M&A Vocabulary – Understanding the experts: “Purchase Price Allocation”

In transactions, sooner or later the accounting treatment of a business acquisition—i.e., Purchase Price Allocation (“PPA”)—becomes relevant. At the latest at the time of initial consolidation of the acquisition target in the group financial statements (share deal), but also in asset deals or mergers (typically affecting both separate and consolidated financial statements), the requirements of IFRS 3 on Business Combinations may apply.
Since key performance indicators (KPIs) such as EBIT, group net income, or the amount of Goodwill are influenced by a PPA, it is advisable to address this topic early on, already during the transaction phase, as a so-called pre-deal PPA.

PPA for deriving Goodwill

As part of a PPA, at the acquisition date the cost of the business acquisition (purchase price) must be allocated to the identifiable assets, liabilities, and contingent liabilities of the acquired company, remeasured at Fair Value. The resulting positive residual amount remaining after a PPA—between the acquisition cost and the proportionate Fair Value of net assets (remeasured equity) determined taking deferred taxes into account—constitutes Goodwill, which is recognized under intangible assets. The example below illustrates how Goodwill is derived as part of a PPA.

Practical challenges of PPA

The practical challenges of a PPA usually lie in identifying and initially valuing internally generated intangible assets such as brands and customer relationships, for which IFRS consolidated financial statements include an explicit recognition prohibition and which therefore have often not been recorded in any form to date.

To identify intangible values that have not previously been recognized on the balance sheet, a fundamental understanding of the business model, corporate planning, the existing value drivers, and the legal environment of the acquired company is required.

When determining Fair Values, it must be ensured that only those cash flows attributable solely to the intangible assets (stand-alone) are taken into account. Accordingly, the cash flows in the planning model must be adjusted for genuine synergy effects. The economic useful life must be determined based on objective criteria and therefore from the perspective of hypothetical market participants.
The following valuation methods are used in practice:

• Relief-from-royalty method: Valuation of brands, patents, or technologies using a royalty rate analogy.
• Multi-period excess earnings method: Valuation of customer relationships using the residual value method.

Intangible assets generally carry higher risk than the company’s average risk. Therefore, the WACC to be determined based on a hypothetical market participant must be adjusted to the respective risk profile of the intangible asset by applying appropriate premiums to the discount rate.

For plausibility checks, the WACC-to-WARA method is suitable, which compares the weighted return on all assets to the WACC and should align with it.

Conclusion

With ongoing digitalization, intangible values are of considerable importance and are often the dominant value creation factors in companies. A transaction often has a significant impact on the balance sheet and key KPIs, as the so-called step-up of valuable intangible assets can lead to substantial additional amortization in the future. It is therefore advisable to keep these effects in view early in the transaction process.

From the newsletter
“Corporate Law, Deals & Capital Markets” To our
M&A Vocabularies