When should a purchase price allocation be performed?

Purchase price allocation is a fundamental component of consolidated accounting. It must be performed whenever a company is integrated into an existing group through an acquisition or when a new group is formed.

A prerequisite for this is the absence of any exemption regulations and the acquirer's obligation to prepare consolidated financial statements. This obligation is influenced by various factors, including company size and legal structure. Both the International Financial Reporting Standards (IFRS) and the German Commercial Code (German GAAP) provide comprehensive guidelines regarding the consolidation obligation.

Nevertheless, both IFRS and German GAAP stipulate exceptions. For instance, in multi-tiered group structures, certain companies may be exempt from consolidation under specific circumstances. Additionally, the HGB outlines further exemptions based on size criteria.

In conclusion, a purchase price allocation is mandatory whenever a company acquisition results in a change to the group structure and the acquirer is obligated to prepare consolidated financial statements. The precise requirements and exemptions are meticulously outlined in the corresponding accounting standards.

What is the objective of purchase price allocation?

Purchase price allocation is employed to distribute the purchase price paid for a company among its individual assets and liabilities in a transparent and understandable manner. This process serves several primary objectives:

• Recognition of all acquired assets and liabilities: The goal is to encompass not only the assets and liabilities already disclosed in the acquired company's balance sheet but also those acquired through the transaction. This includes intangible assets such as brand rights or customer relationships.
• Reflection of actual values: Rather than adopting the original carrying amounts of assets and liabilities, these are valued at their current fair value during purchase price allocation. "Fair value" represents the amount at which an asset could be sold or a liability settled.
• Determination and disclosure of any goodwill: The difference between the purchase price and the total fair values of all identified assets and liabilities is known as "goodwill." This essentially represents the intangible value of a company arising from factors such as a positive reputation, a robust market position, or effective organization.

Purchase price allocation facilitates a realistic portrayal of the acquired company's assets and liabilities on the acquirer's balance sheet. This is crucial for future group valuations and the determination of intangible asset amortization.

What steps are involved in purchase price allocation?

Purchase price allocation is a three-step process that sequentially addresses the aforementioned objectives:

Step 1: Revaluation of identifiable assets and liabilities

Initially, all assets and liabilities already recognized in the acquired company's balance sheet are revalued at their fair value as of the acquisition date. This also encompasses the disclosure and valuation of so-called hidden reserves or liabilities.

Hidden reserves arise, for example, when an asset is recorded in the balance sheet at a lower acquisition cost than its current market value. Hidden liabilities, conversely, are undisclosed liabilities that can only be identified during the purchase price allocation process.

Step 2: Identification and valuation of intangible assets

Subsequently, all intangible assets developed by the acquired company itself but not previously capitalized in the balance sheet are identified. These include, for example,

• Brands: Powerful brands enhance awareness and acceptance, providing a company with a significant competitive edge.
• Technologies: Patents, licenses, and other technological advancements frequently embody substantial value.
• Customer contracts: Long-term customer contracts offer substantial potential for future cash flow.
• Customer relationships: A well-established customer base can constitute a substantial company asset.

Current market values must be determined for these intangible assets.

Upon completion of the first two stages, the revalued equity of the acquired company becomes available.

Step 3: Determination of goodwill

Finally, goodwill is calculated. It represents the difference between the revalued equity and the purchase price.

This difference embodies the intangible value of the company arising from the aforementioned factors. Deferred taxes on all disclosed hidden reserves must also be considered when calculating goodwill.

These three steps collectively ensure a transparent and understandable allocation of the purchase price.

The outcomes of purchase price allocation significantly influence the Group's future accounting and income statement, particularly concerning intangible asset amortization and the calculation of goodwill impairment tests.

Goodwill: Key distinctions between IFRS and German GAAP

Although the methodology for determining goodwill under IFRS and German GAAP is fundamentally similar, the two accounting standards diverge significantly in their subsequent measurement of goodwill.

IFRS: Impairment only approach

In accordance with International Financial Reporting Standards (IFRS), goodwill is not amortized but is subject to an annual impairment test. It is also subject to an impairment-only approach.

This means that goodwill is written down only if there is concrete evidence that its value has permanently decreased below its carrying amount. Such indications are referred to as "triggering events."

Examples of triggering events include negative business developments, a significant loss in value of similar assets, or a change in the legal framework.

German GAAP: Scheduled and unscheduled depreciation

The German Commercial Code (German GAAP), on the other hand, mandates scheduled amortization of goodwill. As a general rule, goodwill is amortized on a straight-line basis over a ten-year period under HGB.

In addition to scheduled amortization, unscheduled amortization is also possible if there are specific indications of impairment.

Tabular comparison of the differences:

The divergent treatment of goodwill significantly influences the presentation of a company's financial position and profitability:

While IFRS permits a more conservative valuation of goodwill, the scheduled amortization approach under HGB places a greater burden on the income statement.

Badwill: Treatment under IFRS and German GAAP

A special circumstance arises when the purchase price for a company is lower than the sum of its revalued assets minus its liabilities.

This negative difference is known as badwill. It frequently occurs when a company is acquired at a particularly advantageous time (so-called "lucky buy").

