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The shake-up in merger accounting rules requires buyers to identify and more tightly value such assets as patents, know-how, and trademarks.
By Gordon Petrash
Chief Intellectual Property Strategist at Delphion Inc.
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Thanks to the new merger accounting rules promulgated by the Financial Accounting Standards Board (FASB), investors and other corporate stakeholders can gain unprecedented visibility into the way companies manage their intangible assets. The portion covering treatment of intangibles was not the most highly publicized feature of the controversial rules put into effect in mid-2001. But the new mandate is likely to be the start of something much more significant in the way companies account for their intangible assets, which frequently represent the largest portion of the value in 21st Century acquisitions involving technology-dependent companies.
Aside from impacting the increasing incidence of M&A linked to technology and so-called "soft" assets, the timing of the changes are important because corporate stakeholders are demanding greater accounting transparency. As a result, companies must take steps to better articulate, measure, and manage their intangible assets. For acquirers and their professional advisers, the challenge is not only to improve their due diligence of intangible assets at target companies but to assemble new competencies that enable them to address the unique issues of these assets.
FASB's New Rules
The new rules (FASB 141 and 142) are best known for eliminating pooling-of-interest accounting treatment for mergers and acquisitions and requiring companies to test the goodwill in their balance sheets annually and immediately write off any that has become impaired. The sections dealing with intangibles require companies to identify, describe, and value certain classes of intangible assets to a greater degree than they did before. They affect a wide range of assets, including patents, trademarks, logos, brand names, technology advancements, and other non-physical attributes.
Before the rules changes, all that companies involved in acquisitions, joint ventures, or similar transactions had to do was lump intangible assets with other considerations and call it goodwill. There has certainly been a lot of gamesmanship with goodwill, including what assets companies put into that category and what they don't, as well as how the assets are valued and depreciated. Historically, companies have been able to spread the results of their decisions — good or bad — over long periods of time, sometimes as much as 40 years, without having to show much detail.
Now, companies must recognize certain intangible assets separate from goodwill. These assets must be accounted for and, in some cases, depreciated over specific and more compacted periods of time. Acquiring companies must not only account for them at the time of the merger but, in some cases, continuously over future periods. The remaining goodwill must be written down if the annual tests find it to be impaired.
The Market Impact
Some companies are already experiencing the impact of these rules. Analysts estimate that in 2002, the first time impairment tests must be conducted, companies will write down as much as $1 trillion of goodwill created when they overpaid for acquisitions or bought properties that have not performed as expected. AOL Time Warner Inc. grabbed headlines by announcing plans to write down as much as $60 billion this year in overvalued goodwill, most of which resulted from the merger that created the media giant in 2001. What companies were once able to depreciate over a longer period of time, they frequently must get rid of at one time under the new accounting strictures.
Situations like these may not make a difference in the decisions of two companies to merge, but they will put more pressure on them to justify the valuations they use. Shareholders would be better able to understand the expected impact on the merged entity's future and the resulting stock price if they knew how much of a purchase price is related to intangibles and how important acquired intangibles are to the combined organization.
If companies are able to articulate goodwill and demonstrate its value in their new business context, there is an opportunity to have it reflected in their stock prices in a positive way. If they can't articulate and value it convincingly, shareholders may discount the prices of their shares. Historically, management hasn't had to pay attention to those details very much, but the business environment has changed.
For instance, investors and other stakeholders increasingly want to understand more clearly how a company's research and development dollars are being spent and what return on investment (ROI) is being earned on those outlays. The objective is to get more successes for R&D dollars. Determining success or failure requires an ability to measure R&D financial effects. One way managements can do this is by tracking the R&D spending on a new product across the complete process - from development through commercialization. Then they can compare those costs with the sales generated by the new product. Finally, they can calculate an ROI generated from R&D expenditures on the new product.
In this way, a company can show its investors that if, for example, it spends $100 million on R&D, it can get a return of 25% in new product sales, thereby persuading investors to be confident that investment in R&D today will produce value in the future. And they can better understand how investments in training, communications, and other areas improve R&D as a whole. Dow Chemical Corp., which is heavily dependent on internally generated new products, is one company that has been reporting an ROI on its R&D expenses for more than five years.
Baruch Lev, an accounting and finance professor at New York University, notes that the investments in R&D, human resources, and customer acquisition are key drivers of corporate performance today. Yet the value of these investments is not being represented in financial reports. That's due for a change under the new accounting rules.
