Valuing IP Post-Sarbanes-Oxley

It’s no longer a matter of making a best estimate.
BY RUSS BANHAM

EXECUTIVE SUMMARY

ALTHOUGH SARBANES-OXLEY SETS NO SPECIFIC requirements for CPAs valuing intellectual property, it does put greater emphasis on accurate valuation of all assets and imposes punishments on CEOs and CFOs for failure to do so.

INTANGIBLE ASSETS OF ALL KINDS, INCLUDING PATENTS, brand names, in-process research and the like, have become increasingly important to the economic value of a business. This makes it critical to accurately disclose the facts about intellectual property.

SARBANES-OXLEY ISN’T THE ONLY RECENT development affecting IP valuation. FASB Statement nos. 141 (intangible asset identification upon acquisition) and 142 (annual intangible asset fair value measurement) require companies to measure and report on the financial performance of acquired intangible assets.

VALUING IP RAISES COMPETITIVE ISSUES over divulging asset values companies might prefer to keep secret. Companies must balance their need to protect proprietary information with disclosure requirements.

CPAs CAN HELP COMPANIES CHOOSE FROM AMONG several methods for valuing IP assets. These include the market, cost and income approaches. With the market approach, a company compares its IP assets with similar assets in the marketplace that have a known value. The cost approach values IP based on the cost to obtain it; the income approach values it based on its income-producing ability.

RUSS BANHAM is a freelance business writer. His e-mail address is bzwriter@aol.com .

efore 2002, identifying and valuing intellectual property (IP) was more art than science. But in that year Congress passed the Sarbanes-Oxley Act and FASB issued new accounting standards for measuring and reporting on intangible assets. In this high-pressure environment CPAs will find IP valuation is no longer a matter of making a best estimate.

As regulators begin to seek greater clarity in the asset values of publicly traded companies and require them to make more transparent disclosures, the onus is on CPAs to apply more scientific rigor to their IP valuations. But certifying with mathematical exactitude the full value of intangibles such as patents, brands, in-process research and other IP assets can be problematic.

This article describes the valuation issues CPAs face with intangible assets, the rules they must follow and how they can avoid some pitfalls in the search for a value that meets all requirements.

VALUATION CHALLENGES
When it comes to valuing IP, there is nothing in Sarbanes-Oxley that says, “Do this or do that,” says James Rigby, CPA, a managing director in the Los Angeles office of the Financial Valuation Group, a consulting firm specializing in valuation and performance issues. “What Sarbanes-Oxley does do is imply a greater responsibility for recording IP assets on the financial statements. The legislation didn’t change anything in terms of what people should be doing. It just imposed greater responsibility and punishment.”

Overlooked Assets

Some 49% of companies said they relied primarily on intangible assets to create shareholder wealth, yet only 5% had a robust system to measure and track the performance of intangible assets.

Source: “Intangible Assets and Future Value,” Accenture Ltd.,
2003 survey of 120 senior executives, www.accenture.com .

Sarbanes-Oxley says companies “must be more rigorous, accurate and inclusive as far as the material effect of all assets on the bottom line, and then sign off that the numbers are on the money,” agrees Gary Morris, a partner and IP specialist in the Washington, D.C., office of law firm Kenyon & Kenyon. While this level of accuracy generally includes IP, it’s virtually impossible to accomplish with intangible assets such as a patent, copyright or brand name.

Sarbanes-Oxley and FASB Statement no. 141, Business Combinations, and Statement no. 142, Goodwill and Other Intangible Assets, converge with another trend—the increasing importance of intangibles to the value of a business. “IP has increased economic value, requires review by top executives and is garnering enhanced interest from regulators,” says Edward Black, a partner and head of the IP practice group at Boston-based law firm Ropes & Gray. Twenty years ago, intangible assets weren’t that important—bricks and mortar were the key assets. Today, Black says intangible assets are critical, making accurate disclosure more important.

