Purchase Price Allocation: How Goodwill Is Really Calculated (With a Worked Example)

When one company buys another, the buyer almost never pays exactly what the target's balance sheet says it's worth. So where does the extra money go? Purchase price allocation (PPA) answers that question, and it's a favorite topic in technical interviews.

If you can walk through a PPA cleanly, you'll handle questions on goodwill, deferred taxes, merger models and accretion/dilution much more easily. Let's build it step by step with real numbers.

What Purchase Price Allocation Actually Is

Purchase price allocation is the accounting process of spreading the price paid for a company across the assets and liabilities you acquired, at their fair values.

Under US GAAP (ASC 805) and IFRS (IFRS 3), the buyer must:

• Recognize the target's identifiable assets and liabilities at fair value, not at the old book values
• Record any leftover amount as goodwill

Here's the core formula to memorize:

Goodwill = Purchase Price − Fair Value of Net Identifiable Assets

Goodwill is the "plug." It captures what you paid for that isn't separately identifiable: synergies, the assembled workforce, market position, and plain old overpayment.

Why Bankers Care About PPA

PPA isn't just an accountant's chore. It directly changes the numbers in your merger model:

• Asset write-ups create extra depreciation and amortization, which lowers the combined company's net income and EPS
• Write-ups can create deferred tax liabilities, which show up on the pro forma balance sheet
• Goodwill sits on the balance sheet and can later be impaired, which hits earnings

If a buyer's EPS looks less accretive than expected, new D&A from the PPA is often part of the reason.

The PPA Process in 5 Steps

Step 1: Start With the Equity Purchase Price

This is what the buyer pays for the target's equity. For a public company, it's the offer price per share times diluted shares outstanding.

Step 2: Take the Target's Book Value of Equity

This is shareholders' equity on the target's balance sheet, which equals book assets minus book liabilities.

Step 3: Write Off the Target's Existing Goodwill

The target's old goodwill came from its past acquisitions. It isn't an identifiable asset, so it gets wiped out and replaced by new goodwill calculated from this deal.

Step 4: Write Up Assets to Fair Value

Common write-ups include:

• PP&E: old factories and equipment may be carried well below what they're worth today
• Identifiable intangibles: customer relationships, brand names, patents, technology, often never recorded on the target's books because they were built internally
• Inventory: sometimes stepped up as well

Liabilities can be adjusted to fair value too, but in interviews the focus is almost always on asset write-ups.

Step 5: Account for Deferred Taxes, Then Plug Goodwill

In a typical stock purchase, the buyer gets a new book basis in the assets but keeps the old tax basis. That gap creates a deferred tax liability (DTL):

New DTL = Total Asset Write-Ups × Tax Rate

Why a liability? Going forward, the company will record more depreciation on its books than it can deduct for taxes. So book taxes will be lower than cash taxes, and the DTL tracks that future cash tax "owed."

Finally, whatever remains of the purchase price is goodwill.

Worked Example: Let's Run the Numbers

Say BuyerCo acquires TargetCo for $1,000 million in an all-stock purchase of its shares. Here's what we know:

• TargetCo's book value of equity: $400M
• TargetCo's existing goodwill: $50M
• PP&E write-up: $100M
• New identifiable intangibles (customer relationships): $150M
• Tax rate: 25%

(To keep things clean, we'll ignore the target's pre-existing deferred tax balances.)

Calculating Goodwill

So BuyerCo records $462.5M of new goodwill. Notice how the DTL increases goodwill: a new liability lowers net identifiable assets, which leaves a bigger plug.

What It Does to the Income Statement

Assume the PP&E write-up is depreciated over 10 years and the customer relationships are amortized over 5 years:

• Extra depreciation: $100M ÷ 10 = $10M per year
• Extra amortization: $150M ÷ 5 = $30M per year
• Total extra D&A: $40M per year (pre-tax)
• After-tax hit to net income: $40M × (1 − 25%) = $30M per year

That $30M reduction flows straight into the combined company's EPS, which is exactly what you'd capture in an accretion/dilution analysis.

What Happens to the DTL Over Time

Each year, book D&A exceeds tax D&A by $40M. That creates a $10M difference between book taxes and cash taxes ($40M × 25%).

So the DTL unwinds by $10M per year, from $62.5M down toward zero over the life of the write-ups. On the cash flow statement, the DTL decrease shows up as a cash outflow under operating activities, since cash taxes are higher than the book tax expense.

What Happens to Goodwill After the Deal

This is a classic follow-up question, so get it straight:

• Goodwill is not amortized under IFRS or for public companies under US GAAP. (Private companies under US GAAP can elect to amortize it, but interviews almost always assume a public company.)
• It's tested for impairment at least annually. If the acquired business underperforms, the buyer writes goodwill down.
• An impairment is a non-cash charge that reduces net income, gets added back on the cash flow statement, and lowers goodwill and equity on the balance sheet.

Identifiable intangibles are different. Finite-lived intangibles like customer relationships are amortized. Indefinite-lived intangibles like certain trademarks aren't amortized but are tested for impairment.

Stock Deal vs. Asset Deal: The Tax Twist

Everything above assumes a stock purchase, where the tax basis carries over and you get a DTL.

In an asset purchase (or a stock purchase treated as an asset purchase for tax, such as a Section 338(h)(10) election), the buyer gets a step-up in the tax basis too. That changes things:

• No new DTL is created, because book and tax basis match
• Write-ups are tax-deductible, so the buyer gets real cash tax savings
• Goodwill is tax-deductible in the US, amortized for tax purposes over 15 years

That's why buyers often prefer asset deals, and why sellers sometimes push back: asset deals can create a worse tax outcome for the seller.

Common Interview Questions (and How to Answer Them)

"Walk me through how goodwill is calculated in an acquisition."

Start with the purchase price. Subtract the target's book value of equity after writing off its existing goodwill. Then subtract asset write-ups and add back the new DTL created on those write-ups. Whatever's left is goodwill.

"Why does a deferred tax liability get created?"

In a stock deal, assets are written up for book purposes but not for tax purposes. The company will record more D&A on its books than it deducts on its tax return, so future cash taxes will exceed book taxes. The DTL reflects that.

"What if the buyer pays less than the fair value of net assets?"

That's a bargain purchase. Instead of negative goodwill, the buyer first double-checks its valuations, and if the gap is real, it records a gain on the income statement. It's rare, usually seen in distressed sales.

"What happens to transaction fees?"

Under current US GAAP and IFRS, advisory and legal fees are expensed, not added to goodwill. Debt financing fees are treated differently: they're capitalized and amortized over the life of the debt, typically presented as a reduction of the debt balance.

"What if the buyer acquires 80%, not 100%?"

If the buyer gains control, it still consolidates 100% of the target's assets and liabilities at fair value. The 20% it doesn't own shows up as noncontrolling interest in the equity section.

Quick Cheat Sheet

• Goodwill = Purchase Price − Fair Value of Net Identifiable Assets
• Old goodwill gets written off, new goodwill gets created
• Write-ups → more D&A → lower net income and EPS
• Stock deal → new DTL = write-ups × tax rate
• Asset deal → tax step-up, no new DTL, tax-deductible goodwill
• Goodwill isn't amortized (for public companies), just tested for impairment

The Bottom Line

Purchase price allocation comes down to one idea: restate what you bought at fair value, and call the rest goodwill. Once you see why write-ups create D&A and why that creates a DTL, the whole chain of effects clicks.

Practice the worked example above with your own numbers a few times. Change the tax rate, the write-ups, or the deal structure, and make sure you can explain every line out loud. That's exactly the fluency interviewers are testing for.