What is purchase price allocation (PPA)?

Purchase price allocation (definition)

Purchase price allocation (PPA) allocates the cost of a purchased business between assets and liabilities on the new owner’s balance sheet.

The buyer’s accountant completes the purchase price allocation during a merger or acquisition – usually with the assistance of a valuer. The allocation ensures that the purchased company’s assets and liabilities are properly recorded on the new owner’s balance sheet.

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Why purchase price allocation (PPA) is important

There are several reasons why PPA is important to small businesses that acquire other businesses.

  • Financial clarity: An accurate allocation helps the buyer understand the financial implications of the purchase and what they paid for everything.
  • Strategic planning: The asset values influence future business decisions, such as upgrades, expansions, or increasing operational efficiency.
  • Taxation and depreciation: Businesses must allocate the purchase price to ensure taxes and depreciation can be accurately calculated.
  • Part of IFRS: IFRS rules require PPA. PPA also provides transparency for investors and stakeholders during mergers and acquisitions.

Tax authorities and regional Generally Accepted Accounting Principles (GAAP) may also require PPA accounting. Check with tax authorities in your region to determine specific rules.

How purchase price allocation (PPA) is done

Allocating the purchase price of an acquired business is a multi-step process and must comply with accounting standards.

  1. Calculate the net identifiable assets. This involves identifying and valuing the acquired assets and liabilities. These include both tangible assets, like machinery or inventory, and intangible assets like patents. This step determines the fair market value of all the components, including considering their condition, market demand, and earning potential. A fair valuation generally requires input from a valuation expert. Accounting standards determine which valuation methods can be used for each type of asset.
  2. Write-ups or write-downs. These can occur when the fair value of an asset or liability changes during the acquisition. A write-up means the asset increases in value; a write-down means it decreases in value. For example, the valuer may find the value of an asset is higher. These changes are reflected on the balance sheet only – no cash changes hands.
  3. Calculate potential goodwill. The goodwill of a business is the difference between the purchase price and the net value of the assets minus the liabilities. It is recorded on the balance sheet as an intangible asset.

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Purchase price allocation (PPA) example

Let’s say you buy a small landscaping business for $500,000. PPA accounting allocates the value between the landscaping equipment, outstanding liabilities, and goodwill.

  • Tangible assets – the workshop is valued at $329,000; the truck at $25,000, the trailer at $8000; one mower at $3000, two others at $2000; and miscellaneous tools at $1000. Total tangible assets come to $370,000.
  • Liabilities – the business has assumed liabilities of $20,000 in warranty obligations to existing customers.
  • Intangible assets – goodwill is calculated at $150,000

$500,000 - ($370,000-$20,000) = $150,000

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This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.