A company wishes to acquire a particular target company for a variety of reasons. After much negotiation, a purchase price of $30B is agreed upon by both sides. As of the acquisition date, the target company reported net identifiable assets of $8B on its own balance sheet.
Before the target company can complete the acquisition, the target must appraise the assets and liabilities being acquired to determine their Fair Market Value ("FMV") -- the price a willing buyer would pay, and a willing seller would receive, through an arm's length transaction in a market with perfect information. The acquirer hires an appraisal firm (typically an external accounting firm or a valuation advisor) who reports that the FMV of the net assets is $24B.
The figure below walks through the difference between the three values ($8B, $24B, and $30B).
The difference between the $8 and $24 is $16B in write-up -- the values of the net identifiable assets are in effect increased to 3 times the value reported on the original balance sheet. The difference between the $24B and $30B is $6B in goodwill acquired through the transaction—the excess of the purchase price paid over the FMV of the net identifiable assets acquired.
Finally, the acquirer adds both the value of the written-up assets ($24B) as well as the goodwill ($6B) onto the balance sheet, for a total of $30B in new net assets on the acquirer's balance sheet.
Collectively, the process of conducting the appraisal, reporting the FMV of the assets and liabilities, the allocation of the net identifiable assets from the old balance sheet price to the FMV, and the determination of the goodwill in the transaction, is referred to as the PPA process. Note that a purchase price may be less than the target's balance sheet value for a variety of reasons, which can lend itself to a write-down of net assets.
The process of valuing goodwill, while a component of the PPA process, is governed through goodwill accounting.
Read more about this topic: Purchase Price Allocation
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