Answers needed for flaws in M&A accounting standard

How the IFRS standard for business combinations values intangible assets should be rethought, some say.

In the second half of 2014, an enigmatic notice appeared on the International Financial Reporting Standards (IFRS) website. It called for tenders to place a value on IFRS’s intellectual property — that is, on the brand. But what’s most interesting is not the reasons behind the effort, but rather the tacit support it implied for the valuation of brands. After all, counting brands as assets is only partially tolerated under accounting standards.It’s probably no more than coincidental, but the call for tenders appeared just months after the closing date for submissions to the International Accounting Standards Board’s post-implementation review (PIR) of IFRS 3 — Business Combinations.

The purpose of the PIR was to find out from users of the standard whether it was “working as intended.” By the closing date of May 31, 2014, some 100 letters had been received from global regulators, business associations, accounting bodies, academics, professionals, and individuals involved in accounting for mergers and acquisitions. Users generally thought the standard was useful, but they were less impressed with the techniques available to measure the intangibles that were identified for Purchase Price Allocation (PPA). These, they thought, were complicated, time consuming, and expensive.

Similar responses were sent to the U.S. Financial Accounting Standards Board in 2013, when it conducted a PIR regarding its parallel standard for business combinations, ASC 805.

This is a serious challenge to the valuation industry and the range of methods offered. “Brand values vary wildly,” Allan Teixeira, senior technical director at the IASB, told The Economist last year. In a global investment environment in which intangible premiums represent as much as 80% of total value and in which brands make up more than 50% of intangibles identified in business-combination PPAs, this problem needs to be addressed.

Time for a new approach

The villain of IFRS 3 could be the oddly named but popular Relief from Royalty technique for valuing trademarks. It assumes that a company owns its trademark, but that if it didn’t, it would have to pay a license fee to a third party for its use. The value of the asset is the discounted present value of the stream of after-tax royalty payments the company is relieved from paying. The technique is embedded in the tool boxes of accounting firms, banks, and trademark attorneys who specialize in this form of intangible asset.

At first examination, it is a simple and universally applied approach. Closer examination reveals inconsistencies and flaws:

Royalty rate: The royalty rate is critical to the calculation, yet there is no standard way to estimate it. There are mathematical models in the finance literature, but most are too complex for everyday use and some obfuscate simple approaches with complex equations. There are two frequently used approaches: referencing to royalty databases, and variations on the 25% rule.

A number of companies scan the media and compile reported data for royalty or license-fee transactions. Thus it is possible for a company to take a market-based approach by buying from these companies information on royalty rates applied in the company’s industry or similar ones. The problem is that royalty-rate information is thin in many categories: there is insufficient data to form a firm idea of what rate to use. Often when data is available, it has been accumulated over a number of years and thus some of it might be out of date. There is a circular problem too: a proportion of the rates quoted could have been sourced from the royalty-recording companies themselves.

The 25% rule was established in the 1950s as an observed pattern: the mean share of gross profit (the ratio of operating profit to revenue) is 75% to the licensee and 25% to the licensor. This “rule” has been applied as what many valuers describe as a “starting point.” While it is frequently used, there is no standard approach to modifying the 25% rule to suit different circumstances.

This is a major criticism of Relief from Royalty and why many, including responders to the PIR, consider it too subjective. Efforts by academics to standardize the “rule” have actually increased the confusion, because while the original stated that the ratio was operating profit to turnover, it is common today to select EBIT, EBITDA, or any expression of profit in between. Sadly, 25% of the EBIT-to-revenue or EBITDA-to-revenue ratio will differ from the operating-profit-to-revenue ratio.

Useful life of asset: Accounting standards require assets to be valued over the length of their useful economic lives. But what is the useful economic life of an intangible asset? A patented drug has a legally known life — that is, until the patent expires. But it has been shown that a large proportion of brands seen on supermarket shelves or vehicle showrooms, for instance, have existed for half a century, and some iconic brands, like Coca-Cola, Kellogg, and Mercedes-Benz, have been with us for more than 100 years.

Some experts say that this is not a problem, because with discounted cash flow, there is no value after a decade and a half. That is not so. A simple test shows that at the discount rates being applied today, which can be as low as 5%, there is still value at 40 years and beyond.

The example given above for pharmaceuticals provides a solution when there is a finite life, but the standard setters have disturbed English grammar by insisting that the antonym of finite in the case of an asset is not “infinite,” but rather “indefinite.” Further, they state that if an intangible asset has an indefinite life it is not to be amortized, but rather carried on the balance sheet at its original value (at the time it was acquired, not developed) and tested annually for impairment.

This renders the frequently used method of establishing a residual — calculating a growing perpetuity on the nth year — totally inappropriate, because it projects cash flows to infinity whereas an indefinite period is called for. This creates a conundrum. Some use the annuity — a device used to add on an amount to the calculated value to account for the long-lived life of an intangible asset — and add a large amount to the value that arises from dividing the nth year, after a discount factor has been applied, by the discount rate. Or the need to model a long life is ignored altogether.

To some extent this is dealt with by adjusting the number of years in the forecast schedule, normally between five and ten years. Either way the choice is subjective and fails to account for the indefinite useful life of the brand.

Taxation amortization benefit (TAB): In some tax jurisdictions, it is permitted to claim the annual amortization of the goodwill amount as an allowable expense. Thus when calculating the value of an intangible using discounted cash flow, valuers estimate what this tax saving would be and add it to the value, because the owner of the trademark would normally claim it. It should be clear therefore that TAB is appropriate only when there is a finite useful economic life. If the economic life is indefinite the asset is carried in the balance sheet and tested for impairment, but there is no TAB. This self-evident fact is often ignored, leading to further inconsistency.

A solution in sight?

Thomson Reuters recently announced that the 4,000 mergers and acquisitions it counted for 2014 had a total value of $3.5 trillion. Thus, it would seem important that the world’s valuation industry should examine how it goes about its work and adopt a system that answers the criticisms that came forth in both the PIR conducted by IASB last year and FASB’s earlier PIR.

An approach is called for that is uncomplicated, uses observable inputs where possible, is simple to apply, and is not expensive to conduct.

For the past three years the U.S. Marketing Accountability Standards Board (MASB) — created in 2004 in part to establish stronger accounting treatment of the hundreds of billions of dollars companies spend every year promoting their brands — has been working to develop such a model. Initially, it’s being designed for internal use in linking marketing activity to company finances, but in time it could be extended or modified to become a globally accepted way of measuring intangible assets, and brands in particular.

The IASB’s PIR makes clear that the capital markets and their record keepers, together with those who spend money on marketing, are in urgent need of an intangible asset valuation approach that can be used affordably and with confidence. They do not think Relief from Royalty fits this bill.

In the absence of such an alternative, the standard setters might conclude that the business combination standards should be retrogressed to where they were at the turn of the century. That backward step would fly in the face of the intangible nature of the contemporary world economic structure. The new MASB approach might come not a moment too soon.

Source: CFO – By Roger Sinclair and Michael L. Moore

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