An Empirical Analysis of the Quality of the PPA - Purchase Price Allocation

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A simple analysis of accounting principles cannot prove IFRSs’ ability to improve the quality of
accounting information. Such a result, indeed, can only be demonstrated by observing their
practical application. Nevertheless, as a consequence of the lack of a real survey, no empirical
analysis or similar study specifically concerning the effectiveness of IFRSs on accounting
information quality is currently available in literature. Contrariwise, a small literature is available
concerning the impact on financial information of some innovations recently included into the USA
accounting principles, the US GAAP, which are really similar to those introduced in Europe by IFRSs
and preceded them by four years (Guatri and Bini, 2003c). Bens and Heltzer (2004) and Chen et al.
(2004) showed that the overall impact of such innovations on financial information on intangibles
has been positive.
IFRSs introduced two great innovations, the impact on intangibles of which looks highly relevant.
These innovations are:
(1) The possibility to value selected strategic resources at fair value, thus taking into account their
ability to create value. Presently, according to IFRSs the most relevant area of fair value
application is the determination of values of assets acquired in business combinations; but its
application to internally developed assets, although at the moment subject to severe restrictions,
must not be ignored (Langendijk et al., 2003, Guatri and Bini, 2003b, 2005);
(2) The regulation of impairment test, i.e. the procedure aimed at identifying eventual impairment
losses of an asset’s value. Such a regulation permits the utilise of the test itself as a value control
system, together or even as a substitute of amortisation, thus eliminating the concept of useful life
and introducing the intangible asset with indefinite life (Harper, 2001; Guatri and Bini, 2003a).
Beatty and Weber (2006) investigate firms’ actions upon the adoption of SFAS 142 and find that
opportunistic reporting incentives affected the decision to record goodwill impairment as a one-
time extraordinary charge in the transition period. It is yet to be explored how reliable firms’
routine valuation of goodwill and other intangible assets (i.e. identifiable intangible assets2) is
post SFAS 142.
The SFAS 142, published in 2001 by FASB, removes the assumption that intangibles have a definite
life and mandated an impairment test based on discounted cash flows. Unfortunately, this
standard did not have better luck.
Bens and Heltzer (2004) said that ‘‘there is no statistical difference between the short-window
abnormal returns in the pre- and post-SFAS 142 samples, suggesting that changes in fair value
accounting of SFAS 142 do not impact the information content of accounting data’’. The FASB
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responded to this evidence of the feeble value relevance of the impairment test by publishing an
exposure draft, ‘‘Fair Value Measurement’’ (FASB, 2004), which constitutes a further attempt to
limit management’s discretionary power in recognizing the impairment of assets. In this paper, the
FASB emphasized the role of market prices to define the so-called fair value hierarchy to be
followed in impairment tests. However, this had the effect of shifting the focus of fair value
accounting from mark-to-expectations to mark-to-market. In a fair value accounting systems,
commodity-like assets are entered at their current market price while for such strategic assets as
goodwill and acquired intangibles the search for a current market price is an exercise in futility, as
there is no active market for these assets and their substitutes. The market for strategic assets is
necessarily a seller’s market, where price is a function of the buyer’s special capabilities. Hence the
need for a meaningful impairment test conducted on strategic assets to rely on the recoverable
value determined through expected cash flow streams.
Li et al. (2004), for their part, make a case for a cause–effect relationship between the decision of
certain companies to write off their goodwill between January 2002 and March 2003 and the
decrease of their stock prices in the two years before the write-off.
Francis et al. (1996) noted the absence of ‘‘significant (investors) reaction to write-offs of either
goodwill or PP&E’’. The same conclusion was reached by Bunsis (1997), who indicated that
writeoffs had no significant informative value for the stock market in the pre-SFAS 121 period.
The IFRS and US-GAAP accounting regulations for business combinations involve the application of
the purchase method. The “Pooling of interests” method has been discontinued.
For accounting purposes this requires the allocation of the purchase price to the acquired assets
and liabilities at fair value at the acquisition date.
In this connection, the PPA poses a complex challenge for the acquiring company.
The process involves determining the purchase price, identifying hidden reserves and charges
reflected in the assets and liabilities shown in the acquiree’s balance sheet, as well as identifying
and valuing intangible assets and liabilities previously not recognized in the balance sheet. The fair
value approach is required, whereas fair value is defined as the amount at which an asset could be
exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length
transaction.
