Purchase price allocation, from price to goodwill

1. 1. Book equity

   $400 million

   Assets $700 million less liabilities $300 million. The buyer pays $600 million more than that.

2. 2. Write-ups

   $360 million

   PP&E $100 million + inventory $20 million + customer relationships $180 million + trade name $60 million = $360 million. The two intangibles are new: Bellweather built them itself, so they were never on its books.

3. 3. Deferred tax liability

   $90 million

   A stock purchase leaves Bellweather's tax basis where it was, so the books now carry $360 million more than the tax basis. As those assets are depreciated, amortized, sold or impaired, the books will deduct more than the tax return does, so taxable income will run above book income later: $360 million × 25% = $90 million of deferred tax liability.

4. 4. Fair value of net assets

   $670 million

   $400 million + $360 million − $90 million = $670 million.

5. 5. Goodwill

   $330 million

   $1,000 million − $670 million = $330 million. Check: goodwill + write-ups − deferred tax = 330 + 360 − 90 = $600 million, the premium over book. The $15 million of fees is expensed, not added to goodwill.

The buyer has 100 million shares. Straight-line depreciation and amortization, the inventory step-up flows into cost of goods sold as the inventory is sold in year 1, and the trade name is not amortized because we gave it an indefinite life.

1. 1. New yearly charges

   $10 million + $20 million a year

   PP&E $100 million ÷ 10 = $10 million of depreciation. Customer relationships $180 million ÷ 9 = $20 million of amortization.

2. 2. Year 1

   $50 million pre-tax

   $10 million + $20 million + the $20 million inventory step-up = $50 million. Book tax falls by $12.5 million, which comes out of the deferred tax liability, not out of cash. Net income falls $37.5 million, $0.375 a share.

3. 3. Year 2 on

   $22.5 million a year after tax

   Without the inventory step-up, $30 million pre-tax and $22.5 million after tax, $0.225 a share, until the customer relationships are fully amortized.

4. 4. Cash

   No change

   Cash taxes follow the old tax basis, so none of this changes cash. The deferred tax liability winds down instead: $90 million to $77.5 million after year 1.

5. 5. Goodwill

   Tested, not amortized

   The $330 million of goodwill stays on the balance sheet. Under US GAAP for public companies it is tested for impairment at least once a year, and under FASB's 2017 update the company writes off the amount by which a reporting unit's carrying amount exceeds its fair value, capped at its goodwill.

Now the buyer pays $1,000 million in cash for Bellweather's assets and takes on its $300 million of liabilities. The buyer's tax basis becomes what it paid, so book and tax basis match and no deferred tax liability arises, our simplification. For the tax savings we count only the intangibles and goodwill, deducted over 15 years, at a 10% discount rate.

1. 1. Book goodwill

   $240 million

   $1,000 million − ($400 million + $360 million) = $240 million. $90 million less than the stock deal, which is exactly the deferred tax liability that no longer exists.

2. 2. Tax allocation by class

   Classes I to VI: $1,060 million

   Both sides report the allocation to the IRS on Form 8594, in seven classes. Cash $50 million (class I), receivables $100 million (class III), inventory $170 million (class IV), PP&E $500 million (class V), customer relationships and trade name $240 million (class VI).

3. 3. The residual

   Class VII goodwill $240 million

   For tax, consideration includes the liabilities taken on: $1,000 million + $300 million = $1,300 million. Less classes I to VI leaves $240 million for goodwill and going concern value, the same as book goodwill here.

4. 4. The deduction

   $8 million a year less tax

   Intangibles $240 million + goodwill $240 million = $480 million, deducted over 15 years: $32 million a year, saving $8 million of tax at 25%.

5. 5. What it is worth

   $60.8 million

   $8 million × 7.606, the 15-year annuity factor at 10%, is $60.8 million today. It is one reason buyers often prefer asset deals, and why sellers, who may pay more tax on one, may ask a higher price.

1. 1

   Walk me through a purchase price allocation.

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   Short answer. Start from the target's book equity. Write its assets and liabilities up to fair value and add intangibles it never booked. In a stock deal, record a deferred tax liability on the write-ups. Goodwill is the price less that adjusted net asset figure.

