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Purchase Price Allocations: Not just an accounting hassle
By Niteen Heerasing, Associate Director, Advisory Deals - Transactions
Signing on the dotted line on a Share Purchase Agreement is often seen as the finishing line for those involved in an M&A transaction but in reality is the first of many crucial steps to integrate the acquisition in the books of the buyer.
IFRS requires that the purchase price paid (in a business combination) needs to be allocated to the assets acquired and liabilities assumed, a process that is also referred to as a ‘purchase price allocation’ or PPA.
What is it?
The basic principle behind a PPA is that the value of the consideration in a transaction must be allocated to the acquired assets and liabilities, with the residual value being allocated to goodwill.
Why is it important?
Reflecting the true financial position of the company
Besides being an accounting requirement, a comprehensive PPA ensures that the financial statements of the purchaser accurately reflect the assets and liabilities acquired including the intangible assets purchased. This is especially important in asset-light industries such as financial services where the income producing assets are made up of brand value and customer relationships. This is important for stakeholders such as investors, creditors, and regulatory bodies who rely on financial statements to make informed decisions.
Tax
The Income Tax Act 1995 (“ITA”) grants annual allowance for items of a capital nature which are subject to depreciation under the normal accounting principles. Usual intangible assets such as brands, patents and customer relationships would fall under that category. However, goodwill (under IFRS) is not subject to depreciation but only impairment - no annual allowance or allowable expense with respect to goodwill would be permitted under the ITA.
This is a seldom considered structuring aspect of a transaction. There are a number of transactions where no PPA is carried out and the excess of the purchase price over the acquired net assets is simply booked as goodwill. The acquirer simply loses out on potential annual allowance that could have legitimately been claimed against the intangible assets purchase.
Structuring these types of transactions requires careful consideration as the above would only apply on purchase of business assets and integrating them within the acquirer’s legal entity as the tax laws only apply at company level. Goodwill or intangible assets arising upon consolidation would not qualify for relief at the company level.
There are however other numerous tax, legal and regulatory issues that need to be considered by the M&A team when choosing to do an asset purchase and integration rather than purchasing the legal entity.
Financial analysis
Lumping all intangible assets in goodwill can potentially overstate reported profits and increases the volatility of reported profit especially if a significant portion of the identified intangible assets (not recognised in the books of the target company) have a limited economic life and are therefore subject to amortisation.
For example: Assuming Company A purchased Company B for MUR100m. Company B has MUR50m of net assets recorded on its balance sheet as at the acquisition date. There are MUR40m of customer intangible assets that would be identified if a PPA was carried out. The Goodwill booked in the accounts would be MUR50m if no PPA was carried out and MUR10m in the opposite situation.
Assuming the combined EBITDA is MUR100m, under a scenario where no PPA is carried out, there would be no amortisation of the customer intangibles (10 year straight-line). However, the goodwill will be reassessed for impairment annually and may flag up for impairment. Under the assumption, that impairment occurs in Year 5 and 10. Year 5 and Year 10 PAT would be significantly lower in that year. Although the total PAT over the 10 years in both cases would be the same (assuming no claim for tax allowance is made for the customer intangibles), the potential impairment may flag up concerns to investors and other stakeholders that Company A overpaid for Company B and/or PAT is now more volatile (dividends at risk)
Strategic planning
The results of the PPA i.e. being able to accurately reflect the assets and liabilities onboarded during a business combination provide an important source of information to Management when deciding on the overall strategy of the company.This includes deciding on which assets to retain, liabilities to pay off and how to structure the tax affairs of the company in a more efficient manner.
When do I do it?
Recently, pre-Deal PPA have become more commonplace, especially in larger transactions. The main reason for carrying out pre-deal PPA is to obtain more clarity on the value of intangible assets of the targets which are not necessarily booked on the balance sheet of the Target. This enables the acquiring company to perform a number of analyses which would not necessarily be possible without a PPA.
Focused due diligence and integration
A PPA can highlight the value of the main intangible assets which are sometimes not captured by financial due diligence. For example in banking acquisitions the main intangible assets identified are the value of core deposit and current accounts. These provide cheap sources of financing which enables banks to loan out funds at a margin. However, the value of these core deposits is seldom quantified during a due diligence.
Similarly, attribution rates of these depositors and how these depositors will be integrated and deployed into the purchaser portfolio are seldom considered at the due diligence stage whereas these would form part of the analysis of a PPA exercise.
Impact on the buyer’s financial statement
A PreDeal PPA can help the acquirer forecast the impact of the acquisition on the combined financial statements. This is especially important if the acquirer is restricted by covenants or other shareholder agreements which limit its leverage. This scenario analysis can also help to determine the profitability of the buyer and the target on a combined basis post the transaction. An analysis of the tax benefits of the amortisation of the intangible assets can also be incorporated at this stage. This would permit a more accurate calculation of the returns of the acquisition.
A PPA (ideally carried out Pre-Deal) is a crucial process for accurate financial reporting, compliance with accounting standards, tax benefits, strategic planning, and risk management. While the process can be complex, the benefits outweigh the costs in the long run.
A PPA is an important tool that can help buyers unlock the value of their acquisitions whilst identifying value leakages during the integration process.
Niteen Heerasing
Associate Director - Transactions | PwC Mauritius | T: +230 404 5063 | E: niteen.heerasing@pwc.com
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