The practice of allocating the purchase price paid in a business combination to specific assets and liabilities of the firm being purchased is known as purchase price allocation, sometimes known as allocation of consideration. This is a crucial stage in the accounting for a business combination since it makes sure that the acquired company’s assets and liabilities are reflected on the acquirer’s balance sheet at their fair market value.
The following phases are often included in the purchase price allocation process:
- List the assets purchased and obligations taken on: Finding all of the assets bought and liabilities taken on during the company combination is the first stage in purchase price allocation. This encompasses both actual and intangible assets, such as real estate, machinery, and equipment (e.g. patents, trademarks, and customer relationships).).
- Calculate the fair market value of the assets bought and the obligations taken on: The fair value of each asset purchased and liability taken on must then be determined. A third-party appraiser often performs this uses reputable valuation techniques like the income approach, market approach, or cost approach.
- Distribute the purchase amount across the assets bought and the obligations taken on: Allocating the purchase price from the business combination to the various assets and liabilities of the acquired firm is the last phase. This is accomplished by allocating a percentage of the purchase price based on the fair value of each asset and obligation.
Here is an illustration of how these procedures may be used in a company merger:
- 100% of Company B’s outstanding shares is purchased by Company A for $500,000 in cash, accounts receivable for $100,000, inventory for $150,000, and property, plant, and equipment for $200,000.
- The liabilities assumed consist of $100,000 in accounts payable and $100,000 in long-term debt.
The purchase price allocation in this case would be as follows:
- Cash: $50,000 divided by $500,000 equals 10% of the price.
- Receivables: $100,000 divided by $500,000 equals 20% of the purchase price.
Inventory: $150,000 divided by $500,000 is 30% of the purchasing price.
- Real estate: $200,000 divided by $500,000 equals 40% of the buying price.
- Accounts payable equals 20% of the purchase price ($100,000 / $500,000).
- Long-term debt: $100,000 divided by $500,000 equals 20% of the cost of the property.
This allocation shows that assets and liabilities of Company B were assigned a total purchase price of $500,000, which is equal to the amount paid by Company A in the business combination.
Purchase price allocation includes recognizing and measuring any goodwill resulting from the business combination in addition to assigning the purchase price to the specific assets and liabilities of the acquired firm. Goodwill is an intangible asset that develops when the acquirer pays more than the fair value of the assets they are buying and the liabilities they are taking on. In the previous case, for instance, the goodwill resulting from the acquisition would be $50,000 ($500,000 – $450,000) if the fair value of the assets bought and liabilities assumed was $450,000.
It’s crucial for businesses to adhere to the pertinent accounting rules and guidelines when creating their financial statements since the accounting for purchase price allocation and goodwill might be complicated. Financial statements can be incorrectly reported if a business combination is not properly accounted for, and there may also be legal and regulatory repercussions.