Purchase Price Allocation: Overview, Example & Formula

In 2018, Apple bought Shazam for $400 million. Once the transaction closed, Apple was required by regulators, including the IRS and FASB, to report the allocation of that $400 million purchase on its financial statements. Purchase price allocation is an essential corporate finance concept to understand; whether you are involved in mergers and acquisitions at a company or just want to be well-informed about companies, you might choose to invest in. Keep reading to learn the basics, including the formulas used, of purchase price allocation.

To understand purchase price allocation, you first must understand its origins. A few accounting and reporting regulating agencies require some version of purchase price allocation.

The Financial Accounting Standards Board (FASB) is an independent organization that establishes financial accounting and reporting standards for public and private companies.

FASB’s mission is to “establish and improve financial accounting and reporting standards to provide useful information to investors and other users of financial reports and educate stakeholders on how to understand and implement those standards most effectively.” It does so via the Generally Accepted Accounting Principles (GAAP).

The United States Securities and Exchange Commission designates the FASB as the accounting standard setter for public companies. This means that all publicly-traded companies must follow the standards set by the FASB in every area of their accounting. We refer to these standards as the U.S. GAAP.

GAAP’s international counterpart is the International Financial Reporting Standards (IFRS), set by the International Accounting Standards Board (IASB). Public companies worldwide follow this set of financial accounting and reporting standards. While similar, the IFRS and GAAP aren’t identical.

For the purposes of this article, all you should know is that both IFRS and GAAP require purchase price allocation for mergers and acquisitions.

Companies must pay taxes on their financial gains, just like individuals. The United States Internal Revenue Service (IRS) requires its own version of purchase price allocation to make sure that corporations accurately report their transactions and pay fair taxes.

The Internal Revenue Code (IRC) requires buyers and sellers to report asset acquisitions in respective classes using the residual method. In the residual method, components of the transaction are split into different classes. IRC Section 1060 and Section 338(b)(5) outline specific reporting requirements.

Mergers and acquisitions (M&A) are business combination deals in which one business buys another business. When an M&A transaction closes, the acquirer is required to calculate and report the purchase price allocation (PPA) on its financial statements.

Purchase price allocation is the process of valuing the assets and liabilities acquired in a business combination deal. The allocated purchase price is the fair value of the tangible and intangible assets and liabilities. PPA is a tedious accounting practice that takes into account three main components of a transaction: net identifiable assets, goodwill, and write-up.

Net identifiable assets are the value of the assets of the acquired company minus the value of its liabilities. Think of it like the net worth of a business. It includes all of the quantifiable assets, tangible and intangible. Another term for this is net book value.

A write-up accounts for the difference in fair market value and the net identifiable assets. Another term for this is fair value adjustments.

An independent business valuation specialist assesses the transaction and determines the necessary book value adjustment. He or she assesses the acquired assets and liabilities and assigns their fair market value. The difference between the fair value and the net identifiable assets is the write-up amount.

Most M&As don’t solely consist of the exchange of assets and liabilities. Ultimately, they are business deals between human beings. To close a deal and make it appealing to both parties, the purchase price usually includes some amount above the fair market value.

This difference between the total purchase price and the fair value is the goodwill value. The U.S. GAAP and IFRS require purchasers to report and reevaluate goodwill at least once per year. In other words, they have to find a way to calculate the monetary value of goodwill.

The formula for purchase price allocation is simple in theory. But when it comes to real-world transactions, it can be quite complex. Professional accountants and financial specialists are responsible for making sure purchase price allocations meet accounting and reporting standards.

Here are the formulas that summarize purchase price allocation:

Here is an example that might help you better understand how purchase price allocation works.

Company X purchased Company Y for $15 million. As the acquirer, Company X completes a purchase price allocation that meets current GAAP standards. First, Company X determines the net identifiable assets of Company Y. Company Y’s assets have a book value of $8 million. Company Y’s liabilities have a book value of $3 million. Therefore, the net assets equate to $5 million.

Next, Company X hires a third-party business valuation specialist to assess the fair market value of Company Y. The specialist determines that the fair value of Company Y is $12 million. Therefore, the write-up amount is $7 million.

The purchase price of Company Y is greater than its fair market value. Therefore, Company X must record the goodwill. Company X recognizes $3 million as goodwill.

Finally, the entire purchase price has been allocated. Company X records this in their balance sheet and reports it to the FASB and IRS.

Are you interested in what it takes to purchase an existing business? Keep learning about funding options to finance a business purchase and explore your options for business loans.

Purchase price allocation is important because it accurately records the value components of a transaction. Not only do regulatory agencies such as the FASB and IRS require PPA, but it’s crucial for transparent financial reporting to a company’s shareholders.

Purchase price allocation is required for tax and financial reporting purposes. The IRS requires purchase price allocations in order to accurately tax companies. The FASB and IASB require PPAs to ensure accurate, honest, and consistent financial reporting of publicly traded companies.

New Zealand requires companies to report purchase price allocation uniformly following Inland Revenue’s national accounting standards. This allows the government to appropriately collect taxes from companies.

Purchase price allocation matters to the seller because it can affect their taxes too. Some asset acquisition transactions require both the buyer and seller to report a purchase price allocation. In these cases, it’s beneficial for both parties to agree on one allocation.