   Gives one number for each step and checks the total against the premium over book.

   • “Where do the fair values come from?”
   • “What if goodwill comes out negative?”
2. 2

   What is goodwill, and how is it created?

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   Short answer. The part of the price that can't be tied to identifiable assets: the workforce, synergies, the going business. It appears only when one company buys another.

   Says it is tested for impairment rather than amortized under US GAAP for public companies. Practice it, see a model answer

3. 3

   What happens if the price is below the fair value of net assets?

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   Short answer. A bargain purchase. Under IFRS 3 the excess is recognized in profit or loss right away, and FASB's standard also has the buyer recognize the excess in earnings as a gain.

   Adds that it is rare and usually a sign of a distressed seller.

4. 4

   What happens to the target's existing goodwill?

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   Short answer. It is not carried over. The buyer doesn't recognize it, and new goodwill is computed from this deal.

   Explains that old goodwill is not an identifiable asset the buyer acquires.

1. 5

   Why do write-ups create a deferred tax liability in a stock deal?

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   Short answer. Because the tax basis doesn't change. Book depreciation on the higher values will exceed tax depreciation, so taxable income, and cash tax, will run above book income and book tax expense as the write-ups are used up. The liability records that.

   Shows that the liability raises goodwill by the same amount.

2. 6

   What is a deferred tax liability, and where does it come from?

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   Short answer. Tax the company will pay later because book and tax rules differ in timing, most often from faster tax depreciation.

   Uses the PPA case as a second source of it. Practice it, see a model answer

3. 7

   What's the difference between an asset deal, a stock deal and a 338(h)(10) election?

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   Short answer. In an asset deal the buyer's tax basis steps up and goodwill can be deducted over 15 years. In a stock deal the old basis carries over. A 338(h)(10) election treats a stock purchase as an asset sale for tax.

   Puts a value on the step-up, as example 3 does. Practice it, see a model answer

4. 8

   What creates a deferred tax asset?

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   Short answer. Expenses booked before they are deductible, or losses carried forward. In a deal, an asset written down below its tax basis, a liability recorded above its tax basis, or acquired tax losses can create one.

   Mentions that a deferred tax asset may need a valuation allowance. Practice it, see a model answer

1. 9

   How does a purchase price allocation change the buyer's EPS?

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   Short answer. New depreciation and amortization on the write-ups lower net income, and the inventory step-up hits the first year. Goodwill doesn't, unless it is impaired.

   Puts a per-share figure on it, as example 2 does.

2. 10

   Walk me through a merger model.

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   Short answer. Combine the two income statements, add the new interest and the PPA's depreciation and amortization, take off lost interest on cash used, and divide by the new share count to get pro forma EPS.

   Places the PPA step correctly in the model. Practice it, see a model answer

3. 11

   A company writes down an asset by $100. Walk me through the three statements.

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   Short answer. Pre-tax income falls $100 and net income by the after-tax amount. The write-down is added back on the cash flow statement, so cash moves only by any tax effect. The asset falls by $100 and equity by the net income drop.

   Says whether the write-down is deductible for tax, which changes the cash line. Practice it, see a model answer

4. 12

   Why does acquired deferred revenue matter in a deal?

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   Short answer. Because it is revenue the buyer will recognize later. Since ASU 2021-08, a US buyer records acquired contract liabilities under the revenue standard as if it had originated the contracts, so less of it disappears in the allocation.

   Says what that does to the buyer's revenue in the first year.

• Goodwill as price minus book value

  That gives $600 million in example 1, not $330 million. The write-ups and the deferred tax come first.

• Forgetting the deferred tax liability

  In a stock deal it adds $90 million to goodwill in our example.

• Adding deal fees to goodwill

  Under US GAAP the buyer expenses acquisition costs as they are incurred, apart from the costs of issuing debt or equity.

• Amortizing goodwill in the model

  For a US public buyer goodwill is tested for impairment, not amortized. Intangibles with a set life are amortized.

• Changing cash taxes in a stock deal

  Book depreciation rises, tax depreciation doesn't, so cash taxes stay put and the deferred tax liability unwinds.