Purchase price allocation is an acquisition accounting and reflects target company net assets acquired (adjusted book value) and price (Purchase price) paid for the acquisition. The difference between the purchase price and adjusted book value of target is called ‘goodwill.
= Value of cash or stock consideration + Target employee Past service benefit that have no future benefit + acquisition related cost (Prior to Dec 2008)
Adjusted book value is the fair value of the assets acquired adjusted for the growth opportunity.
Short history of Acquisition accounting
A decade ago, there were two methods of merger accounting at least in United states, Pooling and Purchase price allocation and the acquirer can pick any from these two
Pooling or pooling-of interest
Under this method the acquirers only consolidate the book value and disregard or conceal the goodwill or the premium paid. To do that acquiring firm was required to jump through hoops and some of which are very expensive.
Under this method, difference between the market value of assets acquired and price paid is treated as goodwill and amortized over fixed period not to exceed 40 years and also amortization was not tax deductable.
Amendment to Acquisition accounting
Due to these two different methods of merger accounting comparison was tricky and also amortization of goodwill treat both the good and bad acquisition in same way, therefore in June 2001 rules were amended and pooling system was discontinued. Also accountants were required to revalue the acquired company and impair the goodwill rather than amortizing the goodwill. Also some intangible assets like customer list and technology patent can be added to the target firm to some extent.
These changes were meant to bring more transparency for the investor about the acquisition cost and more accountability for bad acquisition.