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Are companies properly valuing and assigning acquired intangibles to business units?
Tim Reason, CFO Magazine
July 1, 2003
Two years ago, the Financial Accounting Standards Board seemed to hand a rare gift to companies when it eliminated the amortization of goodwill. No longer would the premium paid for acquiring a company chip away at earnings for decades — instead, it could be carried on the balance sheet as a non-wasting asset.
There was, of course, a catch: goodwill and other intangibles must be allocated to the appropriate reporting unit and tested regularly for impairment. Moreover, goodwill excludes many types of intangibles with definite lives, which still must be recognized and amortized. And any impairment charges are a straight hit to earnings.
Then there's the cost: to ensure compliance and avoid unexpected charges, many companies are paying more for professional valuation services to value goodwill and other intangibles.
With FASB emphasizing fair value as the best measure of worth in many types of accounting transactions, valuation services are booming. And thanks to the Sarbanes-Oxley Act, companies can no longer rely on their auditors to produce any valuation that they might subsequently have to audit. Hiring an outside valuation expert to perform a purchase-price allocation can cost a public company anywhere from $50,000 to $500,000, depending on the size of the deal. And the bucks don't stop there — FAS 142 requires impairment testing at least once a year.
"FAS 142 has been good for [our valuation] business, and it will continue to be because of ongoing testing," says George D. Shaw, Boston-based managing director of Grant Thornton Corporate Finance LLC, the accounting firm's M&A advisory subsidiary. Typically, he says, costs come down after the first "couple of rounds" of valuation.
Old Habits Die Hard
Paying outsiders for such services isn't required, of course, although auditors may demand it for particularly complex deals. Before FAS 141 and 142, companies either didn't need to do valuations at all (if they used the pooling method) or often could do them without help. Those that used purchase accounting often simply lumped intangibles with goodwill. Instead of assessing a fair value for each identifiable intangible, they shortened the maximum 40-year amortization period of actual goodwill by a weighted average life to account for other intangibles. This simple residual approach wasn't technically correct, but it was cheap and, in practice, accepted by both auditors and the Securities and Exchange Commission. "The majority of companies did this," says Steve Gerard, Boston-based managing director of Standard & Poor's Corporate Value Consulting unit. "It was an inexpensive way to achieve a reasonable, if not exactly rigorous, result."
The danger today is that firms sometimes continue to use variations of that formula for back-of-the-envelope calculations early in a deal. Whether deliberate or not, overstating goodwill can make an otherwise marginally dilutive deal look accretive — until more-rigorous accounting is applied.
A purchase price that requires revision because it underestimates the amount of amortizable intangibles can put CFOs, controllers, or auditors in an awkward spot as a deal moves toward closing. In fact, valuation services quietly market their outsider status as a way to take some of the heat off of internal financial folks who don't want to be seen as potential deal-breakers. Even then, there are cases when the conflict between FAS 141 compliance and pressure to get a deal done has boiled over. "We have encountered situations where clients were clearly ignoring the rules, and at that point, we have walked away from assignments," says Gerard.
Fortunately, CFOs or controllers who find themselves at odds with a deal-making CEO or an aggressive investment- bank estimate have another powerful ally. "Boards are paying more attention to acquisitions since Sarbanes-Oxley," says Shaw. They, too, are quick to seek outside help. "It used to be that if a CEO wanted to do a deal, it was his ball game," Shaw explains. "Now, boards are putting the deal makers under more pressure."
Not A Big Deal?
Impairment testing, adds Shaw, has introduced "a more uncertain, volatile treatment of goodwill" than the straight-line depreciation of the past. That's another argument in favor of professional valuation — goodwill impairment can play havoc with a company's books. That was particularly true of stock deals done during the boom, when inflated stock prices led to inflated goodwill. A case in point: AOL Time Warner — a deal done with AOL's high-flying stock as currency — took a goodwill impairment charge of $54 billion after adopting FAS 142.
Business reorganizations can also result in impairment. FAS 142 does not rely specifically on business segments as defined by FAS 131, but on often smaller "reporting units." To make sure that companies don't reshuffle reporting units simply to shield goodwill from impairment, FASB declared that any restructuring will automatically trigger an impairment test. Boeing, for example, recorded a charge of $2.4 billion when it adopted FAS 142 in the first quarter of 2002, then took another $931 million this April after a January reorganization triggered an early round of impairment testing.
CFOs are quick to note that changes in accounting haven't changed the way they do deals. The ultimate measure is still the cash generated by the deal, and impairments, if they occur, are a noncash charge.
"The reality is that you have already spent the cash," says Tom Manley, CFO of Burlington, Massachusetts-based Cognos Inc., which recently acquired planning-software provider Adaytum for $157 million in cash. "I think shareholders understand that impairment is not going to be an incremental cash expense." However, he adds, "it is obviously a very big negative if a company is writing off a substantial amount of goodwill because [the acquisition] is not living up to expectations."
Despite the notable charges by some firms last year — which, not coincidentally, could be attributed to a one-time accounting change — the perceived and actual risk of impairment seems low for many companies. Cognos, for example, will amortize $27.5 million in intangibles over the next five to seven years, but as a midsize company, it has only one reporting unit. Thus, Cognos's market value would have to fall below the company's book value before the Adaytum goodwill would be subject to further impairment testing. "Although it is a lot of goodwill on our balance sheet, it is small relative to the value of our company. It would be very difficult to find an impairment, given that I have one reporting unit," says Manley, who nonetheless brought in outside valuation experts for the Adaytum deal.
Large companies with multiple units would seem more vulnerable, but those units can often provide a substantial cushion against impairments. "Hopefully, the accounting isn't influencing how people do acquisitions," observes Manley.
Goodwill accounting is, however, influencing the way the SEC looks at companies. This may be the most powerful argument for getting outside help. While external valuations do not absolve companies of liability, regulators are likely to view them more favorably.
Moreover, valuation firms offer a structured process and a paper trail that can come in handy if a company's valuation practices are challenged — as they increasingly are. In February, the SEC released a review of 2002 filings by Fortune 500 companies, noting that goodwill impairment was among the critical disclosures that often "seemed to conflict significantly with generally accepted accounting principles or SEC rules, or to be materially deficient in explanation or clarity." Among the additional information the SEC demanded were clearer descriptions of accounting policies for measuring impairment, as well as better information on how reporting units are determined and how goodwill is allocated to those units.
Under FAS 142, identifiable intangibles must be recognized separately from goodwill. But that doesn't necessarily mean they must be amortized. Assets considered to have indefinite lives — powerful brand names such as Coca-Cola, for example — can escape amortization.
But CFOs should think twice before considering that a plus — declaring an intangible to be immortal subjects it to regular impairment testing. "You could be replacing periodic, known amortization with a lot of lumpy, unpredictable impairment," notes Paul Barnes, managing director of Standard and Poor's Corporate Value Consulting unit. Paragraph 11 of FAS 142 requires that "no legal, regulatory, contractual, competitive, economic, or other factors" limit the asset's useful life. And unlike goodwill or intangibles allocated to business units, there's no way to cushion an indefinite-lived intangible. "The indefinite-lived intangible asset stands naked in its impairment testing, so its impairment could be very visible," says Barnes.