Often intangible assets such as customer relationships, brands, patents, technologies and the like
constitute the central value drivers of the acquired company, and are therefore of most interest to
the acquiring company in the acquisition process. Their identification and recognition in the
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balance sheet depends on a precise analysis of the business model of the company being taken
over. The fair value of these intangible assets must then be determined in accordance with
prescribed valuation approaches and methods.
b. Scope of a Purchase Price Allocation
Irrespective of international accounting standards, a PPA is always necessary when a lump-sum
purchase price was paid for a bundle of assets and liabilities, which for accounting purposes must
be divided by the acquirer among the acquired assets and liabilities. The applicable accounting
regulations specify for what kind of transactions a PPA has to be performed, for which assets and
liabilities a revaluation has to be conducted and which values have to be recognized on the
balance sheet. International accounting standards require the purchase price in a business
combination to be allocated at the time of the acquisition to all identifiable assets and liabilities
that meet the applicable recognition criteria. They must be reported in the acquirer’s balance
sheet at their attributable fair value (considering minority interests, if applicable). This transforms
the book-value balance sheet of the acquired company into a fair value balance sheet. The
residual value, after taking into account any deferred taxes, is recognized as goodwill.
The determination of goodwill to be recognised on the opening balance sheet is:
Acquisition costs
- Fair value of tangible assets
- Fair value of intangible assets
+ fair value of liabilities
+ fair value of contingent liabilities
+/- deferred taxes
= goodwill as residual income
c. Significance of a Purchase Price Allocation
A PPA is not only a complex, technical and organizationally challenging process, but also leads, in
the context of consolidation accounting, to consequences that are regularly underestimated at the
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beginning of the process (see fig. 2). Particular emphasis must be placed on the information about
the business combination that the purchaser must provide under the extensive disclosure
requirements. Among other items, the acquired intangible assets and the compensated expected
potential (goodwill) must be disclosed to the capital market. More often than not intangible assets
such as brands, patents, customer relationships, technologies and the like constitute the key value
drivers of many companies, and must therefore be regarded as an important motivating factor for
the acquisition.
Researchers and regulators have long debated the accounting for intangible assets. The debate
centers on the relevance and reliability of intangible valuation and the existing research produces
mixed results. Value-relevance studies examine the association between constructed or
recognized value of intangibles and firms’ market values to infer the relevance of capitalized
intangibles (e.g., Lev and Sougiannis, 1996; and Kallapur and Kwan, 2004). While these studies find
significant associations, Kallapur and Kwan (2004) also note that the association varies with
contracting considerations, suggesting that the reliability of intangible valuation is affected by
managers’ reporting incentives. A second line of research investigates the determinants of
voluntary recognition of intangible assets to infer the reliability of intangible measurements. While
Muller (1999) finds that contracting motives significantly affect the decision to recognize
intangible assets, Wyatt (2005) argues that the underlying economics are more important
determinants of the decision than contracting motives.
The passage of SFAS 142, Goodwill and Other Intangible Assets, further intensifies this debate.
Under SFAS 142, acquired goodwill is no longer subject to amortization. Firms are required to
allocate goodwill to reporting units based on benefits expected from the acquisitions and then
conduct periodic goodwill impairment tests based on estimated fair values of reporting units and
identifiable net assets.
Watts (2003) argues that the implementation of SFAS 142 relies on unverifiable fair value
estimates that are likely to be manipulated. He also points out that lobbying activities played a
role in the formulation of SFAS 142. Ramanna (2006) examines the lobbying process and argues
that the lobbying firms supported the fair-value-based goodwill impairment test as a means to
seek greater flexibility in accounting. Beatty and Weber (2006) investigate firms’ actions upon the
adoption of SFAS 142 and find that opportunistic reporting incentives affected the decision to
record goodwill impairment as a one-time extraordinary charge in the transition period. It is yet to
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be explored how reliable firms’ routine valuation of goodwill and other intangible assets (i.e.
identifiable intangible assets2) is post SFAS 142.
Motivated by the debate on the accounting for intangible assets and that on SFAS 142, this study
investigates the allocation of purchase price between goodwill and other intangible assets, the
initial valuation of these acquired assets, upon the completion of a merger or an acquisition. The
allocation process provides a unique setting for examining the reliability of intangible valuation.
