from Dutch GAAP (RJ) to IFRS because of, for example, the requirements of IFRS 15 (revenue recognition) or IFRS 16. (lease accounting).
The purchase price paid (in a company combination) must then be allocated to the assets bought and obligations assumed, a procedure known as a "purchase price allocation" or PPA, in accordance with the financial reporting standards (RJ and IFRS). This can be a challenging endeavor. To begin with, the purchase price might not have been paid totally in cash but rather in equity, deferred payments, or conditional payments like earn-outs. As a result, the purchase price's exact value might not be known at the time the PPA is carried out.
Fair value modifications
The amount of goodwill paid in the transaction must be determined using an accurate and trustworthy assessment of the purchase price. Goodwill is the difference between the price paid for the shares and the value of the net assets acquired. This goodwill amount, however, might not be the one that appears on the balance sheet. The PPA's objective is to determine whether the initial balance sheet's declared book value and the fair value of each asset and liability are different. The asset or obligation is revalued in the balance sheet to its fair value if there are significant discrepancies between fair value and book value, with the goodwill amount serving as a balancing factor. Real estate, machinery, equipment, inventories, investments in partners, and possibly long-term loans are the traditional candidates for revaluation.
New asset and liability identification, recognition, and valuation
The acquired firm may also contain assets and liabilities that did not previously satisfy the criteria for recognition, in addition to possible fair value modifications for items already present on the initial balance sheet. For instance, if a business sells products under a well-known brand name that was domestically developed and maintained, this brand would not appear on the balance sheet. When this business is acquired, the buyer will undoubtedly have taken into account the brand in the asking price he was willing to pay and will consequently have paid for its "goodwill." In that instance, the reporting standards demand that the brand name be valued and recorded in the books. Customer relationships, databases, contracts, intellectual property, favorable or unfavorable contracts, and contingent liabilities are more instances of such identifiable things.
Cash-generating units and goodwill
What is left after all assets and liabilities have been allocated as much of the purchase price as possible is goodwill, which is the value that the company anticipates will be derived in the future from assets that do not yet exist, such as growth from potential consumers or synergistic effects. This goodwill sum must then be evaluated yearly to see if the business can recover it, as per the reporting criteria. An impairment of goodwill occurs when it seems that the goodwill will not be recovered (in full or in part). The ultimate goodwill amount needs to be distributed to the cash-generating units in the case of multiple cash-generating units, which are the smallest group of assets that independently generate assets from the rest of the business, such as a business unit or product segment.
Problems facing the controller
The internal financial controller, who is tasked with performing the PPA, has frequently not been a member of the M&A transaction team. The experts who used to be on this team are currently too preoccupied to work on a new deal. A purchase price allocation is also a rare occurrence for many controllers; as a PPA may only happen sometimes, most of them do not need to specialize in this area of accounting. Can you picture this person's struggle?
The controller must, among other things, ascertain what has been agreed in the share purchase agreement (SPA), determine the actual purchase price, comprehend the assumptions underlying the financial forecast used as the basis for the purchase price paid, and value newly ided assets without much experience in the field of PPA, participation in the transaction process, or proper (internal) transaction documents.
A disappointing surprise?
The PPA might have an effect on the balance sheet in the future as well. For instance, the amortization of a recently established brand name will lower net profit and may thus negatively affect the company's ability to pay dividends. Future EBITDAs may also be impacted by (fair value) revisions to inventory or the recognition of advantageous contracts. This can come as a very nasty after-transaction surprise. A pre-PPA analysis carried out at the transaction phase might have foreseen these effects.
How to concentrate on adding real value
This is why it's crucial to recognize that an M&A deal is actually a cycle, with each stage having an impact on the ones that follow. In a perfect M&A cycle, a pre-PPA study is carried out before the deal is closed, with an emphasis on the early identification of acquired assets and synergies and on what the (consolidated) post-deal financial statements would look like. Additionally, in order to quickly prepare the task and win the external accountant's approval, the financial controllers assigned to carry out the purchase price allocation need sufficient backing and accurate paperwork. This ensures that the business can concentrate on providing the promised returns following the transaction, which is the final stage of the M&A cycle and the subject of our next article.
How Should the Purchase Price Be Distributed in an Asset Sale?
The value received by both purchasers and sellers in an acquisition can be significantly impacted by how the purchase price is allocated among the various asset types mentioned above. Purchase price allocation preferences of sellers and purchasers frequently conflict. That is, allocation of purchase price is typically a zero-sum game; any tax benefit received by a seller will be forfeited by a buyer, and vice versa.
Buyers like to allocate the acquisition price to assets that can be rapidly subtracted from the income of their New Company. For instance, buyers want the value of fixed assets to be as large as possible since they can depreciate them over 5 or 7 years, which is two to three times faster than they can amortize the goodwill alternative. The asset classes that will be subject to capital gains tax treatment are prioritized by sellers when allocating the purchase price. Fortunately, asset classification is simple when using the necessary residual method.
