Valuing Intangibles for Financial Reporting: Understanding the Interplay of FASB Statements
Business Valuation Advisor, Fall 2007

Twenty years ago, most mergers and acquisitions involved the traditional “bricks and mortar” companies, and most of the assets were tangible–real estate, plant, property, and equipment. The old accounting rules, which governed purchase price allocations, tended to throw everything into goodwill, amortized over 40 years.

But the Internet changed the focus of the U.S. economy to assets of the “information age” and transactions involving technology companies. The Financial Accounting Standards Board (FASB) began looking at the billions of dollars in business combinations being allocated to goodwill and decided that, in an acquisition, the fair value of specific intangible assets should be recognized and placed on the balance sheet, amortized over a remaining useful life. That’s when FASB Statements of Financial Accounting Standards (SFAS) No. 141, 141R, and 142 appeared on the scene. Now there are more M&A transactions with assets tilted toward intangibles, requiring a sound understanding regarding intangible valuations.

Identifying Intangibles

Paragraph 39 of SFAS 141 (Business Combinations) states: “An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights or, if not contractual, only if it is capable of being sold, transferred, licensed, rented or exchanged.”  Examples of intangible assets that meet these criteria are:

• Marketing-related: trademarks, trade names, trade dress, Internet domain names
• Customer-related: customer lists, order backlog, customer relationships
• Artist-related: plays, books, videos, musical works
• Contract-based: licensing rights, supply contracts, leases, franchise rights
• Technology-based: patents, software, databases, trade secrets, IPR&D (in- process research and development)

Generally, SFAS 141 provides for allocation of the identifiable intangibles on the date of acquisition, and then SFAS 142 (Goodwill and Other Intangible Assets) provides a test for impairment of those assets in the years following the acquisition, as these assets are no longer amortized. SFAS 142 also tests for impairment of indefinite-lived intangible assets (such as a trade name) for which a useful life may not be readily estimated.

Additionally, in its currently proposed Statement 141R (Business Combinations: Applying the Acquisition Method), the FASB would require contingent assets and liabilities to be recorded at their fair values as of the acquisition date. Similarly, 141R would capitalize IPR&D—technology that’s in process as of the acquisition date but not fully developed; it would be considered an indefinite-lived intangible asset until it became developed, at which point a life would be assigned. This revised statement will eventually create an even greater emphasis on estimating the fair value of IPR&D.

Finally, SFAS 144 (Accounting for the Impairment or Disposal of Long-Lived Assets) governs the impairment testing for definite-lived intangible (and tangible) assets, which are subject to amortization in the years following the acquisition.

Factoring FAS 157 into Intangible Valuations

There are now nearly three dozen FASB statements that mention fair value, and FAS 157 (Fair Value Measurements) attempts to clarify these by: (a) defining fair value; (b) establishing a framework for measuring fair value in GAAP; and (c) expanding disclosures about fair value measurements. (Note: SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007.)

In this context, the FASB is trying to match the actual transactions taking place with their purpose and their pricing value from an exit perspective. Compared to the definition of fair value in FAS 141, the definition in SFAS 157 is much cleaner:

SFAS 141: “Fair value is the amount at which that asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties; that is, other than in a forced or liquidation sale.”

SFAS 157: “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Of course, this still raises questions regarding “market participants” and “orderly transaction,” but in general, SFAS 157’s definition of fair value is much closer to fair market value. Because it theoretically eliminates synergies from any particular buyer, SFAS 157’s definition is not as close to investment value, unless the market participants would generally recognize them.

Reconciling Fair Value for Financial Reporting with Other Purposes

It’s critical to understand the nuances between the various FASB statements and their requirements. There is a difference between valuing intangible assets for financial reporting and for other purposes, and some of the methodologies recommended in the FASB pronouncements may not be appropriate in other venues. Essentially, a valuation for financial reporting purposes should follow the dictates of its particular context.