Value paid by the acquirer in a company combination is known as the purchase consideration. It may take the shape of money, stocks, or other assets. Allocating the purchase consideration is a crucial stage in the accounting for a corporate merger since it makes sure that the acquired company’s assets and liabilities are recognized on the acquirer’s balance sheet at their fair market value.
A firm must allocate the purchase money to the specific assets and liabilities of the acquired company when it acquires another business. This process, known as purchase price allocation, makes sure that the acquired company’s assets and liabilities are shown on the acquirer’s balance sheet at their fair market value.
The following phases are often included in the purchase price allocation process:
- Identify the assets purchased and liabilities assumed: The identification of all the assets acquired and liabilities assumed in the business 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 use is reputable valuation techniques like the income approach, market approach, or cost approach.
- Allocate the purchase price to the assets acquired and liabilities assumed: 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 stock is purchased by Company A for $500,000; the assets acquired are $50,000 in cash; $100,000 in accounts receivable; $150,000 in inventory; and $200,000 in property, plant, and equipment; the liabilities assumed are $100,000 in long-term debt and $100,000 in accounts payable.
The purchase price allocation in this case would be as follows:
- Cash: $50,000 / $500,000 = 10% of the purchase price
- Accounts receivable: $100,000 / $500,000 = 20% of the purchase price
- Inventory: $150,000 / $500,000 = 30% of the purchase price
- Property, plant, and equipment: $200,000 / $500,000 = 40% of the purchase price
- Accounts payable: $100,000 / $500,000 = 20% of the purchase price
- Long-term debt: $100,000 / $500,000 = 20% of the purchase price
This allocation demonstrates that a total purchase price of $500,000—equal to the sum paid by Company A in the business combination—was assigned to the assets and liabilities of Company B.
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 purchase would be $50,000 if the fair value of the assets bought and liabilities assumed was $450,000.