Three sections of Sarbanes-Oxley, while not directed specifically at intellectual property, particularly affect public companies with IP that is material to their business. Section 302 requires CEOs and CFOs to certify the financial information presented in their annual and quarterly reports is accurate—fairly presenting “in all material respects” the company’s financial condition. Section 404 says companies must document and certify their internal financial reporting procedures and controls. Section 409 requires them to deliver real-time reports of “material events” affecting the company to shareholders or other “stakeholders.”

Sarbanes-Oxley isn’t the only recent development affecting IP valuation. Statement nos. 141 (intangible asset identification upon acquisition) and 142 (annual intangible asset fair value measurement) require companies to measure and report on the financial performance of acquired intangible assets. In the wake of recent business scandals, leading accounting firms such as PricewaterhouseCoopers and Grant Thornton are urging a migration from rules-based accounting standards to a principles-based methodology, a system many foreign countries use. Principles-based standards, which use broad guidelines focusing on the spirit of an underlying principle, would reduce the complexity and gamesmanship IP valuation currently involves. CPAs would apply professional judgment to determine the fair presentation of IP value rather than rules for all possible circumstances.

Michael Mard, CPA/ABV, a managing director in the Tampa, Fla., office of Financial Valuation Group, says FASB’s goal is to develop procedures that will reasonably estimate market values. “The issue with following bright-line rules-based standards is that those rules tend to multiply, ultimately becoming an exercise in checking the box, with no regard for fundamental economic forces.” Principles-based standards, he says, will keep the eye on the ball—those underlying forces.

FUZZY FACTS
Companies value IP for three primary purposes: financial reporting; transactions (determining the value of a property to sell, buy or give to charity); and litigation (typically over unauthorized use of the IP in question). Absent specific requirements covering IP, Sarbanes-Oxley has changed the financial reporting climate in which companies value all assets. “Companies must measure, monitor and disclose the relationship between intellectual property rights and a company’s financial performance, and translate changes in the scope and strength of those rights into reportable indicators of financial performance,” explains Lisa Vertinsky, an associate and IP attorney with the Boston law firm Wolf, Greenfield & Sacks.

More generally, sections 302, 404 and 409 suggest CPAs need to “rethink the role of intellectual property valuations and audits in corporate strategy, as well as introduce new systems to ensure that information about IP is communicated to and understood by top decision makers, and translated into financial reports,” she notes.

Influenced by Sarbanes-Oxley and FASB financial reporting requirements, a company owning IP of material value must

Identify the assets.

Pinpoint any changes or transactions that may affect these assets.

Properly value the assets (critical in a merger or acquisition where the asset value appears on the balance sheet).

Demonstrate it has adequate internal controls for managing IP assets.

For a checklist of information CPAs will find useful in valuing various types of intangible assets including copyrights, customer relationships, in-process research, know-how, patents, software, proprietary technology and trademarks, click here .

While Sarbanes-Oxley didn’t change the actual IP valuation process, it reaffirms the need to correctly value IP assets—and added some teeth to ensure compliance. “Sarbanes-Oxley imposes more stringent standards for accurately reporting financial matters that have a material impact on the company’s financial health,” says Morris. “When you have an intangible asset such as a patent or trademark, the boundaries are not as clear as with a tangible asset such as a building. When you try to describe exactly what IP you own, things get fuzzy fast.”

THE VALUE OF VALUING
Statements nos. 141 and 142 also put pressure on CPAs who value IP to ensure appropriate valuation. The accounting rules require breaking down acquired assets into separate categories that traditionally were lumped together into a single intangibles or goodwill reporting item. Categories include “marketing-related assets,” covering trademarks, “customer-related assets” (customer lists), “contract-based assets” (licenses and employment agreements), “artistic-related assets” (photographs) and “technology-based assets” (trade secrets and patents).

The rules provide a framework CPAs can use to organize intangible assets into categories and then require companies to create accurate measures for these assets that can be monitored and adjusted over time. CPAs then must incorporate these measures into the financial statements and update them periodically and when certain events—such as an acquisition—occur.

