Business Combination Purchase Price Allocation Procedures
By Robert F. Reilly
Intangibles and Goodwill Allocations in Accounting
The author explains the basic provisions of SFAS 141 and 142 on accounting for business combinations using the purchase method and on the impairment of intangible assets and goodwill. Many companies will be using these two standards as they enter into new mergers and acquisitions. The article goes through an example of the process of valuing the intangibles, a project that most companies will have done by valuation experts, and of using those valuations in the purchase price allocation.
In 2001, FASB released SFAS 141 and 142, which radically changed GAAP for business combinations. Prior business combination GAAP, including the purchase accounting method, the pooling-of-interests accounting method, and acquired goodwill recognition and amortization, were provided in Accounting Principles Board (APB) 16 and 17. Under the FASB statements, a business combination is defined broadly to include most instances of corporate change of control. Accordingly, most merger and acquisition (M&A) transactions will be recorded using purchase price allocation (PPA) for financial accounting purposes.
Purchase Price Allocation Financial Accounting
SFAS 141 and 142 provide GAAP guidance with regard to business combination PPA. SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets, are effective for business acquisitions initiated after June 30, 2001. SFAS 141 provides that all business combinations be accounted for using the purchase method of accounting. SFAS 142 provides guidance related to the capitalization and amortization of acquired intangible assets (including goodwill) in a business combination.
SFAS 141, paragraph 10, provides the following broad definition of a business combination:
The provisions of this Statement apply equally to a business combination in which (a) one or more entities are merged or become subsidiaries, (b) one entity transfers net assets or its owners transfer their equity interests to another, or (c) all entities transfer net assets or the owners of those entities transfer their equity interests to a newly formed entity (some of which are referred to as roll-up or put-together transactions). All those transactions are business combinations regardless of whether the form of consideration given is cash, other assets, a business or a subsidiary of the entity, debt, common or preferred shares or other equity interests, or a combination of those forms and regardless of whether the former owners of one of the combining entities as a group retain or receive a majority of the voting rights of the combined entity. An exchange of a business for a business also is a business combination.
SFAS 141, paragraph 35, provides the general framework for the PPA typical of an M&A transaction accounted for as a purchase:
Following the process described in paragraphs 36–46 (commonly referred to as the purchase price allocation), an acquiring entity shall allocate the cost of an acquired entity to the assets acquired and liabilities assumed based on their estimated fair values at date of acquisition (refer to paragraph 48).
SFAS 141, paragraph 39, provides the following accounting definition of an acquired intangible asset (other than goodwill):
An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired entity or from other rights and obligations). If an intangible asset does not arise from contractual or other legal rights, it shall be recognized as an asset apart from goodwill only if it is separable, that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so). For purposes of this Statement, however, an intangible asset that cannot be sold, transferred, licensed, rented, or exchanged individually is considered separable if it can be sold, transferred, licensed, rented, or exchanged in combination with a related contract, asset, or liability. For purposes of this Statement, an assembled workforce shall not be recognized as an intangible asset apart from goodwill.The Sidebar presents a summary listing of the discrete intangible assets identified in SFAS 141 Appendix A (Implementation Guidance, paragraph A14).
SFAS 141 applies the residual method of accounting for goodwill (i.e., total purchase price – liabilities assumed – financial assets – tangible assets – recognized intangible assets = goodwill), as described in paragraph 43:
The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed shall be recognized as an asset referred to as goodwill. An acquired intangible asset that does not meet the criteria in paragraph 39 shall be included in the amount recognized as goodwill.
SFAS 142 introduces new GAAP provisions for the remaining useful life (RUL) estimation, amortization, and impairment of acquired intangible assets, including goodwill. These provisions require periodic business unit valuation analyses that were not necessary under previous GAAP. These new provisions will likely cause periodic adjustments to the corporate acquirer’s financial statements.
Paragraph 11 of SFAS 142 describes the estimation of RUL for acquired intangible assets:
The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity.
Paragraph 12 of SFAS 142 provides guidance related to the amortization of acquired intangible assets:
A recognized intangible asset shall be amortized over its useful life to the reporting entity unless that life is determined to be indefinite. If an intangible asset has a finite useful life, but the precise length of that life is not known, that intangible asset shall be amortized over the best estimate of its useful life. The method of amortization shall reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. If that pattern cannot be reliably determined, a straight-line amortization method shall be used.
SFAS 142 calls for the periodic reconsideration of each acquired intangible’s RUL, as discussed in paragraph 14:
An entity shall evaluate the remaining useful life of an intangible asset that is being amortized each reporting period to determine whether events and circumstances warrant a revision to the remaining period of amortization. If the estimate of an intangible asset’s remaining useful life is changed, the remaining carrying amount of the intangible asset shall be amortized prospectively over that revised remaining useful life.
SFAS 142 exempts some intangibles from amortization, as described in paragraph 16:
If an intangible asset is determined to have an indefinite useful life, it shall not be amortized until its useful life is determined to be no longer indefinite. An entity shall evaluate the remaining useful life of an intangible asset that is not being amortized each reporting period to determine whether events and circumstances continue to support an indefinite useful life.
