Challenges for management and focus areas

Purchase price allocation and M&A transactions

Regardless of the objective being pursued in an M&A transaction, it is usually followed by a Purchase Price Allocation (PPA) required by relevant financial reporting standards. The goal is to provide a clear and accurate representation of the acquired company's financial position on the acquirer's balance sheet after the acquisition.

The PPA tends to be a challenging and important task as it raises valuation, accounting and tax issues at once as well as it may have a significant impact on the earnings position and tax burden of a company. In this article we will uncover several challenges which are usually faced by management and financial departments of companies participating in M&A activities.

Purchase price and Business plan                                                     

A starting point for a PPA is a completed transaction and an agreed consideration which needs to be valued. When a purchase price comprises a consideration in kind (stock or equity Swaps, debt settlements or any other non-cash form of compensation) and/or stipulates elements of contingent consideration (earn-outs, milestone payments), it may cause complexity in estimating their fair value. The management needs to select an adequate way to assess a total consideration, non-cash positions and, for instance, assigning probabilities to different outcomes in case of contingencies.

Another complication lays in the necessity to check the reasonableness of the Business Plan compared to the agreed purchase price. Projected proceedings according to the accepted business plan and the total consideration for a business should result in a reasonable internal rate of return which reflects the relevant risks. At the same time the valuation of entity’s assets is based on a weighted average cost of capital (WACC) required by the debt and equity stakeholders. The key challenge here is to strike the right balance between the internal rate of return (IRR), WACC and the weighted rate of return (WARA) earned by assets of the acquired company.

Underlying Business plan must be based on reasonable assumptions partly derived from market expectations or from specific measures the investor intends to take after the transaction. However, it should be noted that fair values to be determined in the course of the PPA can only include general market assumptions and measures that comparable investors in the industry could implement accordingly. If a business plan proves to be inappropriate, it must be adjusted. For this reason, a review of the business plan is necessary to ensure that it is suitable as a basis for the PPA. Potential overestimates of parameters such as growth rates in the business plan represent a risk for future impairments of assets and goodwill.

Besides, business plans may contain expected synergies which are typically considered during the preparations of the deal. Such synergies refer to the additional value that the combined entity (acquirer and target) can achieve through an acquisition. However, since a PPA is conducted from a market participant point of view one should be accurate when performing the valuation of assets and liabilities for PPA purposes. In this context, synergies need to be analyzed to identify those which are achievable only within a deal with a particular acquirer.

Assets identification and valuation

Once the total purchase price is determined, the next step is to break it down into the fair values of the individual assets acquired and liabilities assumed, since a company is not acquired for no reason, but because of valuable assets it holds and economic outlook which a deal opens. The goal is to arrive at a fair and accurate representation of the financial position of the acquired company at the time of acquisition following necessary accounting principles, such HGB (DRS 23), IFRS (IFRS 3, IFRS 13), US GAAP (ASC 805), etc.

In this sense, difficulties may occur while identifying recognizable intangible assets as part of the acquired business. Normally, hidden reserves are identified during the PPA: intangible assets, such as customer relationships, trademarks, and technology, are valued and recognized separately on the balance sheet if they meet specific recognition criteria.

To determine fair values of identified assets and liabilities, one should apply a proper valuation method. This might be tricky as well – since it is necessary not only to select a reasonable approach but also to consider asset-specific risks within the assessment process.

Tax effects

A purchase price allocation normally leads to several significant tax specific effects which need to be considered by the management. Among those effects is amortization of a goodwill which is allowed under German GAAP and German tax regulations.

During the valuation for PPA purposes it is also necessary to consider so called tax amortization benefits: depending on the applicable accounting standards and tax regulations, tax amortization benefits are considered when assessing the fair value of identifiable intangible assets.

Besides, in Germany a PPA for tax purposes must be carried out for asset deals or the acquisition of partnerships. In other cases, deferred tax liabilities or assets may arise due to the differences between the carrying amount and tax base of assets and liabilities.

Subsequent measurement of goodwill

Both under IFRS and German GAAP a goodwill needs to be tested for impairment. The difference however lies in the fact that a potential impairment under HGB may be lower, as the corresponding goodwill is regularly amortized under German regulations.

According to Kroll studies, in 2022 top ten largest goodwill writedowns at S&P 500 companies amounted USD 35.4 bn compared to USD 6.1 bn in 2021. Uncertainty on the world markets causes increasing both cash and non-cash expenses, the latter being often represented by the impairment.

Volatility of interest rates, changes in business projections, increase in prices for energy resources – all these factors contribute to uncertainties and may cause goodwill impairment. In this respect, financial departments should be aware of possibility of goodwill impairment and its effects on financial statements.

Conclusion

A PPA is a challenging and complex task faced by finance departments after each M&A deal. Grant Thornton brings a wealth of expertise to the table, offering comprehensive guidance in M&A transactions and adeptly supporting clients in executing PPAs. We share the PPA challenges and elaborate to facilitate a smooth execution of the business combination process for companies.