Shareholders are going to demand that companies pay attention to the valuing of intangibles while managers who want to succeed will want to know what the ROI on expenditures for intangibles is going to be so they can prioritize outlays in limited budgets. They will try to improve returns on the investments in those intangibles by using best practices for measuring and managing them.
Gaining Competitive Advantage
There is an opportunity today for companies to gain a competitive advantage by better managing their intangible assets, and some firms already are beginning to leapfrog their competition by managing their intangibles well. They are winning disputes in court and getting better at acquiring businesses with value-creating intangibles. They have more robust brands because of the market's strong, positive perception of their reputations and quality. They are better able to invest their money optimally because they can gauge the returns on their investments in intangible assets. And they're making better deals.
For example, a host of companies are acquiring intangible assets from failed dot-coms. These forward-thinking buyers are making themselves stronger and positioning themselves for growth by gaining intellectual property, customer lists, and talent that have value even though the original owners did not survive. In 2001, companies paid nearly $40 billion to buy all or part of 1,289 dot-coms. The acquiring companies are gaining a competitive advantage because, in most cases, they know both what intangible assets they already have and what they can use to increase corporate value. They have the information they need to make wise decisions regarding intangible assets.
In the due diligence prior to the closing of a deal, the more knowledge acquirers have about their own intangible assets and the target's intangible assets, the better the deal they are likely to make. Historically, it hasn't been unusual for such due diligence to be done after the closing of a deal, often simply to justify its cost or allocate the purchase price for tax purposes. That has led to some disastrous mistakes from assigning wrong values to intangibles to overlooking them altogether to failing to obtain assets that were supposed to be key elements of the transaction. In one of the most publicized investigative miscues, Volkswagen AG bought Rolls-Royce Motor Cars Ltd. in the U.K., only to find it could not use that coveted trademark, one of the deal's primary attractions, for five years.
How do companies gain more value from their intangible assets? They need to start by having a comprehensive portfolio of these assets and a systematic method of identifying the important intangibles and compiling necessary information about them. It's important to have a recognized valuation tool to determine which of the assets are the crown jewels. This should include the assets that are important today as well as the ones with potential to be important in the future. The process also includes identifying the assets that can be ignored or purged.
The process of creating a portfolio can be arduous but it's critical. It most often starts with the low-hanging fruit, like patents and other intellectual property. It can then expand into broader areas, like know-how, brands, and business agreements.
Once an acquiring company has an inventory of its own intangible assets, it is in position to conduct a proper assessment of the intangible properties of the target so it really knows what it is getting. Many of the intangible assets of a company are kept secret from outside parties but because of regulations and reporting mechanisms, it is hard to keep them all under wraps. I have been involved in deals in which the acquiring party has known significantly more about the intangible assets of the target than the seller's management did. That in-depth knowledge can offer a tremendous advantage to experienced acquirers who can equate it with true value.
Expanding Skills
While context is a key consideration for determining the values of assets in all M&A deals, it plays a greater part in the valuation of intangible assets than it does for their tangible counterparts. Depending on the context — the social or geopolitical environment for example — the value of an intangible asset can swing much higher or lower than that of a tangible asset.
As a result, the business world's increasing focus on intangible assets will mean that M&A pros will need to demonstrate an even greater ability to analyze business context. When viewed only on the basis of hard numbers, an asset may look attractive. But when other "soft" factors are taken into consideration, the asset may lose luster.
Fully understanding and analyzing the context surrounding a business transaction requires different competencies than usually have been associated with M&A. Many M&A pros have come up through the traditional ranks of a company, with service in such areas as sales, finance, marketing, and manufacturing. But to determine the value of intangibles, they also will need skills associated with legal, human resources, public affairs, and taxes and accounting.
For example, M&A professionals increasingly will be called on to consider the impact on value of such elements as the joining of corporate cultures. The likelihood that two companies will be able to successfully merge their cultures more than ever impacts the value of a deal. If one company emphasizes participatory management and the other hierarchical management, their ability to unite is going to be hindered unless they execute realistic plans to bridge the differences. Merger professionals also need the skills to deal with external considerations - such as how society will perceive a transaction or how government will respond - which also have great impact on the value of intangibles.
The business world is entering a new era, one in which intangible assets of many companies are the principal sources of value and the primary means for increasing value. The FASB's new rules are the most recent recognition of this new reality, foreshadowing increased pressures for accounting transparency, particularly in the area of intangible assets. It is imperative for companies involved in M&A to sharpen their focus on the intangibles they are buying and subsequently will be managing.
As published in Mergers and Acquisitions Journal, May 01, 2002.
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