Why Is a Purchase Price Allocation So Important?
FTI Consulting's Joe Suh on how fair value is determined under GAAP reporting requirements.
Generally accepted accounting principles require buyers of real property to prepare a purchase price allocation upon closing of the transaction. As detailed below, a PPA appropriately allocates the purchase price among the tangible and intangible assets. PPA guidance pursuant to FASB Accounting Standards Codification Topic 805 (ASC 805) provides guidelines for determining the fair value of each component, ensuring accurate and compliant financial reporting.
Here are the key reasons a PPA is necessary under ASC 805.
Fair value measurement
ASC 805 requires the buyer to determine and record the acquired assets at their fair values as of the acquisition date. Fair value represents the amount at which the assets could be exchanged between knowledgeable and willing parties in an arm’s length transaction.
Typical tangible asset classifications and the valuation approaches used in estimating fair value include:
Land—Development of an opinion of land value is completed by comparing the subject site to similar, recently sold properties in the surrounding or competing area. Prices being paid for comparably zoned land with a similar use to the subject property should be considered.
Building—A “go-dark” (as if vacant) value is determined based on a discounted cash flow or a direct capitalization approach representing the total value associated with the real property asset categories including land, site improvements and building improvements. For recently built properties, the cost approach (i.e., replacement cost new less deductions for all forms of depreciation) is considered.
Site Improvements—The value of the site improvements (parking, sidewalks, curbs, landscaping, etc.) is estimated based on a review of the physical description. The improvements are placed into related categories and a value is estimated using cost guides, such as Marshall & Swift Valuation Service, taking into consideration physical depreciation, functional and external obsolescence, and other reasonable adjustments.
FF&E—This generally applies only to hotels and multifamily apartments and is estimated based on survey data and cost guides, taking into consideration depreciation and other reasonable adjustments.
Tenant Improvements—Based on market-oriented estimates of comparable improvements, as supported by recent comparable lease data and interviews of local market participants.
Typical intangible asset classifications and the valuation approaches used in estimating fair value include:
Above and Below Market Leases—The difference between any contractual tenant lease and a market lease over the contractual lease term is calculated on a net present value basis.
In-Place Lease Value—Reflects the downtime costs incurred to replace the existing tenant.
Assumed Ground lease—A mark-to-market adjustment calculated based on any positive or negative leasehold value as of the acquisition date.
Assumed Debt—A mark-to-market adjustment calculated based on market-oriented financing terms as of the acquisition date.
Some common errors or omissions associated with improperly prepared PPAs include an allocation of the total purchase price to only land and building without any consideration to the intangible assets. This is typically due to a lack of understanding of ASC 805, relevant valuation concepts, and the technical nature of preparing the calculations.
Accurate financial reporting
By allocating the purchase price among the identifiable assets, a PPA ensures that the assets are properly recognized and disclosed in the financial statements. It provides transparency and enhances the comparability of financial information among similar assets. This information is crucial for investors, creditors and other stakeholders in assessing the financial position and performance of the acquiring entity.
Compliance with accounting standards
ASC 805 establishes the accounting rules and principles for asset acquisitions. Adhering to these standards is important for regulatory compliance, as well as to ensure consistency and comparability in financial reporting. Conducting a PPA allows the acquiring entity to demonstrate compliance with ASC 805 and other applicable accounting standards, providing reliable and auditable financial statements. PPAs typically undergo a comprehensive review by the acquiring entity’s audit firm. A PPA contained within a Restricted Appraisal Report, prepared by a licensed and experienced professional, lends credibility and independence to the analyses. The qualified PPA expert is typically involved during the audit review process, providing support in addressing any audit questions to finalization of the PPA.
Asset management and decision-making
The PPA process provides beneficial information about the value and composition of the acquired assets. It helps management make informed decisions regarding resource allocation, capital investments and growth strategies. For example, if a disproportionate percentage of the purchase price is allocated to the land, it may warrant implementation of a capital improvement program to enhance the building value. Also, the above- and below-market lease estimates can be used as a basis for leasing strategy in signing new and renewal leases. The allocated values of the assets can also assist in evaluating the return on investment and assessing the financial performance of individual assets.
In summary, a PPA under GAAP reporting requirements is necessary to accurately measure and allocate the fair values of acquired assets in compliance with accounting standards. Furthermore, a well-prepared PPA ensures transparent financial reporting that provides stakeholders with reliable information about the value and composition of acquired assets.
Joe Suh is a managing director in the Real Estate Advisory group within the Real Estate Solutions practice at FTI Consulting. Joe specializes in providing valuation and advisory services across a broad range of property types located in the United States and internationally. He has over 20 years of broad-based real estate advisory experience with leading U.S. real estate investors.
The views expressed herein are those of the author(s) and not necessarily the views of https://www.fticonsulting.com/FTI Consulting, Inc., its management, its subsidiaries, its affiliates or its other professionals. FTI Consulting, Inc., including its subsidiaries and affiliates, is a consulting firm and is not a certified public accounting firm or a law firm.