Goodwill Impairment Test
A significant change from previous purchase accounting is the new requirement for the periodic testing of value impairment for both separately recognized intangibles and goodwill. Paragraph 17 specifies the test of impairment for separately recognized intangible assets:
An intangible asset that is not subject to amortization shall be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. (Paragraph 5 of Statement 121 includes examples of impairment indicators.) The impairment test shall consist of a comparison of the fair value of an intangible asset with its carrying amount. If the carrying amount of an intangible asset exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess. After an impairment loss is recognized, the adjusted carrying amount of the intangible asset shall be its new accounting basis.
And paragraph 18 provides for the recognition of impairment for acquired goodwill:
Goodwill shall be tested for impairment at a level of reporting referred to as a reporting unit. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value.
Paragraph 54 identifies the accounting for previously recorded goodwill:
All goodwill recognized in an entity’s statement of financial position at the date this Statement is initially applied shall be assigned to one or more reporting units. Goodwill shall be assigned in a reasonable and supportable manner. The sources of previously recognized goodwill shall be considered in making that initial assignment as well as reporting units to which the related acquired net assets were assigned.
Example of a Purchase Price Allocation
In this example, North-South Corporation (NSC) is a publicly traded corporation that owns and operates the North-South Railroad (NSRR). East-West Corporation (EWC) owns and operates the East-West Railroad (EWRR). EWC sold 100% of the stock of its wholly owned EWRR subsidiary to NSC for a total consideration of $4 billion on December 31, 2002.
The seller corporation agreed to make an IRC section 338(h)(10) election. This election allows NSC to treat the stock acquisition as an asset acquisition. Accordingly, the tax basis in the transferred EWRR assets will be adjusted to fair market value as of the transaction date.
On December 31, 2002, EWRR had $100 million of cash and marketable securities on hand, $200 million of accounts receivable, and $100 million of inventory and supplies. Based on a contemporaneous appraisal, EWRR had $600 million of tangible personal property (TPP). Also based on a contemporaneous appraisal, EWRR owned $1 billion of real estate (RE). Based on these facts, the EWRR purchase includes $400 million of financial assets, $600 million of TPP, and $1,000 million of RE. These asset categories account for $2 billion of the $4 billion total transaction price. Accordingly, the EWRR purchase transaction included $2 billion of acquired intangible assets.
A valuation of EWRR reveals that the railroad owned these discrete intangible assets as of December 31, 2002:
Example of an Intangible Asset Valuation Analysis
Customized computer software. Analysis of the new replacement cost and allowances for functional and economic obsolescence led to a $400 million fair market value for the computer software, based on the following factors:
Favorable training facility lease. The appropriate discount rate (corresponding to a pretax cost savings level of economic income) for this intangible asset was estimated at 12%. The subject lease has a 10-year remaining term. The annual rent expense savings is $3.5 million. The direct capitalization factor for a 12% discount rate and a 10-year period is 5.7 times (with the simplified assumption of year-end compounding). The present value of the rental expense savings is $20 million.
Freight-hauling customer contracts. Of the EWRR total annual revenue of $10 billion, $6 billion represents freight revenues from recurring contracts. EWRR earns a 12% (pretax) net cash flow profit margin on this contract business. The appropriate capital charges and economic rents for a fair rate of return on the tangible and intangible assets used in the production of this contract-related income were subtracted from the revenue, leaving an estimated 5% (pretax) economic income margin on this customer contract business. The appropriate discount rate for this measure of economic income is 14%. Based on this 14% discount rate, a 5% annual growth rate, and a three-year remaining term, the corresponding direct capitalization factor is 2.5 times. The present value of the $300 million contract-related economic income (i.e., $6 billion revenues at a 5% margin), increasing at 5% per year, is $750 million.
Favorable supply contracts. The favorable contracts generate $20 million of (pretax) annual savings. The direct capitalization multiple corresponding to a 14% discount rate and a three-year RUL is 2.3 times. The present value of $20 million annual savings is approximately $50 million.
Trackage rights agreements. EWRR saves $100 million per year (pretax), increasing at 5% per year, by using trackage rights on other railroads. The RUL of the trackage rights agreements is 20 years. The direct capitalization multiple for a 14% discount rate, a 5% growth rate, and a 20-year period is 9.1 times. The present value of the $100 million expense savings is $90 million.
Trained and assembled workforce. The EWRR has a workforce of 10,000 employees. The fair market value of the EWRR workforce was estimated at $300 million, based on an estimate of a replacement cost new less depreciation (RCNLD) analysis that considered the following:
Proprietary technology. EWRR saves $20 million per year by operating a proprietary intermodal freight handling system (as compared to the operating cost more traditional systems). This annual savings is expected to increase at 6% per year. The RUL of the technology is 10 years. The direct capitalization factor corresponding to a 14% discount rate, a 6% growth rate, and a 10-year period is 6.7 times. The present value of the $20 million annual savings, increasing at 6% per year, is $130 million.
Trademarks and trade names. EWRR generates $1 billion in annual revenues in markets where it competes directly with other railroads. EWRR wins this business from its direct railroad competitors because of its reputation for quality, service, safety, and delivery. This revenue stream will increase at 4% per year. Guidelines for trademark use licenses indicate that an appropriate market-derived trademark royalty rate is 3%. The 3% royalty rate corresponds to a $30 million (i.e., $1 billion revenues times a 3% license fee) royalty savings to EWRR. The direct capitalization factor corresponding to a 14% discount rate, a 4% growth rate, and a 10-year period is 6.1 times. The present value of the $30 million royalty savings, increasing at 4% per year, is $180 million .
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