by phil aNtooN
agreements; databases; core deposits;
mortgage servicing rights; copyrights;
film, music libraries; licensing and royalty agreements; communications licenses;
reserves; backlog; contracts; and leasehold Interests.
There are three generally accepted methodologies to estimate the value of intangible assets: the income approach, the market approach and the cost approach.
Income approach. This is typically the most applicable approach when valuing income-producing intangible assets, as value is measured by calculating the present value of future economic benefits to be derived by the asset. The two most frequently used variations of the income approach are the excess cash flow method and the royalty savings (or relief from royalty) approach.
The principle behind the excess cash flow method is that the fair value of an income-generating intangible asset is measured by the present value of its projected future cash flows, over its remaining useful life.
To estimate excess cash flows, revenues attributable to the intangible asset are first projected over the remaining useful life of the asset. Next, expected costs, including cost of sales, operating expenses and income taxes, are deducted from projected revenues to arrive at after-tax cash flows.
From after-tax cash flows, depreciation is added back and after-tax contributory charges (for the use of tangible and other intangible assets) are deducted to arrive at the excess cash flows specifically attributable to the intangible asset. These excess cash flows are then discounted to the present and summed to arrive at the fair value of the intangible asset.
Under the royalty savings (or relief from
royalty) method, the value of an asset is reflected in the present value of after-tax royalties the owner of the asset avoids paying by owning the asset and not having to licence it from a third party.
Market approach. This measures the value of an asset through an analysis of recent sales or offerings of comparable assets. Sales and offering prices are adjusted for differences in location, time of sale, utility and the terms and conditions of sale between the asset being valued and the comparable assets.
Due to the general lack of publicly available sale or transaction data regarding individual intangible assets (with the exception of communication licences, where auctions in Europe and individual licence sales and swaps in the US do provide some market data), a market approach is often not applicable in valuing intangible assets.
Cost approach. This measures the value of an intangible asset by the cost to replace it with another of like utility. The cost approach recognises that a prudent investor would not ordinarily pay more for an asset than the cost to replace it new. The cost approach is often most applicable when valuing intangible assets that are not income-generating, (e.g., internally developed software that is used for internal purposes and databases). For income-generating intangible assets, the cost approach is often not utilised because even if the development effort associated with the asset was distinguishable, the cost approach tends to understate the true value since the costs involved in developing the asset are typically not commensurate with the cash flow it may generate for the business.
The implementation of IFRS 3 can have a dramatic impact on how companies execute their acquisition process, as well
as affect day-to-day operations, even post merger. Thus, all companies planning acquisitions should take steps to ensure they are well versed in the requirements and implementation of IFRS 3, as it will consume resources on a variety of levels.
The acquirer’s management must be able to articulate in the announcement of the transaction what the deal drivers are, with the understanding there will be an expectation from the auditors and regulatory authorities that those drivers (e.g., strong brand name, customer relationship) will be identified and valued as part of the IFRS 3 analysis. The group tasked with implementing the IFRS 3 accounting will likely need to identify and engage an independent valuation firm specialising in IFRS 3 valuation analyses (a company’s auditors are precluded from providing this service to their audit clients due to independence restrictions), and they will spend significant amount of time complying with the required financial reporting. A number of individuals across the firm will likely be asked to participate in discussions with the valuation expert to better understand the nature, background, outlook, and specific details of the various intangible assets, all at a time when many resources are focused on their day-to-day tasks as along with the post merger integration. These are but a few of the strains that will be placed on the acquirer’s resources and which should be considered in advance.
For companies that are sensitive to any potential negative movements in earnings per share (EPS), IFRS 3 can also have a significant impact on the decision to execute a transaction. This is simply because the requirement to identify, value and amortise intangible assets over their respective remaining useful lives (not to mention
depreciate tangible assets) has a direct affect on the EPS of the deal. An acquisition that is EPS accretive – before consideration of intangible asset amortisation – could in fact become EPS dilutive once the amortisation is accounted for. Some companies may actually decide not to move forward with the transaction to avoid dilution to their EPS.
While the accounting treatment is
required and thus avoidance of valuing and amortising assets is not possible, many companies will have an analysis conducted prior to the announcement and/or the close of the transaction in order to ensure that the markets are well aware of the potential EPS effect of the deal, including all intangible and tangible assets. While in many cases a full IFRS 3 valuation may not be practical on a pre-acquisition due to lack of available access to information, confidentiality, etc., it is possible to conduct a high level analysis. Although this approach will not allow for a formal opinion of the values of the identifiable assets of the target, it can provide important information regarding the potential range of EPS effects inclusive of the tangible and intangible assets.
Regardless of the size or complexity of a transaction, companies should ensure – early on in the acquisition process – that they have a firm understanding of the technical accounting requirements of IFRS 3, and that they have allocated appropriate resources, engaged an independent firm to execute the valuation, and can clearly and readily articulate the value drivers of the acquisition and relate those drivers to the IFRS 3 valuation and EPS effect.
Phil Antoon is global practice leader of the Valuation Services Practice at Kroll.
You are the CFO of a US company and are managing the divestiture of a profitable overseas operation. After months of due diligence, your prospective buyer backs out, citing that the acquisition would be dilutive to its earnings. How can that be? Your US GAAP (Generally Accepted Accounting Principles) carve-out financial statements show that the overseas
division is profitable. As you investigate the situation, you find that the prospective buyer reports under International Financial Reporting Standards (IFRS). At present, you do not have the time, infrastructure or knowledge in place to understand how a set of accounting standards brought down a multi-million dollar deal.
With IFRS now in use in over 100 countries and the increasing globalisation of markets, the likelihood that US GAAP and IFRS will come face-to-face in M&A is real. Although accounting standards alone do not
frequently dictate business decisions, they can be a key aspect of a prospective buyer’s list of considerations. By being proactive in understanding the role IFRS could play in M&A decision-making, CFOs can position themselves to be better negotiators and avoid situations like the one described above.
IFRS: the global financial reporting language
Today, more than 12,000 public companies around the world use IFRS as their primary reporting framework. With markets such as
Canada, South Korea and China committed to adopting IFRS, eventually all major territories and capital markets will require or permit IFRS as early as 2011.
Of the top 10 global capital markets (US, Japan, UK, France, Canada, Germany, Hong Kong, Spain, Switzerland and Australia) the majority already use IFRS while
Canada and Switzerland are in the process of converging to IFRS, according to the Economist Intelligence Unit.
Even in the US, which uses US GAAP, the Securities and Exchange Commission (SEC) has recently eliminated the need for foreign private issuers to reconcile to US GAAP as long as they use IFRS as issued by the International Accounting Standards Board (IASB), the international standard setter. Many believe 2008 could bring an SEC proposal allowing the use of IFRS by US public companies. The SEC’s actions have increased the urgency for companies to fully understand IFRS, the differences between IFRS and US GAAP, and how IFRS impacts their M&A endeavours.
Impact on M&A activity
IFRS has introduced a new set of challenges for dealmakers. As companies expand overseas through acquisitions or appeal to a broader group of buyers for a division they are divesting, they are likely to encounter IFRS and need to assess its impact on their transactions. The target may be located in a country that already embraces IFRS