First, while existing studies on goodwill valuation focus on the impairment assessment in poor
performing firms, the allocation setting is less affected by potential confounding effects of
extreme economic performance. Second, although the fair value of acquired entity is verifiable at
the time of allocation, the fair values of individual assets are not, thereby providing opportunities
for manipulation. Third, as a result of the new differential treatment of goodwill and most
identifiable intangible assets post SFAS 142, the allocation of purchase price among different
assets directly affects acquirers’ subsequent financial reporting, hence providing motivations for
manipulation.
In contrast to goodwill that is no longer amortized under SFAS 142, identifiable intangible assets
with finite lives such as developed technologies and customer base are still subject to
amortization. Recording amortization regularly constrains managers’ accounting discretion. Also,
managers are reportedly concerned with the amortization of acquired intangibles leading to lower
reported earnings after acquisitions (Johnson, 1993). As executive compensation is usually tied to
earnings, intangible amortization can reduce CEO bonuses. CEOs are thus motivated to record less
intangibles post SFAS 142 to cut amortization expenses. In particular, older CEOs likely have a
stronger incentive to avoid amortization expenses and maximize short-term compensation
(Dechow and Sloan, 1991), given their limited horizon and weakened career concerns. We
hypothesize that older CEOs allocate more purchase price to goodwill relative to identifiable
intangibles than determined by the underlying economics.
However, it can be costly to manipulate the initial valuation of acquired intangible assets by
recording more goodwill relative to other intangible assets. Allocating more purchase price to
goodwill increases the likelihood of large goodwill impairment write-offs in the future. Pender
(2001) argues that goodwill write-offs are considered a manifestation of past acquisition mistakes
that can lead to management dismissal.
On the one hand, conclusions can be drawn regarding the expectations and motives associated
with the acquisition.
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On the other hand, the results of PPAs from comparable transactions may suggest starting points
for an analysis of the benefits of the transaction – and the amount of the residual goodwill can
provide indications as to the reasonableness of the purchase price. Furthermore, the allocation of
the purchase price has an important impact on future operating results of the acquiring group. In
the postacquisition balance sheet, the goodwill must be allocated to cash-generating units as per
IFRS 3 and to reporting units as per SFAS 141/142, respectively, for the purpose of impairment
testing. The determination of cash-generating units or reporting units, together with the al
location of the goodwill to those units, is a fundamental component of future impairment tests.
Within the rules of the accounting standards, the goodwill allocation offers the acquirer a unique
degree of latitude in the preparation of the balance sheet, which has a significant influence on the
risk of a potential future need for an impairment adjustment. Intangible assets with an indefinite
life are also subject to a regular impairment test, and are thus exposed to the risk of unscheduled
impairment charges. In contrast, assets with a definite (limited) life are amortized on a scheduled
basis. The determination of the remaining life is therefore an important factor regarding the
recognition of intangible assets. The estimated remaining economic useful life determines the
amount of fair value as well as the temporal allocation of the annual amortisation.
In the event that the need for a potential exceptional value reduction is indicated, an impairment
test must be conducted for all affected assets at that time.
Possible implications of a Purchase Price Allocation are:
 Important information for the capital market;
 Impact on future economic results;
 Possible effect on transfer-pricing issues;
 Potential effects on the tax balance sheet;
 Recognition of fair values of all acquised assets, liabilities and contingent liabilities;
 Identification and valuatin of all intangible assets;
 Basis of future impairment tests;
 Basis of future goodwill impairment tests;
d. Process
While difficulties are frequently encountered in determining the fair values of the assets and
liabilities already recognized in the balance sheet of the acquiree, the central challenge of a PPA
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lies in the identification and valuation of intangible assets not previously reported by the acquiree,
i.e. where balance sheet recognition criteria were previously not met.
The accounting for goodwill and intangibles has been debated for decades. The debate relates to
specific accounting treatments of intangibles but fundamentally centers on the relevance and
reliability of intangibles valuation. One line of research focuses on the value relevance of
capitalized intangibles by examining the association between constructed or recognized value of
intangibles and firms’ market values. For example, Lev and Sougiannis (1996) treat R&D expenses
as if they were capitalized and examine the relation between the constructed R&D value and
firms’ market values.
Barth et al. (1998) examine the relation between brand name values estimated by the financial
press and firms’ market values. Kallapur and Kwan (2004) investigate the association between
recognized brand names and firms’ market values for a sample of U.K. listed firms. While these
studies find the association to be significant and positive, some of them also note problems with
the reliability of intangible measurements. Kallapur and Kwan (2004) find that the association is
lower when firms have stronger contracting incentives related to listing requirements and debt
financing. Furthermore, the approach of inferring value relevance from the documented
associations has been challenged (see Holthausen and Watts, 2001).
