Five Primary Actions to Prepare Purchase Price Allocation

Purchase price allocation is an important step in financial reporting after the completion of an M&A or business integration. It is defined as the tasks of assigning the cost of an acquired entity (also known as purchase price) to the assets acquired and liabilities assumed. Purchase price allocation is typically conducted in accordance with accounting standard ASC 805 (applicable in the US) or IFRS 3 Revised (applicable outside the US) and is based on the acquisition method of accounting. 
Primary actions for purchase price allocation:

• Understanding the transaction and investment rationale

The first and foremost step is transaction analysis. Key points in this step include:

1. Identifying the acquirer
2. Determining the closing date
3. Determining whether it is an asset purchase or stock purchase
4. Understanding key investment rationale

• Determining purchase consideration

Purchase consideration can take many forms such as cash, stock, earnouts, notes payable, and assumed liabilities. Earnouts are future payouts contingent upon the achievability of certain performance milestones. It is important to review the purchase agreement thoroughly to understand the key components of the purchase consideration. 

• Ascertaining cost of the target company

The cost or valuation of the target company is important to analyze whether the purchase consideration paid corroborates the fair value of the target company as of the transaction date. Income and market approaches are primarily used to value the target company. The acquired company’s assets and liabilities are to be valued based on the market participant theory. 

• Identifying and determining the valuation of intangible assets

According to ASC 805, an intangible asset will be recognized as an asset (apart from goodwill) if a) it is the output of a contractual or lawful right or b) it is capable of being segregated from the acquired entity and sold, rented, transferred, licensed or bartered. 
The following valuation approaches are adopted to value intangible assets:

Cost Approach -	Market Approach -	Income Approach
Replacement Cost New Method -	Multiples Method -	Relief from Royalty Method
Reproduction Cost New Method -	Profit Margin Method	- Multi-period Excess Earnings Method
		Incremental Cash Flow Method

Tax benefits available due to amortization should be included while determining the fair value of intangibles acquired. 

• Assessing the reasonableness of the transaction

The final step in purchase price allocation, this entails allocating the remaining purchase consideration to goodwill and assessing the overall reasonableness of the transaction. The reasonableness can be analyzed through Weighted Average Return on Assets (WARA). The WARA analysis is done on the fair value of the assets to calculate the implied rate of return on goodwill based on the Internal Rate of Return (IRR). Ideally, IRR should be consistent with the Weighted Average Cost of Capital (WACC). Reconciliation of WACC-WARA-IRR is critical to purchase price allocation. 

Purchase price allocation is a complex process, requiring an in-depth understanding of the acquired business as well as professional expertise in the application of various valuation methodologies.