A New Scorecard for Intellectual Property

AUDITORS AND CORPORATE FINANCE EXECUTIVES must be aware of an important distinction in accounting for business combinations—certain intangibles such as intellectual property (IP) must be amortized and cannot be allocated to goodwill. FASB implemented new standards, effective July 2001, which changed the accounting treatment for business combinations by eliminating pooling and goodwill amortization.

REGULATORS WILL QUESTION ALLOCATING the purchase price to goodwill rather than to intellectual property and other intangible assets unless companies can support the allocation. CPAs must recognize these issues when accounting for purchase price allocations to ensure their clients are not surprised by SEC inquiries after the business combination is completed.

CPAs SHOULD ASK THESE QUESTIONS when conducting or reviewing a valuation of intellectual property for a purchase price allocation: What IP does the target own, and how is it categorized? Is the IP licensed? Has the target purchased IP from other entities? What about IP that is not formally protected yet? Is the target involved in IP litigation? Has the target allocated IP to the right reporting unit?

WHILE PURCHASE PRICE ALLOCATION ISSUES with respect to intellectual property are no more important than other factors to the economic success of a business combination, the allocation process is critical because it will affect reported earnings.

BECAUSE CPAs MOST LIKELY VALUE holding company assets for tax purposes, they can use the creation of a holding company advantageously when handling accounting issues that arise as a result of the new standards.

Trademarks and Patents on the Rise From 1990 to 2000, the number of patents issued and the number of trademarks registered annually have increased 88%. (Based on fiscal year ended September 30, 2000.) Source: Performance and Accountability Report Fiscal Year 2000, United States Patent and Trademark Office. www.uspto.gov .

YOU DON’T WANT THIS SITUATION

A hypothetical computer software company, with the help of its CPA firm, recently completed the acquisition of a smaller competitor. Although the fair value of the target’s acquired net assets was $500 million, the board agreed on a $900 million purchase price given the target’s superior technology, sales growth and leading market position. The company expected the acquisition target to create a presence in a new market virtually overnight. The company’s board was particularly convinced of the merits of the deal after learning it would not have to amortize the massive amount of goodwill the purchase created due to recent accounting changes. The accounting treatment would ensure continued earnings growth after the acquisition, a major goal for the board.

Six months after the deal, however, the board learned about an SEC inquiry into the accounting methodology the company had used in the transaction. Not wanting to amortize, the company had allocated only a small portion of the purchase price to intangibles and treated most of the $400 million premium paid over the fair value of the acquired net assets as goodwill in its financial statements. The SEC challenged the allocation of the purchase price between goodwill and intangibles and determined an additional $80 million of it should have gone to the target’s patent portfolio and therefore been treated as intangible assets, not goodwill. The change will force the company to reduce earnings estimates and restate its financials. As the board convenes, the CEO and CFO must explain what happened and why.

HOW TO IDENTIFY INTELLECTUAL PROPERTY

When the company prepared its financial statements, it made a common mistake and attributed too much of the purchase price premium to goodwill. CPAs and other members of the team should have identified the patent portfolio as an intangible asset that would need to be amortized. In the example, the company could have avoided its dilemma by focusing on the target’s patents and licenses.

Here are some questions CPAs should ask when conducting or reviewing purchase price allocations and valuations for their clients:

What intellectual property does the target own? Identify patents, trademarks, copyrights or other intellectual property assets that belong to the target company. Determine whether the target has an intellectual property business plan. An IP business plan typically inventories intellectual property assets and documents the best strategic opportunities to generate value. Some plans also help entities measure the economic contribution of their IP activities. Not all companies will have an intellectual property plan, but the acquisition of an IP-rich company could trigger the need for one. Indexing the intellectual property assets into general categories will assist the valuation process for the acquiring company. If the target does not know and understand how to categorize what it owns or does not have an appropriate business plan, that could signal bigger problems. For example, if an entity is attempting to allocate significant value to IP assets that it does not have plans to use or enforce, it could be difficult to support the valuation. Technology companies in particular need to know what intellectual property assets they own.

Is the intellectual property licensed? Determine whether the intellectual property assets have been licensed to third parties. When an IP owner allows someone to use these assets, the owner typically receives royalty payments. Valuators must determine what those royalty streams are worth. If reliable future royalty income information is available, CPAs can use a discounted cash flow approach to determine the fair value of the licensed assets at the time of the transaction.

