How to Perform Purchase Price Allocation Under Ind AS 103

When one company acquires another, the purchase price rarely matches the book value of everything it acquires. That difference doesn't simply disappear. It needs to be explained and allocated across the individual assets and liabilities acquired. This process is known as Purchase Price Allocation (PPA) and, in India, is governed by Ind AS 103.

When Company A acquires Company B, it doesn't simply record the entire purchase consideration as one amount. Ind AS 103 requires the buyer to identify and allocate the purchase price among the assets acquired and liabilities assumed, including tangible assets, intangible assets, and other identifiable items.

Whatever remains after this allocation is generally recognized as goodwill. In simple terms, goodwill represents the excess of the purchase consideration over the fair value of the identifiable net assets acquired.

The Three Steps in a PPA

Step 1: Identify What Was Actually Acquired

The first step goes well beyond identifying obvious assets such as cash, inventory, property, and equipment. A PPA requires the buyer to identify all assets acquired and liabilities assumed, including intangible assets that may not have appeared on the seller's balance sheet. These can include customer relationships, brands, proprietary technology, patents, and other identifiable intangible assets.

This is often one of the more challenging parts of the process. A seller's balance sheet may not fully reflect the value of its internally developed intangible assets because accounting standards generally do not allow many internally generated intangibles to be recognized as assets.

Step 2: Assign a Fair Value to Each Item

Once the assets and liabilities have been identified, they need to be measured at fair value as of the acquisition date, rather than simply carried over at their existing book values.

This is where valuation expertise becomes particularly important. While some assets may have observable market prices, many intangible assets do not. Their value therefore has to be estimated using appropriate valuation methodologies and assumptions.

Step 3: Calculate Goodwill

After all identifiable assets and liabilities have been measured at fair value, the calculation of goodwill is relatively straightforward:

Purchase consideration – Fair value of net identifiable assets acquired = Goodwill

If the calculation results in a negative amount, the transaction may represent a bargain purchase, subject to the requirements of Ind AS 103.

Why Are Intangible Assets Often the Hardest Part?

Valuing tangible assets such as buildings and machinery can be relatively straightforward when comparable market information is available. Intangible assets are much more challenging because there is often no active market from which to obtain a directly observable price.

Different valuation approaches may therefore be used depending on the nature of the asset:

• Relief-from-royalty method — commonly used for brands, trademarks, and similar assets. It estimates the value based on the royalties the company would otherwise have to pay to license the asset.
• Multi-period excess earnings method (MPEEM) — commonly used for customer relationships and other income-generating intangible assets. It estimates the future earnings attributable specifically to the asset after considering appropriate charges for supporting assets.
• Cost-based approaches — may be appropriate for certain technology and other assets where value is closely related to the cost of recreating or replacing the asset.

The choice of methodology and the assumptions used can have a significant impact on the overall PPA. An incorrect valuation of an intangible asset can also affect the amortization expense recognized in subsequent years and, where applicable, future impairment assessments.

Why Does PPA Matter Beyond the Accounting Team?

A PPA can affect a company's financial statements for years after an acquisition. If intangible assets are undervalued, more of the purchase price may end up being allocated to goodwill. Goodwill is not amortized under Ind AS but is subject to impairment testing. If the goodwill balance is subsequently impaired, the resulting charge can have a significant impact on reported earnings.

On the other hand, if identifiable intangible assets are valued too highly, the company may recognize higher amortization expenses in future periods, which can directly reduce reported profits.This is why investors, auditors, and regulators pay close attention to PPA. The allocation made at the acquisition date can influence reported assets, goodwill, amortization, impairment, and ultimately the financial results for several years.

A poorly supported PPA can also lead to audit queries, delays in financial reporting, or additional scrutiny in a subsequent transaction.

A Common Mistake Worth Avoiding

One common mistake is treating PPA as a formality and simply using the same assumptions that supported the negotiated transaction price.

That isn't the purpose of a PPA.The deal price reflects the commercial negotiations between the buyer and seller. The PPA, on the other hand, is a fair-value exercise that requires the assets acquired and liabilities assumed to be identified and measured appropriately as of the acquisition date.

Ultimately, Purchase Price Allocation determines how an acquisition is reflected in the buyer's financial statements long after the deal has closed. Getting the fair values right, particularly for intangible assets, is critical to ensuring that the financial statements accurately represent the economics of the transaction.