Allocation of purchase price asset sale is one of the most significant aspects to consider when selling a particular business entity. It is a necessary procedure for tax purposes and often acts as an area of negotiation after both parties agree upon the specific sale's price, terms, and conditions. The following blog discusses the importance of the allocation of purchase price asset sale, its benefits, and other associated details.
What is Purchase Price Allocation?
Purchase price allocation assigns the value of an acquired company or asset to specific tangible and intangible assets and liabilities. The objective of purchase price allocation is to fairly and accurately reflect the fair value of the assets and liabilities acquired and the residual goodwill. Purchase price allocation is a practice prevalent in acquisition accounting in which the acquirer allocates purchase prices into the liabilities and assets of the acquired target organizations. It is a significant step associated with account reporting after completing a particular organization's merger and acquisition with another business entity.
The purchase price asset sale allocation helps create important considerations for the seller parties, who must understand the entire process. It further assists in determining the seller's tax liabilities and the buyer's tax basis in the assets acquired by the latter. The purchase price allocation is based on the fair market value of the assets acquired, which is the amount that would be paid if the assets were sold in a close transactional process. The fair market value of each asset is determined through valuation techniques such as discounted cash flow analysis or comparable transactions. Once the fair market value of the assets is determined, the purchase price is allocated to specific assets and liabilities based on their relative fair values.
It includes allocating the purchase price to tangible assets such as property, plant, and equipment, intangible assets such as patents and trademarks, and liabilities such as accounts payable and long-term debt. The purchase price allocation process in an asset sale is governed by generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) and is subject to regulatory requirements, such as SEC regulations.
Essential Components of Purchase Price Allocation
Purchase price allocation is the most convenient resort for buyers and sellers to agree upon specific terms related to their respective assets and liabilities. It allows them to complete the transaction and the subsequent merger and acquisition process of a particular business. Here is a breakdown of the significant components of purchase price allocation.
Net Identifiable Assets
They refer to the total value of the acquired company's assets which are less the amount of liabilities. Such assets have a certain value, and their benefits get recognized and quantified over time.
It is the adjusting increase to a particular asset's book value that comes into formation if its carrying value is less than the fair market value.
It refers to the amount paid more than a particular target company's net value of its assets after liability deduction.
Purchase Price Allocation Factors
The purchase price allocation is determined based on several underlying factors that include the fair market value of the assets acquired, legal and contractual restrictions, expected future cash flows generated by assets, valuation techniques used, accounting principles, and regulatory requirements.
Fair Market Value of Assets Acquired
The fair market value of assets acquired is the key factor in the purchase price allocation process. The fair market value of each asset is determined based on the prices of comparable assets in the market or through valuation techniques such as discounted cash flow analysis. The fair market value of assets acquired is a crucial input for the purchase price allocation, as it reflects the amount that would be paid if the assets were sold in a closed transactional process.
Legal and Contractual Restrictions
Legal and contractual restrictions can impact the allocation of the purchase price. For example, the terms of a contract may limit the use of certain assets, thereby affecting the expected future cash flows generated by those assets. Moreover, some assets may be subject to legal restrictions such as liens, encumbrances, or other claims that impact their value.
Expected Future Cash Flows Generated by Assets
The expected future cash flows generated by assets are another important factor in the purchase price allocation process. The expected future cash flows are used to determine the present value of assets, which is then used to allocate the purchase price. For example, suppose an asset is expected to generate significant future cash flows. In that case, it is allocated a higher portion of the purchase price than assets with lower expected future cash flows.
Valuation techniques play a crucial role in the purchase price allocation process. The most commonly used valuation techniques include discounted cash flow analysis, comparable transactions, and other market-based methods. The choice of the valuation technique will impact the fair market value of assets and the purchase price allocation.
Accounting Principles and Regulatory Requirements
Accounting principles and regulatory requirements also play a role in purchasing price allocation. Generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) guide the measurement and recognition of intangible assets, property, plant, equipment, and goodwill. In addition, regulatory requirements, such as SEC regulations, also impact the purchase price allocation.
Allocation of Purchase Price to Specific Liabilities and Assets
The allocation of the purchase price to specific assets and liabilities is based on their relative fair values. It includes the allocation of the purchase price to tangible assets such as property, plant, and equipment, intangible assets such as patents and trademarks, and liabilities such as accounts payable and long-term debt. The allocation of the purchase price is critical as it impacts the financial statements and provides useful information to stakeholders about the value of the assets and liabilities acquired.
Key Terms Related to Allocation of Purchase Price Asset Sale
Allocation of the purchase price is necessary for tax determination, and every business organization must opt for it ahead of a merger and acquisition. However, it is a legal procedure, and its documentation may include complicated terms that everyone cannot understand. That is why it is recommended to know a few key terms related to purchasing price allocation, as mentioned below.
- Asset: It refers to a valuable or useful item or property owned by a particular individual or organization.
- Liability: It refers to the state of remaining legally responsible for certain situations.
- Asset Sale: It refers to the purchase of individual liabilities and assets.
- Stock: It describes the ownership of equity in a particular organization.
- Stock Sale: It refers to the purchasing of a business owner's shares of a particular corporation.
- Contract: It is an agreement signed between two or more parties over certain agreed-upon terms and conditions.
- Equipment: It is a tangible long-term asset that benefits a particular business over several years.
- Lease: It is the legally enforceable contract signed between parties where one party conveys property, land, or other services to the other for a specific period.
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