Accounting Standards

Purchase Accounting, Goodwill and Price Allocation

Under ASC 805 and IFRS 3, an acquirer records the target's identifiable assets and liabilities at fair value on the acquisition date. The excess of purchase consideration over net identifiable fair value is goodwill. The purchase price allocation creates new intangible assets, inventory step-ups and deferred taxes that change post-deal earnings, EBITDA comparability and covenant calculations.

What is purchase accounting?

When one company obtains control of another business, ASC 805 under US GAAP and IFRS 3 under international standards require the acquisition method. The acquirer measures the consideration transferred, recognizes the target's identifiable assets acquired and liabilities assumed at fair value as of the acquisition date, and records any remaining difference as goodwill. The target's historical book values are replaced by new fair value amounts in the acquirer's consolidated statements, so the post-deal balance sheet can look very different from the target's own.

Consideration includes cash, equity issued at fair value, and contingent consideration such as earnouts measured at fair value at closing. Transaction costs such as advisory and legal fees are expensed rather than capitalized. If the acquirer previously held an interest in the target, that interest is remeasured to fair value. Noncontrolling interests are also measured, either at fair value or at their share of net assets depending on the framework and election, which affects the goodwill figure and future comparisons.

How does a purchase price allocation work?

The purchase price allocation (PPA) assigns the consideration to each identifiable asset and liability. Tangible assets such as inventory and property are revalued to fair value. Intangible assets must be recognized separately from goodwill if they arise from contractual or legal rights or are separable. Common examples include customer relationships, trade names, developed technology, backlog, non-compete agreements and favorable contracts. Each is valued using techniques such as the multi-period excess earnings method, relief from royalty or cost approaches. The valuation of each asset depends on assumptions about cash flows, attrition and discount rates.

Liabilities are also measured at fair value, including contingent liabilities in some circumstances, and deferred revenue is remeasured. Deferred taxes are then recorded for differences between the new book values and the tax bases. In a stock acquisition without a tax basis step-up, writing assets up for book purposes creates a deferred tax liability, which increases goodwill. Asset acquisitions or certain tax elections can step up tax basis as well, reducing or eliminating that liability and changing the economics. The structure of the deal therefore shapes the allocation as much as the assets do.

How does purchase accounting affect post-deal earnings?

Several items depress reported earnings after a deal without affecting cash. Inventory written up to fair value flows through cost of goods sold as the inventory is sold, compressing gross margin for the first turn. Newly recognized intangible assets with finite lives are amortized, adding expense below EBITDA. Written-up fixed assets produce higher depreciation. These effects mean post-deal net income and EBIT are not comparable with pre-deal figures, which matters when assessing trends or calculating returns. Pro forma presentations that combine pre-deal and post-deal periods need careful adjustment for the same reason.

Goodwill and indefinite-lived intangibles are not amortized under US GAAP for public companies or under IFRS; they are tested for impairment at least annually. Private companies under US GAAP may elect to amortize goodwill over a period of up to ten years. Impairment charges can be large and sudden, typically following a decline in performance relative to the acquisition case. Underwriters should treat goodwill impairments as an indicator of overpayment or underperformance rather than as an event that changes cash flow directly.

• Inventory step-up: higher COGS in the first turn after closing
• Intangible amortization: expense below EBITDA over useful lives
• Deferred revenue remeasurement: can reduce post-deal revenue under some frameworks
• Contingent consideration: fair value changes run through earnings

What should underwriters look for in a PPA?

For lending, the PPA matters less for its accounting results than for what it reveals. The allocation between goodwill and identifiable intangibles shows how much of the price relies on future earnings power versus identifiable assets. Customer relationship valuations reveal assumptions about attrition. Large contingent consideration liabilities represent future cash obligations that may be debt-like. The valuation report supporting the PPA can provide useful independent analysis of cash flows, royalty rates and discount rates applied to the acquired business. Reviewing that report alongside the lender's own diligence can expose differences in assumptions that deserve explanation.

Underwriters should adjust EBITDA for purchase accounting effects that distort comparability, such as inventory step-up charges flowing through cost of goods sold, and ensure covenant definitions handle them. They should also recognize that tangible net worth covenants are heavily affected by acquisitions, because goodwill and intangibles are usually excluded, so an acquisitive borrower can show growing book equity alongside negative tangible net worth. Collateral analysis should place limited reliance on goodwill and intangibles, which typically have low recovery values in a liquidation.

What is a bargain purchase and when does it occur?

Occasionally the fair value of identifiable net assets exceeds the consideration paid. Before recognizing a gain, the acquirer must reassess whether all assets and liabilities were correctly identified and measured. If the excess remains, it is recognized as a bargain purchase gain in earnings. Bargain purchases tend to arise in distressed sales, forced dispositions or situations where the seller faces constraints that prevent an orderly process at full value. Measurement period adjustments can also change the allocation for up to one year after the acquisition date as more information about acquisition-date facts becomes available, so early figures should be treated as provisional and the final allocation reviewed when it is completed.

Underwriters should treat a bargain purchase gain as a non-cash, nonrecurring item and exclude it from EBITDA and from any earnings-based metric. They should also consider why the seller accepted a price below asset value: undisclosed liabilities, environmental issues, customer losses or operational problems may explain the discount. A reported gain is therefore a signal to examine the acquired business more closely, not evidence of value creation in itself, and diligence should focus on the specific reasons for the discount.

Purchase price allocation in a stock acquisition

1. Consideration = $500.0 million. Book value of target net assets = $200.0 million, with no existing goodwill.
2. Fair value step-ups: PP&E +$30.0 million, inventory +$10.0 million, customer relationships $120.0 million, trade name $40.0 million, developed technology $50.0 million. Total step-ups = $250.0 million.
3. No tax basis step-up, so a deferred tax liability is recorded at 25%: 250.0 x 0.25 = $62.5 million.
4. Fair value of identifiable net assets = 200.0 + 250.0 - 62.5 = $387.5 million.
5. Goodwill = 500.0 - 387.5 = $112.5 million.
6. Post-deal effects: the $10.0 million inventory step-up runs through COGS in the first turn; customer relationships amortized over 10 years add 120.0 / 10 = $12.0 million of annual amortization below EBITDA.

How underwriters apply this

• Exclude inventory step-up charges, bargain purchase gains and contingent consideration remeasurements from normalized EBITDA.
• Treat earnouts and other contingent consideration as debt-like when sizing leverage.
• Use the PPA valuation to test the attrition, royalty and discount assumptions behind the purchase price.
• Measure tangible net worth separately, since goodwill and intangibles dominate post-acquisition balance sheets.
• Give minimal collateral credit to goodwill and acquired intangibles.

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