To illustrate, assume a patent portfolio license agreement calls for three annual payments of $20 million each for use of the patent portfolio. Using a 20% discount rate on the $60 million in total future payments yields a $42 million fair value.

The discount rate should reflect the time value of money as well as the risk the royalty income projection may not be achieved. If the risk to the acquiring entity of not receiving the future income is high, then a higher discount rate is required. (FASB Concept Statement no. 7, Using Cash Flow Information and Present Value in Accounting Measurements, discusses other present value modeling alternatives and is referenced within Statement no. 142 as an appendix.) If the target’s patent portfolio generates $20 million a year in royalties, it will be almost impossible not to ascribe value to the patents when the company allocates the purchase price. License and royalty agreements specifically are included in Statement no. 141 as examples of intangible assets that meet the criteria for recognition apart from goodwill.

Has the target purchased intellectual property from other entities? Another sign that intellectual property deserves a valuation is a recent sale or purchase. If the target company recently had acquired a group of patents from another entity, they will require a separate valuation as an intangible asset. If the transaction had occurred recently and the circumstances surrounding the transaction are still similar, the transaction price could help support the valuation. For example, if the target company had recently purchased a patent portfolio for $10 million, the acquiring entity could potentially utilize the $10 million purchase price to justify attributing that amount to the same assets during the purchase-price-allocation process.

Is the target involved in intellectual property litigation? Businesses go to court over IP rights because use of a valuable asset is at stake. If the target has been involved in such litigation, valuators should identify the specific intellectual property assets at issue and determine whether the situation points to an undervalued asset. If the target has used IP litigation to successfully remove a competitor from a line of business or collected a large settlement from another, this could indicate that the underlying intellectual property will require a separate valuation for allocation purposes.

What about valuing “new” intellectual property which is not formally protected? Perhaps the most difficult valuation in a business combination involves IP assets the target has not used yet, not licensed yet or not patented yet or formally protected at the time of purchase. The valuation process is hampered when the valuators do not have an income stream to value or do not know whether an asset’s patent application will ever issue.

In many acquisitions, the target company may be developing next-generation products based on a combination of know-how, patent applications and recently issued patents. During the purchase price allocation, finance professionals should review how much money the target has invested in the technology and determine whether the company has cash flow projections or cost benefit analyses that value the technology for internal purposes. “While these assets have not yet produced revenue for the target company, clearly they may have value,” observes Frank R. McPike Jr., CPA, president and CEO of Competitive Technologies Inc., a Fairfield, Connecticut, provider of patent and technology licensing and commercialization services. CPAs can forecast royalty streams for licensed IP assets based partially on historical experience. “However, for unlicensed intellectual property, often the approach is to find assets with similar characteristics but further along in their life cycle to use as a proxy,” says Jeanne Wendschuh, CPA, controller for Competitive Technologies.

Has the company allocated the intellectual property to the correct reporting unit? FASB requires companies to allocate and test for goodwill impairment at the reporting unit level. A reporting unit is an operating segment that is at the level at which management reviews and assesses the operating segment’s performance. Reporting units have discrete, stand-alone financial information (a definition of reporting units can be found in Statement no. 142). Company managers also have to make sure intellectual property and other intangible assets are assigned to the proper reporting unit. Companies should already understand why certain units or divisions own or maintain IP assets. If the target company is confused and cannot answer questions about which division controls which intellectual property assets, this should raise a red flag to the valuators and buyer during the valuation process.