Both Sarbanes-Oxley and Statement nos. 141 and 142 raise complicated competitive issues by forcing companies to divulge IP asset values they might prefer to keep secret. “What you disclose to investors you also disclose to competitors,” Rigby says. It’s a matter of what is considered prudent. “If it’s damaging to the company to give information to competitors, it’s also damaging to the investor.” Rigby says a company may not want to release all the information some investors would like. “There has to be a happy balance.”

Vertinsky agrees: “Companies must balance the need to protect their proprietary information against the disclosure requirements, which means the law may sometimes trump good business judgment.” Certain strategies that depend on secrecy may, in some instances, be unavailable or available only for limited times. She cites an example where a company gets a cease and desist letter from another company that says its activities are infringing on the latter’s intellectual property. This could “have a big impact on your product strategy. It may be something you don’t want competitors to know. At what point does this become something you have to disclose?”

At the same time, though, the disclosure requirements might interpret this information as material in the context of a 10-K filing. “You may need to disclose even though you aren’t certain an actual infringement took place. The rules may accelerate the need to reveal information.” Vertinsky says. Her advice, in the absence of anecdotal evidence of how the rules will be enforced, is to have a consistent set of guidelines in place for how to treat such information. She advises companies to “think carefully about the dual role those guidelines play as good for both company strategy and compliance with regulations. You want to be able to demonstrate you have internal controls in place—with input from IP counsel and management—demonstrating that you are trying to comply.”

Yet another strain for CPAs who value IP is uncertainty surrounding principles-based accounting standards and their potential impact on IP. A FASB statement on fair value measurements, targeted for this quarter, will continue FASB’s march toward principles-based, away from rules-based, standards, says Mard. “The forthcoming FASB statement establishes a framework CPAs can use when measuring intellectual property for financial reporting. It follows a hierarchy that centers around quoted market prices and market participation. The framework also establishes whether such assets are to be appraised on a stand-alone ‘exchange’ basis or ‘in use’ as a going concern.” More information on the contents of the forthcoming statement is available www.fasb.org/project/fv_measurement.shtml .

While these measurement techniques add to the transparency of management’s reporting of asset values, they must be “tempered by the economic realities of managing such assets in a market environment that moves up and down and from moment to moment,” Mard adds. “The regulatory application of fair value may be different from the economic reality.” The result, however, will be more information for the public and for shareholders.

Against this backdrop, valuators are attempting to add more discipline to identifying and valuing IP assets. “There is no such thing as an easy valuation,” says Ethan Horwitz, chairman of the IP group in the New York office of national law firm Goodwin Proctor. “Valuation is half art and half science. You can get pretty close to a proper valuation, but you’re never going to get a firm number the way you could with publicly traded stock.” Horwitz says formulas are difficult to rely on and IP valuation decisions are “all over the place,” with any two experts likely to have very different views.

For more information on the steps to follow in valuing intangible assets using various available methods, see the checklist available here.

BEST PRACTICES
The first step CPAs should take in valuing IP is to systematically identify the relationship between a company’s intangible assets and its financial performance. “Decision makers need to understand how intangible assets relate to the company’s current and future financial performance and operation,” says Vertinsky. “They must appreciate the law and economics of IP development, acquisition and enforcement strategies, and be able to translate information about the strength and scope of IP rights into reportable financial data.” For example, she says, when a court rules a company’s patent is invalid, the business must evaluate the ruling in terms of its likely impact on profitability. This will turn on factors such as whether the patent rights were generating license revenue or preventing third parties from producing competitive products, thus supporting high prices and profit margins the company can no longer sustain.

According to Morris, no matter how broad and impressive a patent may be, “it’s no good if it is proved invalid.” That means CPAs have to look at how a patent was procured and the state of the art at the time the products allegedly were invented. Morris advises CPAs to “scrutinize the scope of the claims and then have someone who knows patent law give them the once-over. What it says on its face may not be its actual scope.” Then apply all this to how the business intends to use the patent.