Another line of research investigates the determinants of a firm’s decision in recognizing
intangible assets to infer the relevance and reliability of the accounting for intangibles. Muller
(1999) finds that contracting incentives such as exchange listing requirements and debt
contracting have a significant impact on U.K. firms’ decision to capitalize acquired brand names.
However, Wyatt (2005) argues that the underlying economics such as prevailing technology
conditions are more important determinants of the recognition of intangibles than contracting
incentives. She examines the intangible recognition decision for a large cross section of Australian
listed firms and constructs the technology conditions variables largely at the industry level.
However, while her technology condition variables can explain a significant portion of the
variation of recognized identifiable intangibles, they do not explain much of the variation in
goodwill and capitalized R&D assets.
The passage of the fair-value-based SFAS 142 extended the debate on the accounting for goodwill
and other intangibles. Watts (2003) argues that the implementation of SFAS 142 relies on
unverifiable fair value estimates that are likely to be manipulated. He also contends that lobbying
activities played a role in the formulation of SFAS 142. Ramanna (2006) investigates firms’
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lobbying positions in the rulemaking period of SFAS 142 and finds that those anticipating greater
accounting flexibility in the goodwill impairment assessment were more likely to support the
impairment test proposal. He suggests that firms are likely to use the manipulation potential post
SFAS 142. Beatty and Weber (2006) examine the determinants of firms’ accounting choices in the
initial impairment assessment under SFAS 142. They find that equity market concerns and
contracting incentives affected firms’ decision to accelerate or delay the impairment recognition.
Such findings are consistent with the notion that management incentives affect fair value
estimates of goodwill.
However, since their study examines an extraordinary one-time charge, the findings may not be
generalizable to routine reporting of fair value estimates. Bens and Heltzer (2006) investigate the
timeliness and information content of goodwill write-offs around SFAS 142 passage and they do
not find any significant changes post SFAS 142. Li et al. (2006) find that investors and financial
analysts react negatively to the announcement of an impairment loss in the transition period of
SFAS 142 and that the impairment loss is followed by a decline in subsequent performance.
A systematic processing sequence of a Purchase Price Allocation might be structured as:
 Analysis:
o Determination whether transaction requires a PPA al all;
o Identification of acquirer;
o Determination of acquisition date and purchase price;
o Transaction rationale and business plan analysis;
 Identification:
o Identification of all acquires assetsand liabilities deviating from their
respective fair values;
o Identification of previously non recognized intangible assets and
contingent liabilities;
o Check on recognition criteria regarding the identified assets and
liabilities;
 Valuation:
o Determination of valuation methods and key assumption;
o Determination of valuation parameters [e.g. cost of capital];
o Fair value calculations;
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 Accounting:
o Deferred tax calculation;
o Residual goodwill derivation/analysis of potential negative goodwill;
o Goodwill, asset and liability allocation to cash generating units;
o Execution of necessary accounting adjustments and bookings;
o Reporting.
i.Preliminary analysis
The preliminary analysis starts with the identification of the acquiring company, which is not
always obvious at first sight.
The date of acquisition is similar to the allocation and hence the valuation date and must be
determined. Under IFRS 3, the date as of which control over the net assets and the financial and
operating activities of the acquired company passes to the purchaser, is the relevant valuation
date. Under SFAS 141/ 142, in contrast, the valuation is conducted at the time when the
transaction is consummated, usually the closing date. The analysis of the business plan enables the
identification of the central value drivers of the acquired company and provides an understanding
of the amount and composition of the purchase price.
ii.Identification
With regard to the balance sheet recognition of assets and liabilities in a business combination, a
distinction is drawn between tangible and intangible assets, liabilities and contingent liabilities. In
case of tangible assets and liabilities the question arises as to the extent to which the reported
book values differ from its fair values. Besides machinery in capitalintensive operations, land and
real estate often carry significant hidden reserves and are regularly analysed more closely in the
valuation process. Liabilities are recorded at the value required to meet the present obligation on
the valuation date. Under IFRS, restructuring provisions are only recognized if the acquired
company already fulfilled the recognition criteria of IAS 37 at the time of the acquisition. Under
US-GAAP, in contrast, recognition occurs if certain criteria regarding the nature and timing of the
restructuring are met.