Purchase price allocation: Ensuring accuracy, transparency and compliance Valuation services
Purchase price allocation: Ensuring accuracy, transparency and compliance
Article
Introduction
With an increasingly diverse range of intangible assets driving the value of UK businesses and continuing economic uncertainty, there is a growing level of audit scrutiny regarding the valuation of intangible assets and goodwill in purchase price accounting. The UK’s audit regulation body, the Financial Reporting Council (FRC), acknowledges the increasing prevalence of intangible assets noting a “wide recognition of the growing importance of intangibles as we move towards a knowledge-based economy”, whilst also recognising the complexities this brings, due to “an accounting system that’s designed for a relatively stable world where companies were characterised by their physical assets, not the world we live in today that’s relatively uncertain, fluid and unknown and where intangible assets dominate” 1 . The incremental value generated by intangible assets and goodwill is notoriously difficult to quantify. Their valuation, and the wider purchase price allocation (PPA) process, are underpinned by complex techniques and often dependent on highly subjective assumptions. As such - and given that purchase price accounting typically requires such assets to be capitalised on balance sheet - PPA exercises are heavily scrutinised by auditors. The FRC states that “for many intangibles, the measurement uncertainty of fair value is so great as to call into question whether it could provide a representationally faithful depiction”. The complexities have been exacerbated in recent years due to the COVID-19 pandemic and a range of other economic challenges, leading to an increase in regulatory focus. A covid response paper from the Institute of Chartered Accountants in England and Wales (ICAEW) stated that “Assessing the valuation and impairment of clients’ assets has always demanded accountants’ toughest scrutiny and clearest judgment. Those skills and insights have never been more critical.” 2 The UK Government intervened with a 2021 policy paper published by the Department for Business reminding auditors of their “specific responsibility”, in particular “when reaching an overall judgement of whether the financial statements constitute a true and fair view of the entity’s financial position, but also for example judgements about line items in accounts such as revenue, goodwill and other intangible assets” 3 . In the current climate more than ever, astutely navigating the complexities of PPA is crucial to ensuring an informative and transparent set of accounts and a smooth audit process, whilst making well informed decisions leads to a better understanding of the impact on earnings and impairment testing in future periods. The esoteric nature of intangible asset valuation can lead to a complex and involved PPA process, which starts with establishing the reporting requirements.
In the current climate more than ever, astutely navigating the complexities of PPA is crucial to ensuring an informative and transparent set of accounts and a smooth audit process. Jim Davies Financial Advisory
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Purchase price allocation: Ensuring accuracy, transparency and compliance
Accounting requirements
Companies that report under UK GAAP can conduct PPA exercises in accordance with IFRS principles and may elect to do so if there are plans to transition to IFRS in the future, or for reasons of good governance, transparency, and increased disclosure within the financial statements. The choice of accounting standard can influence the recognition of intangible assets and various technical points relating to purchase consideration, asset valuation and accounting lives. Purchase consideration In simple transaction structures purchase consideration is simply the cash amount paid for the acquired business - though it is important to recognise the distinction between enterprise and equity value where acquisitions have not been completed on a debt-free, cash-free basis. Where transaction structures include deferred consideration, or elements that are contingent on future performance metrics, such components are required to be fair-valued and included in the purchase consideration as at the acquisition date. Cash Generating Units The selection of CGUs plays an important role in determining the overall shape of a purchase price allocation and dictates the extent of allocation and supporting analysis required. If multiple CGUs are recognised the purchase consideration must be split between them, requiring a valuation of each one. Furthermore, all assets and liabilities must then be valued and allocated at a CGU level. CGU selection is primarily driven by accounting definitions (a CGU being broadly defined as the smallest group of assets that generate cash inflows that are largely independent of the cash inflows from other assets or groups of assets), whilst other practical considerations may include:
Companies reporting under both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Practice in the UK (UK GAAP) are required to capitalise the fair value of all acquired assets and liabilities following an acquisition. Acquired intangible assets must first be identified, then valued and capitalised if certain criteria are met. Purchase consideration requires inclusion of the fair value of any contingent or deferred elements, and the balance of purchase consideration less the fair value of acquired net assets (including intangible assets) is required to be capitalised as goodwill. IFRS stipulates that intangible assets must be recognised separately from goodwill if they are deemed to be separable or arise from contractual or legal rights. The recognition criteria differs under UK GAAP where intangible assets are required to be recognised if deemed to be both separable and arising from contractual or legal rights. This leads to differences in the practical assessment of intangible assets under different accounting standards. The allocation of purchase consideration is required at a cash-generating unit level, a ‘CGU’ being the smallest group of assets that generate cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Acquired assets with indefinite lives are required to be depreciated or amortised, and the carrying value of intangible assets and goodwill is required to be tested for impairment at future reporting dates.
Practical considerations
For many intangibles, the measurement uncertainty of fair value is so great as to call into question whether it could provide a representationally faithful depiction.
• The existing group reporting structure • Future impairment testing • Information availability
Prior to determining the value of acquired assets and goodwill, there are certain up-front considerations that influence the broader shape of a PPA exercise. Primary amongst these are: Accounting standards Purchase price allocations are typically conducted in line with the accounting standards that the consolidated acquiring entity reports under, however there may be other considerations.