Residual Approach
The residual technique comprises valuing the assets being purchased at fair market value, allocating the purchase price to the appropriate asset class, and allocating any remaining value to goodwill.
According to the residual technique, the purchase price must be distributed as follows:
The amount of Class I assets (cash and equivalents) transferred from seller to buyer shall be deducted from the purchase price.
Allocate the remaining purchase price in the following order: Class II assets (Securities), Class III assets (Accounts Receivable), Class IV assets (Inventory), Class V assets (Fixed Assets), and Class VI assets (Intangibles). Allocate the balance of the purchase price to each class's assets in proportion to their fair market worth on the day of purchase.
Any outstanding purchase price should be applied to Class VII assets (Goodwill).
An asset's fair market value as of the purchase date cannot be more than the amount assigned to it, except Class VII assets. If an asset in one of the aforementioned classes potentially belong to more than one class, it should be assigned to the class with the lower number (for example, if an asset could be included in Class III or IV, choose Class III).
Allocation of Purchase Price Example
Let's use Bob's Tees R Us, our fictitious company, as an example. Hadley is purchasing Bob's Tees R Us in a debt-free, cash-free deal and the company is set up as a S Corporation. Hadley is merely taking on Bob's accounts payable as a liability. Bob is keeping all other obligations, both known and unknowable. According to Bob's Tees R Us' balance sheet:
Bob has agreed to sell Bob's Tees R Us to Hadley for a total price of $5.0 million, which includes $4.0 million in cash and a $1 million seller note. A professional assessor is hired by Hadley and Bob, who values Bob's fixed assets at $750,000. Bob pays the highest possible marginal tax rate. Hadley and Bob concur on the purchase price allocation listed below, which leads in the following tax position for Bob:
$925,000 in taxes from the sale are owed by Bob in total. Due to the sale price exceeding his tax basis in the fixed assets, Bob is subject to the highest marginal tax rate on his fixed assets outside of the favored goodwill. Depreciation recapture, a concept, is responsible for this result.
Recapture of Depreciation
The discrepancy between the sale price and the sellers' tax basis in the fixed assets is known as depreciation recapture. When a company sells a business or sells a depreciated fixed asset in the regular course of business, depreciation recapture may take place.
What is the formula for depreciation recapture?
The difference between the fair value of the sellers' fixed assets and the carrying value of the sellers' fixed assets is used to determine depreciation recapture in a purchase price allocation. The perspectives of sellers regarding the "worth" of their fixed assets can differ widely; some may take into account the book value, while others may take into account the used equipment market value or even the liquidation value. To ascertain the genuine fair value of fixed assets for a purchase price allocation, a professional appraisal should be carried out.
Sellers with substantial amounts of fixed assets that have been heavily depreciated, especially those that are subject to accelerated depreciation, may be surprised by the tax penalty brought on by the recapture of depreciation. Let's go over an illustration using an example.
Owner of Tom's Clubs R Us is Bob's brother Tom. Fixed assets at Tom's Clubs R Us cost $5 million to buy. Tom employed accelerated depreciation, specifically Section 179 deductions, to depreciate his fixed assets in order to reduce his past profits and associated taxes on the recommendation of his accountant. The tax base of Tom's fixed assets is $500,000. Tom is unaware of how purchase price allocation functions because he hasn't read this post.
Tom believes that since that is his carrying value for tax purposes, only $500,000 should be given to fixed assets in a purchase price allocation. As a result, Tom anticipates that the sale of his fixed assets will result in no taxable gain, with the remaining gain being due to goodwill and taxed at capital gains rates.
Tom didn't know that the purchase price allocation method uses the fair value of his fixed assets rather than their tax base. The purchaser of Tom's Clubs R Us commissions a qualified assessor, who generates a $4.5 million fair value estimate for Tom's fixed assets. Depreciation recapture, which is taxed as ordinary income, is applicable to the $4 million difference between $4.5 million and $500,000 in value. Tom is currently subject to a 37% tax rate on his ordinary income and a 20% tax rate on long-term capital gains. The "extra" 17% in Tom's situation amounts to $680,000 in "added tax" on the sale.
Tom argues with the Buyer that Tom should not be forced to pay the additional $680,000 in tax. The Buyer tells Tom that he used accelerated depreciation to lower his income taxes over the past few years, which is why his depreciation recapture tax bill is so high. Consequently, the IRS will only receive a make-whole from Tom's depreciation recapture. Tom did not actually incur an additional $680,000 in expenses because he had previously benefited from the identical tax break.
Understanding Purchase Price Allocation Is Important
For sellers, understanding the fundamentals of purchase price allocation is crucial since it has significant tax ramifications. This article explains the fundamentals of purchase price allocation, but sellers should seek advice from tax accountants, M&A experts, and lawyers before completing the process. Avoid becoming Tom, who received an unexpected $680,000 tax bill from Uncle Sam.
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