Challenges During Due Diligence: Purchase Price Allocation Issues
Why Should We Care?
Earnings per share impact of the transaction - will the deal be accretive or
Acquisition related costs are expensed versus capitalized
Number of assets (and liabilities) recognized
Finite lived assets vs. indefinite lived assets - amortization expense vs.
annual impairment testing
Useful life considerations
Leases - favorable / unfavorable
Structuring purchase consideration
Contingent consideration - balance sheet and income statement effects
Off-balance sheet entities - consolidation surprises
Financing deals - financial instruments with mandatory redemption provisions -
liability vs. equity treatment
Other pre-deal issues
Collaboration of management, auditors, and valuation specialists is essential
How liabilities are recognized will affect liquidity measures in debt
Board / investor expectations must be
Acquisition Related (Transaction) Costs
Transaction costs that the acquirer incurs to affect a business combination
are not part of the consideration paid. These costs are to be accounted for
separately from the business combination.
Costs include direct payments to investment bankers, advisors, attorneys,
appraisers and accountants.
Most of these costs will only affect the first year w/noticeable impact on
earnings and on the financial projections used to model the deal.
Most restructuring costs intended to achieve synergies (plant closings,
severance payments and golden parachutes, etc.) will be expensed after closing.
Costs are expensed when incurred, except debt and equity issuance costs.
The acquirer’s reimbursement of amounts paid by the acquiree, or its former
owners, for acquisition related costs of the acquirer should also be accounted
for separately from the business combination.
Investor expectations must be managed
The value of the consideration transferred (purchase price) includes the
acquisition date fair value of any contingent consideration.
Contingent arrangements of the acquiree assumed by the acquirer will
measured at fair value. These unresolved contingencies from prior acquiree
transactions can also have a material impact on earnings volatility of the
Contingent consideration will take the form of either:
A contingency classified as an
asset or a
liability will be adjusted to fair
value at each reporting date through earnings.
A contingency classified as equity will not be remeasured. The settlement of
the contingency will be accounted for within equity.
Counterintuitive Accounting Treatment & Potential Risks
If the initial fair value measurement of the earn-out is less than the actual
payment, a loss is recorded in the income statement upon the occurrence of the
payment even if the business performed better than originally expected.
If the initial fair value measurement is greater than the actual payment, a
gain is recorded in the income statement even though the business is performing
worse than originally expected.
Leases - Operating, Capital or Failed / Sale
Recognition of operating leases (normally applies to real property)
The acquirer recognizes an intangible
asset if the terms of an acquiree’s
lease are favorable (below market) as of the acquisition date
The acquirer recognizes a liability if the terms are unfavorable (above
market) as of the acquisition date
Recognition of capital leases
(normally applies to personal property)
Failed / sale leaseback
Unexpected increases in
amortization, depreciation and liabilities are common
Fair value determination can be a
lengthy process causing issues w/debt covenants
In-Process Research & Development (IPR&D)
Tangible and intangible assets used in
R&D are recognized at their acquisition date fair values and are not
immediately charged to expense, regardless of whether they have any
alternative future use in another R&D project. This is a change in
previous accounting treatment.
Considered an indefinite-lived asset (no
amortization) until project is completed or abandoned.
Amortized once completed
Write-off if abandoned
Acquirer would determine the
useful life of the intangible asset on the completion of the R&D
Costs incurred and assets acquired after
the acquisition date are expensed as incurred, if used in R&D
activities w/no alternative future use
Careful determination must be made as to
the existence of IPR&D
Involves transactions where a product or
service has been sold, but not yet delivered
Deferred revenue is typically associated
with the sale of:
Service & maintenance agreements
Work under contract w/associated
Does a legal performance
A defensive asset is an asset that a
buyer does not intend to actively use, but intends to prevent others
from using by withholding the asset from the marketplace. This is
done to prevent competition, or to enhance the value of an existing
A common example of a defensive asset is
an acquired brand that an entity may plan to use for a transition
period, before re-branding the product to its own.
Acquirer’s intentions do not
influence the fair value estimate. Assets are measured using market
Initial measurement of
Acquirer’s determination of how
a market participant would use an asset will have a direct
impact on the initial value ascribed to each defensive asset.
Therefore, identifying market participants, developing market
participant assumptions and determining the appropriate
valuation basis are critical components in developing the
initial FV value measurement for defensive assets.
Not all unused assets are