HOLDING COMPANY ADVANTAGES

Many businesses establish intellectual property holding companies that benefit from lower taxes by transferring the ownership of the intellectual assets to an entity located in a lower tax jurisdiction and having that company charge back royalties. In addition to the tax savings, the holding company can provide company managers and the deal team with insight and support when determining assets’ useful lives, identifying reporting units and creating valuations for fair value purposes. CPAs can use the creation of a holding company advantageously when handling accounting issues that may arise as a result of new FASB standards. Before creating the holding company, CPAs most likely had already valued the assets for tax purposes. By updating those calculations at the time of the purchase price allocation and using the same models to track the value of the intellectual property assets going forward, the company could reduce its financial reporting costs.
For example, assume the CPAs and other financial professionals have prepared a discounted cash flow model to support the valuation and the transfer of the IP assets to the holding company. Using the same models, valuators can determine a new fair value by updating certain key assumptions including the discount rate, the amount and timing of future royalty income and changes in the assets’ useful life. If the existing cash flow valuation model had assumed $10 million in future annual royalty income but now royalty income is expected to be $5 million, the valuator should adjust the model to determine the correct fair value. If certain other factors such as market acceptance of the technology protected by the patent portfolio have changed, valuators should adjust the discount rate to reflect that new information. (Although CPAs prepare intellectual property holding company valuations for tax purposes, they should not confuse an asset’s tax basis with fair value—as provided in Statement no. 141.)

ADDRESS ISSUES EARLY

Since implementing the new standards can be a challenge for some companies, Mark A. Spelker, CPA at J.H. Cohn LLP in Roseland, New Jersey, advises CPAs to inform clients of the requirements early in the process to avoid unnecessary problems after closing the deal. “The new standards will likely increase the amount of intellectual property and other intangible assets recognized in business combinations,” he adds. Spelker acknowledges that while purchase price allocation issues surrounding intellectual property are no more important to the economic success of a deal than other factors, the allocation process is critical because it will affect reported earnings.

The CEO and the corporate finance professionals who serve on the team in the hypothetical company should have properly reviewed the target’s patent portfolio prior to the acquisition. Had they done so they would have advised the board of the need to recognize and amortize the additional intangibles. Howard Weiner, CPA at Holtz Rubenstein & Co., LLP, in Melville, New York, expects that “the SEC will question any acquisition that does not have allocations to various identifiable intangibles” and says it also will look for explanations in financial statements on how these assets were valued and how their useful lives were determined.

“Estimating the useful life of intangible assets may be a difficult process,” says Carmen Eggleston, CPA, a managing director in the Houston office of InteCap Inc., an intellectual property consulting firm. “While patents have a finite life, trademarks can be maintained indefinitely,” she explains. “Also, it’s important to consider that the technological life of a patent may be shorter than its legal life. Companies will need to support not only the allocation of value but the associated lives as well.” For example, using the 20-year legal life of a patent simply because it equals the patent’s legal term is not sufficient if the technology probably will be replaced in five years. Eggleston says when valuators determine the useful life of intangibles, they should consider both contractual and economic factors including expected demand for the technology, risk of obsolescence, product life cycles and the impact of competition.

DISTINCTIONS COUNT

Under historical accounting rules governing business combinations, the distinction between goodwill and intangibles was mandated by regulators but of less concern to investors, companies and CPAs since both items could be amortized annually on financial statements. Weiner believes that although accounting standards had required certain intangibles to be separately identified, companies “often ignored” the distinction. Lynn E. Turner, the former SEC chief accountant, expressed similar concerns last year: “As the staff has been reviewing the goodwill impairment charges recorded by certain companies, I have been surprised by the number of those companies that have not separately identified intangible assets or have represented that they could not separately value them. Instead, they record goodwill for the entire excess purchase price in a business combination.”

Companies attempting to undervalue intangibles to avoid amortization can expect scrutiny from regulators and company stakeholders. The SEC has already stressed to business executives that purchase price allocations between intangibles and goodwill will be a key focus in financial statement reviews, and companies should anticipate requests for documentation to support the purchase price allocation in business combinations. “I expect that purchase price allocations between amortizable and nonamortizable intangibles will become a hot topic at the SEC,” says Spelker. “The allocation of purchase price is a real sleeper in the new FASB statement,” he adds. Weiner believes the SEC has always had a concern that companies were not assigning appropriate lives to all intangibles. Like Spelker, Weiner expects the SEC will pay close attention to how companies implement the new FASB standards on accounting for business combinations.

The business combination accounting changes will increase the importance of proper purchase price allocation between goodwill and intangibles. Companies want to treat their intellectual property portfolio as a valuable asset that supports long-term business strategies, so it is vital they accurately report its value. CPAs can help businesses understand that the new FASB pronouncements will assist them in maximizing benefits from an acquisition by clarifying balance sheet information relating to intangible assets.