How is acquired inventory measured in a purchase price allocation, and what is the income statement effect when that inventory is later sold?

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AcadiFi · Accepted Answer

In a business combination, acquired inventory must be measured at **fair value** on the acquisition date — not at the target's historical cost. The approach differs by inventory stage, and the post-acquisition income statement impact can be dramatic. **Fair Value by Inventory Category** | Category | Fair Value Basis | Typical Step-Up | |---|---|---| | Finished Goods | Selling price less disposal costs and a reasonable profit on selling effort | Moderate to large | | Work-in-Process | Selling price less completion costs, disposal costs, and profit on remaining effort | Moderate | | Raw Materials | Current replacement cost | Small | **Worked Example — Denham Industries acquires Kelton Manufacturing:** Kelton's inventory has a book value of $28 million. The PPA team assigns fair values: | Item | Book Value | Fair Value | Step-Up | |---|---|---|---| | Finished goods | $12M | $16.5M | $4.5M | | WIP | $9M | $11.2M | $2.2M | | Raw materials | $7M | $7.4M | $0.4M | | **Total** | **$28M** | **$35.1M** | **$7.1M** | **The Inventory Step-Up Burn** When Denham sells the acquired finished goods in Q1 post-acquisition, COGS reflects the $16.5M fair value — not Kelton's old $12M cost. This creates a **one-time margin compression**: \`\`\`mermaid flowchart LR A["Acquisition Date
Inventory = $35.1M FV"] --> B["Q1 Post-Close
Sell Finished Goods"] B --> C["COGS at FV = $16.5M
(was $12M book)"] C --> D["Gross Margin
Compressed by $4.5M"] D --> E["Q2+ Normalize
New production at
normal cost"] \`\`\` **Key Points for the Exam:** 1. The step-up is **non-recurring** — analysts typically adjust it out when evaluating normalized earnings. 2. Under both IFRS 3 and ASC 805, the fair value methodology is identical for inventory. 3. Goodwill is affected: a larger inventory step-up reduces the residual goodwill figure. 4. Finished goods see the biggest step-up because they embed the target's full manufacturing margin. Check our CFA Level II FRA modules for detailed PPA walkthroughs and practice problems.

How is acquired inventory measured in a purchase price allocation, and what is the income statement effect when that inventory is later sold?

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