Valuation is a critical consideration in any deal involving a merger, acquisition, initial public offering of stock or similar transaction. As the percentage of an enterprise’s value represented by intellectual property, goodwill and other intangible assets increases, the accounting and financial issues related to how those assets are valued becomes increasingly complex. Complicating things even further, changes in some key Financial Accounting Standards Board (FASB) rules on valuation in business combinations may take effect in the not-too-distant future.

“One critical issue in valuation for mergers, acquisitions and IPOs is getting the values right for the acquired intangible assets, including identifiable intangibles, in-process research and development (IP R&D) and goodwill,” says Mark Shayne, a managing director at Empire Valuation Consultants LLC in New York.

Because properly identifying, valuing and weighting intangible assets can involve both subjective and objective factors, it is a process best left to qualified valuation experts, Shayne adds. “Transparency is a hot-button issue with the SEC and in all segments of the financial reporting community. They look very closely at valuation of goodwill and other intangibles,” he says.

SFAS 142 Seeks to Clarify Intangible Assets Valuation of intangibles gained prominence on the SEC radar screen following the Enron accounting scandal, prompting the FASB to implement many changes requiring the release of more transaction details and greater independence in the development of information. The FASB said it developed Statement of Financial Accounting Standards No. 142 (“SFAS 142”) because: “Analysts and other users of financial statements, as well as company managements, noted that intangible assets are an increasingly important economic resource for many entities and are an increasing proportion of the assets acquired in many transactions. As a result, better information about intangible assets was needed.”

Intangible assets are assets with future economic benefits, no physical substance and a high degree of uncertainty concerning the future benefit. Common types of intangibles include patents, copyrights, franchises, goodwill, organization costs, trade names and trademarks. They fall into five main categories: marketing-related, customer-related, artistic-related, contract-based and technology-based.

“One critical issue in valuation for mergers, acquisitions and IPOs is getting the values right for the acquired intangible assets, including identifiable intangibles, in-process research and development (IP R&D) and goodwill.

Prior to the implementation of SFAS 142, companies were able to carry overvalued goodwill assets on their balance sheets for long periods of time and to amortize goodwill for up to 40 years. Now, companies are required to write down goodwill immediately upon it being deemed overvalued, and they may leave it on their balance sheets only as long as it remains valuable.

Such write-downs are de facto impairment charges, since they tacitly acknowledge a reduction in the ability of the company’s assets to generate as much cash as previously projected. That information, of course, is material to the consideration of a merger, acquisition or IPO, so it becomes increasingly important to secure accurate, verifiable valuations of goodwill.

Recognizing Assets Apart from Goodwill Another FASB standard, SFAS 141, deals with the recognition of intangible assets other than goodwill: “An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired entity or from other rights and obligations).”

Under SFAS 141, an intangible asset that does not arise from contractual or other legal rights is recognized as an asset apart from goodwill only if it is separable (i.e., capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged)—regardless of whether there is an intent to do so.

“It’s very important to identify all intangible assets and value them properly,” Shayne says. “The SEC is looking very closely at this issue and wants to make sure it is done properly, preferably by a qualified firm.”

FASB Proposes Valuation Rules Changes As part of its joint project on business combinations with the International Accounting Standards Board, the FASB has proposed a number of rules changes affecting valuation of intangible assets, some of which may take effect in calendar year 2007, although no definitive dates have been set. Two of the proposed changes are of particular interest to companies that may be involved in business combination deals in the future, Shayne says.

One would shift IP R&D from its current status on the expense side of the ledger (where it can be written off) to the asset side (where it could not). The other would change the accounting for partial and step acquisitions. “Right now, if a deal is structured with a $20 million payment up front and two $5 million payments in each of the next two years—contingent on certain targets being reached—that’s accounted for as a $20 million deal,” Shayne explains. “Under the new rule, the future payments would have to be valued and included as assets under goodwill at the time the deal is transacted.”

It should be noted, however, that while both changes were included in the project’s Exposure Draft, they have been among the most contentious points addressed in comment letters during the feedback period, says Marta Vessels, a project research associate at FASB. As of the project board’s July 2006 meeting, discussion had not begun on either item.

For more information, please contact Joe Gitto at jgitto@gellerco.com.