IFRS: Immediate recognition in profit or loss

Under International Financial Reporting Standards (IFRS), badwill is recognized as income directly on the income statement in the period of acquisition.

This treatment applies regardless of whether the badwill is attributable to a "lucky buy" or to anticipated future losses. This is due to the assumption under IFRS that a company will not be sold below fair value in ordinary circumstances.

HGB: Passive differences

According to the German Commercial Code (German GAAP), however, a negative goodwill must be recognized. It distinguishes between two scenarios for the treatment of badwill:

• „Lucky Buy“: If this is the case, the badwill is recognized as a negative difference with equity characteristics and released to income over the expected useful life of the acquired assets.
• Expected future losses: If losses are anticipated in the future, the badwill must be recognized as a negative difference with the characteristics of a liability. This must then bear interest at an appropriate rate and be released to the income statement when the expected losses occur.

Tabular comparison of the differences:

The divergent treatment of badwill under IFRS and HGB reflects the differing underlying principles:

While IFRS adopts a more conservative perspective, assuming that a "lucky buy" is atypical under normal circumstances, HGB offers a more nuanced treatment that considers the various causes of badwill.

Goodwill and Cash Generating Units (CGU)

To assess the recoverability of goodwill, IAS 36 mandates impairment testing. These tests must be conducted at least annually to ensure that the goodwill value reported on the balance sheet does not persistently exceed the recoverable amount.

Cash-generating units (CGUs) play a pivotal role in this context. A CGU is defined as the smallest unit within a company that autonomously generates a cash flow independent of the cash flows of other assets or liabilities.

As goodwill, being a residual from purchase price allocation, does not generate independent cash flows, it must be allocated to the identified CGUs for the purposes of impairment testing.

Goodwill is allocated to those CGUs that stem from the acquired business operations. It is essential that goodwill allocation is conducted on a comprehensible and consistent basis. The selection of CGUs significantly impacts the scope and complexity of impairment tests.

By allocating to CGUs, impairment testing can be concentrated on the individual divisions of a company. If negative developments arise within a specific business area, this can be detected early, enabling the initiation of appropriate measures. Allocating to CGUs also enhances the transparency of the balance sheet, facilitating a clearer understanding of a company's assets and risks.

The delineation of CGUs is often a complex endeavor requiring a meticulous analysis of a company's business activities. There is no standardized definition for a CGU, and its delineation can vary from one company to another.

Initially determine deferred taxes, followed by goodwill

The implementation of the first two stages of purchase price allocation, namely the revaluation of identifiable assets and liabilities and the identification and valuation of intangible assets, typically results in so-called taxable temporary differences.

These arise when the carrying amount of an asset or liability in the commercial balance sheet (i.e., the balance sheet used to prepare the annual financial statements) diverges from the corresponding value in the tax balance sheet.

An increase in the carrying amount of an asset results in higher depreciation in the future, consequently leading to lower taxable profits. These anticipated future tax payments are referred to as deferred tax liabilities, which are recognized as a liability on the balance sheet.

An increase in the carrying amount of a liability results in lower interest expenses in the future and therefore higher taxable profits. These anticipated future tax savings are referred to as deferred tax assets, which can be capitalized as an asset.

The amount of goodwill results from the difference between the purchase price and the fair value of the net assets of the acquired company. Since deferred taxes are a component of net asset value, they must be considered before calculating goodwill.

Effects of purchase price allocation in subsequent years - under IFRS and German GAAP

The purchase price allocation influences the subsequent accounting and income statement of a company. In particular, the treatment of goodwill differs significantly between IFRS and HGB.

Under IFRS, the amount of goodwill in the purchase price allocation determines the amount of amortization. Low-value intangible assets reduce these scheduled amortization volumes and also result in higher fixed assets in the long term.

The distinctive feature of IFRS, however, is the impairment-only approach: goodwill is not amortized but only written down if there are specific indications of impairment.

Under HGB, the distinction between goodwill and other intangible assets is virtually ineffective, as both are amortized, often using identical amortization rates.

While IFRS offers companies greater flexibility in the valuation of intangible assets, particularly through the impairment-only approach, the treatment of goodwill under HGB is comparatively more conservative.

Given the more limited valuation options and similar amortization rates, the allocation of the purchase price to goodwill and other intangible assets subsequently has a less significant impact on the balance sheet and income statement.

Conclusion – Purchase price allocation IFRS and German GAAP

Purchase price allocation is a fundamental component of company acquisitions, serving to transparently distribute the purchase price among the acquired assets and liabilities. Both IFRS and HGB provide comprehensive guidelines for this process.

The most significant difference between the two standards lies in the treatment of goodwill. While IFRS adheres to an impairment-only approach, which mandates the amortization of goodwill only if there is evidence of impairment, the HGB prescribes scheduled amortization. Additionally, IFRS offers greater flexibility in the measurement of intangible assets.

The choice of accounting standard significantly influences a company's accounting and income statement. Companies should meticulously consider the specific requirements of the respective standards to ensure a correct and transparent presentation of their financial position.

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