Company buyers must apply minds
In-depth analysis required of the fair value of target companies
PRIOR to any acquisition, companies are required to apply a more in-depth analysis of the fair value of the assets and liabilities of a target company. Other items such as contingent assets, liabilities and other intangible assets may also be involved.
Gone are the days when goodwill was calculated by subtracting the attributable net asset value of an acquired entity’s statement of financial position from the purchase price. From now on, whenever an entity obtains control over another business, a purchase price allocation (PPA) must be performed.
A PPA is the process of allocating the cost of an acquired business to the fair value of the assets and liabilities assumed. It also establishes useful lives for identified assets and liabilities.
This, however, applies only to companies that comply with a financial reporting framework, such as international financial reporting standards, South African generally accepted accounting principles or accounting standards for small to medium-sized enterprises, and excludes business combinations under common control.
An example of this is when a business is sold to a fellow subsidiary in a group of companies. In these circumstances, any intangible assets are seen as internally generated and can’t be recognised in terms of international financial reporting standards.
International Financial Reporting Standard (IFRS) 3 outlines various classes of intangible assets as:
Customer-related assets like customer relationships, order books and
A purchase price allocation gives investors a clearer picture of what actual assets were purchased and where the value lies
Market-related trademarks, brands and trade names;
Contract-based assets like royalty agreements, construction contracts, lease and franchise agreements;
Technology-based assets such as patented technology, internally generated software and databases; and
Artistic-related assets such as photographs, plays, operas and musical works.
A PPA gives investors a clearer picture of what actual assets were purchased and where the value lies. If significant value is attributed to customer relationships during the PPA, for example, this could give investors comfort regarding the sustainability of the business and may even substantiate a higher purchase price that was paid.
IFRS 3 provides clear guidance on how to identify intangible assets and suggests appropriate valuation methods. For example, a large goodwill figure may indicate that management has not followed due process in identifying potential intangible assets as well as ascertaining the fair values of all assets and liabilities. Conversely, a PPA indicates that management has closely managed the acquisition and are clear on what has been acquired.
As has been the case for many years, goodwill is not amortised but rather assessed for impairment at least on an annual basis. In contrast, intangible assets identified during the PPA will be amortised over their relevant useful lives. This means the intangible assets’ amortised charges will have an impact on the acquirer’s future earnings by reducing the book value of acquired intangible assets on the statement of financial position. On a positive note, this reduces the risk of future goodwill impairments. Such impairments may have a significant impact on profit dur- ing a single accounting period.
A common misconception is that the reduction in profit, through amortisation of intangibles, will have a negative impact on a company’s perceived value. All analysts, however, exclude these costs when assessing value.
A PPA is unlikely to result in a zero goodwill figure because certain intangible assets may not meet the recognition criteria in terms of IFRS and will remain in goodwill, which could include the value of the assembled workforce, among others.
Also, buyer and seller perceptions of value often differ, and buyers are often willing to pay a slightly higher price for a business in order to exploit synergies.