As we explored in this post, M&A activity has spiked of late and is expected to continue in the near future. As a result, it makes sense for accountants to brush up on the proper accounting for business combinations under ASC Topic 805. This post continues our exploration into some of the more complex areas of accounting for business combinations. In last week’s post, we discussed determining whether a transaction qualified as a business combination or as an asset acquisition. This week, we’ll explore another common issue accountants face when accounting for a business combination: properly identifying and valuing intangible assets acquired in accordance with ASC 805 and ASC 350.
Assuming the transaction qualifies as a business combination, the acquirer is required to identify ALL the assets acquired and liabilities assumed, regardless of whether or not they were previously recorded by the entity being acquired. With respect to the assets acquired, this includes not only tangible assets such as inventory and property, plant, and equipment, but also intangible assets.
U.S. GAAP requires intangible assets to be separately recognized apart from goodwill if they are (a) separable or (b) arise from contractual or legal rights. The list of intangible assets that could be recognized is quite long, and includes assets such as:
- Trademarks and trade names
- Non-competition agreements
- Order or production backlog
- Customer contracts and related customer relationships
- Customer lists
- Lease agreements
- Licensing, royalty, and standstill agreements
- Use rights (e.g. drilling, water, timber, etc.)
- Patented technology
- Trade secrets (e.g. formulas, recipes, processes, etc.)
And that’s just the tip of the iceberg!
Identifying a complete list of intangible assets is not an easy task, especially given the fact that most are not recognized on the acquiree’s balance sheet. Make sure your company (or your client, if you’re an auditor) is performing a thorough analysis to identify all of the acquired intangible assets.
A Private Company Alternative
But wait just a second…maybe your company or client does not have to record all of the intangible assets acquired. Is your company or client a private company? If so, the Private Company Council (PCC) issued guidance that provides an election to certain private companies that allows them to apply an accounting alternative with respect to recognizing or otherwise considering the fair value of intangible assets as a result of any transactions within the scope. The theory behind this change was that identifying and valuing certain intangible assets burdens private companies with undue costs and time – and the benefits weren’t outweighing those costs. This accounting alternative allows private entities to no longer recognize separately from goodwill:
- Customer-related intangible assets unless they are capable of being sold or licensed independently from the other assets of the business, and
- Non-competition agreements
So, what are some examples of customer related intangible assets that may meet that criteria? Examples could include mortgage servicing rights, commodity supply contracts, core deposits, and customer information.
The catch? Any private entity wishing to cash-in on this simplified accounting must also elect to apply the PCC guidance allowing private companies to amortize goodwill.
Valuation of Intangible Assets Acquired
And to add to the complexity, let’s think about how we measure these intangible assets – at fair value. How do you do it? Typically, you’ll see 3 common income approach valuation methods used:
- Relief-from-Royalty – This method determines the fair value of an intangible asset by reference to the capitalized value of the hypothetical royalty payments that would be saved through owning the asset, as compared with licensing the asset from a third party.
- With-and-Without Method – Also known as the incremental cash flow method, this method measures the benefits (e.g., cash flows) derived from ownership of an intangible asset as if it were in place, as compared to the expected cash flows if the intangible asset were not in place. The residual or net cash flows of the two models are ascribable to the intangible asset and, when discounted to its present value, provide an estimate of fair value.
- Multi-Period Excess Earnings Method (MPEEM) – This method involves forecasting the cash flows that a market participant would expect to derive from the business or businesses that use the subject intangible asset. From this forecast of cash flows, the entity deducts the contribution to the cash flows made by contributory assets, tangible and intangible, other than the subject intangible asset. The remaining cash flows are attributable to the subject intangible asset and, once discounted to its present value, provide an estimate of fair value.
As you can see, the valuation of intangible assets acquired in a business combination typically involves sophisticated models using unobservable inputs (i.e. Level 3 fair value measurements). This is why management typically engages specialists to value these assets. Remember that although they are using a specialist, this does not relieve them of their overall responsibility for properly accounting for the business combination.
When management determines that they have a business acquisition that needs to be accounted for using the acquisition method, management should recognize all intangible assets acquired – even those that were not recorded on the acquiree’s balance sheet – at fair value at the acquisition date. The only exception to this rule is for private companies opting to follow the FASB PCC’s guidance, which excludes certain customer related intangibles and non-compete agreements. Valuation of intangible assets acquired at fair value also involves judgement, as many of the models used to determine the fair value are income approach-based models that rely heavily on third party or unobservable inputs. Remember, if your entity or your client chooses to engage a third party specialist to assist in the valuation, management is still responsible for that estimation. Management needs to have a sound understanding of the key inputs and assumptions used in the model and be able to defend why that valuation approach was appropriate.