Horowitz says companies must bring a competent patent attorney to the table to help identify and assess IP asset value. “The best practice is to put a patent attorney, a CPA and a technology person in a room and have them work out scenarios whereby the patent would bring value to the company,” he says. “The technology person can explain how the IP is used, the CPA can describe the value and the patent attorney can focus on the exclusivity. You need all three to come to a decision.”

Third-party audits of IP values are another best practice. Such audits identify IP assets including issued patents, registered trademarks, copyrights, trade secrets and IP acquired or licensed from third parties. They are particularly important in a merger or acquisition, Bishop says, “where you want to be assured the price you’re paying for the assets is commensurate with the value.” The IP audit also may include an evaluation of the procedures the company uses to maintain the assets and avoid unauthorized use of others’ IP rights.

Kevin Haggerty, CPA, senior director of internal audit at QuadraMed Corp., a Reston, Va.-based medical software company with $140 million in annual revenues, says he gets help from third-party financial valuators, who come in once a year to assess the value of the company’s software licenses, patents and other IP assets. They do all the evaluation and testing and document the result.

Once a company has complied with Statement nos. 141 and 142 and separated IP assets into meaningful portfolios, it then must decide on a valuation methodology. There are several approaches, among them the market approach, the cost approach and the income approach. In the first, a company’s IP assets are compared with assets in the marketplace that have a known value. “Much like valuing real estate, you find a comparable property that has a known value and compare it to yours.” The cost approach essentially values IP based on the cost to obtain it. This is either the purchase price or what the company paid the engineers and attorneys to come up with the idea and file the patent application. The income approach bases value on the IP’s income-producing ability. There is no perfect method. The goal is to be consistent.

CPAs should recommend companies develop processes to collect and verify IP-related data. Historically, companies have not regularly kept all the records needed to value intangibles, so many will have to go back and recreate the data from their accounting information systems, Rigby says. That may mean modifying the enterprise resource planning system to capture intangible assets in the same way it does tangible assets.

Ron Epstein, CEO of IPotential, a San Mateo, Calif.-based IP strategy consultant, advises “documentation and more documentation” to back up IP value assessments. “Sarbanes-Oxley is about disclosure,” he emphasizes. “In corporate 10-Ks and 10-Qs, there is a ‘risk factor’ section that offers the opportunity to have lawyers write a good explanation of how you approached valuing the IP, highlighting any areas you are not absolutely sure of. You’re telling regulators ‘we’re doing our best’ to appropriately disclose.”

Handling IP correctly extends beyond valuation issues. Senior executives must manage a company’s IP rights based on their importance to the organization’s overall financial health and must consider their own liability if the numbers don’t stack up. “CEOs and CFOs must feel comfortable when they certify a report that says the company’s IP assets are fairly represented,” says Jody Bishop, senior associate and IP specialist in the Dallas office of law firm Fulbright & Jaworski.

GET READY FOR THE FUTURE
How can CPAs prepare for the possible impact principles-based accounting standards will have on IP valuation? Vertinsky advises networking with companies abroad that already have such rules in place. “It’s better to recognize in advance what you will face on your balance sheet if you’re anticipating a merger or acquisition than to face it all at once,” she says. “Lean on an expert in those parts of the world that already understand the standards.”

AICPA RESOURCES
Publications
Valuation for Financial Reporting: Intangible Assets, Goodwill, and Impairment Analysis—SFAS 141 and 142, John Wiley & Sons, (# WI237531P0200DJA).

Valuation of Intellectual Property and Intangible Assets (3rd ed.), John Wiley & Sons (# WI362816P0000DJA).

CPE
Valuing Goodwill and Intangible Assets, self-study course, (text, # 731263JA).

For more information, to make a purchase or to register, go to www.cpa2biz.com or call the Institute at 888-777-7077.

Credential
Accredited in Business Valuation (ABV)

For more information, see http://bvfls.aicpa.org , click on the Membership tab and then click on “enter into our Accredited in Business Valuation (ABV) Program.”

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