These up-front considerations frame the shape of the exercise and can influence the structure of future reporting requirements such as impairment testing.
The Financial Reporting Council
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Purchase price allocation: Ensuring accuracy, transparency and compliance
Intangible assets
Assessing the valuation and impairment of clients’ assets has always demanded accountants’ toughest scrutiny and clearest judgment. Those skills and insights have never been more
Intangible assets come in various forms and whilst a list of common classes of intangible asset can provide a helpful stating point, each transaction should be assessed based on its specific facts and circumstances. It is helpful to conduct a thorough review of the value drivers and sources of competitive advantage that a business benefits from, whilst keeping an eye on assets often capitalised in the relevant sector, and recognition criteria as defined with the appropriate accounting standards. Valuation The valuation of intangible assets is generally based on one or a combination of the three principal approaches to valuation – the income, market and cost approaches. Given the distinctive and varied nature of intangible assets, a number of specific valuation techniques have been developed by specialist practitioners since the early days of PPA and, whilst there is now a degree of consensus regarding which approaches best suit which classes of asset, there remain significant challenges to valuation due to difficulties in forecasting, benchmarking and separation. To summarise: • A general absence of directly comparable market data – given the lack of active markets for many classes of intangible asset – brings significant challenges to valuation benchmarking under the market approach • The income approach is often challenging due to difficulties in separately forecasting revenue (and associated costs) generated by distinct intangible assets and in benchmarking risk profiles and required returns • The cost approach is often hampered by a lack of detailed information regarding the cost to develop assets in their existing form, and challenges in the separation of historical development costs from costs related to other assets or activities Given the challenges and complexities involved, conducting robust and supportable intangible asset valuations for PPA requires a detailed understanding of the suite of techniques and methodologies that are typically deployed, and experience of rationalising conclusions in the context of the wider PPA exercise. Despite the development and fine-tuning of specialist valuation techniques, intangible asset valuation remains highly subjective. The stark
reality is that key inputs and assumptions are often difficult to support through internal data analysis or external benchmarks. As such, intangible asset valuation is thoroughly scrutinised by auditors, particularly where values are material.
Valuation of other assets and liabilities
critical. ICAEW
Whilst intangible assets are often the main focus in PPA exercises, the requirement is to assess the fair value of all acquired assets and liabilities. As a starting point, consideration may be given to whether the book value of other assets (and all liabilities) provides a reasonable representation of fair value. If that is not deemed to be the case, fair value assessments may need to be undertaken. Other assets and liabilities that it may be necessary to fair value include (but are not limited to):
• Property • Machinery and equipment • Inventory • Deferred income • Contingent liabilities
Finalising
Following the valuation of the relevant assets and liabilities a number of steps are required to finalise a PPA exercise. These typically include: • Conducting secondary valuation approaches, sense- checks and sensitivity analysis • Calculating the residual goodwill (at a CGU level if required) • Conducting allocation sense-checks such as IRR and WARA analysis • Comparing allocations to industry benchmarks • Documenting the analysis, conclusions and support for key assumptions
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Practical advice
Critical thinking around the identification of assets and the
Conclusion
selection of valuation methodologies is important, as is documentation of the analysis and inputs.
Purchase price allocation is an exercise that utilises a range of bespoke methodologies which can be technically complex to apply and dependent on subjective inputs and assumptions. Given the challenges involved, and because the resulting figures provide direct indications of value within the financial statements, audit scrutiny should be expected. Critical thinking around the identification of assets and the selection of valuation methodologies is important, as is documentation of the analysis and inputs. Where key assumptions remain subjective, detailed analysis backed up by commercial reasoning and economic rationale may be required.
Valuation services
FRP has a dedicated Valuation Services team with years of experience in conducting PPA exercises for companies in the UK and internationally, across a wide range of sectors. We support finance teams with services ranging from independent advice to full-scope PPA exercises and support with follow- on matters such as audit review and impairment testing. We are always happy to speak to finance teams in need of support.
Jim Davies Financial Advisory
Notes
1 Financial Reporting Council, 2021. Business Reporting of Intangibles: Realistic proposals. Feedback Statement. [online] Available at: <https:// www.frc.org.uk/getattachment/Feedback-Statement-FINAL.pdf> [Accessed 10 March 2022]. 2 Icaew.com. 2020. Going concern and resilience: lessons learned from COVID-19. [online] Available at: <https://www.icaew.com/technical/ audit-and-assurance/faculty/going-concern-and-resilience-lessons- learned-from-covid19> [Accessed 10 March 2022]. 3 Gov.UK, 2021. Restoring trust in audit and corporate governance. Consultation on the government’s proposals. [online] Department for Business, Energy & Industrial Strategy. Available at: <https://www.gov. uk/government/consultations/restoring-trust-in-audit-and-corporate- governance-proposals-on-reforms> [Accessed 10 March 2022].
Jim Davies Partner Financial Advisory London +44 (0)7841 829 826 jim.davies@frpadvisory.com
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January 2024
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