COVID-19 Resources

A Guide for Purchase Accounting in the Pandemic Age

Written by Lyle Simons, CVA and Jeff Plank, CVA, CEPA, MBA on August 17, 2020

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Global merger and acquisition activity plummeted in the first quarter of 2020, and it’s easy to understand why.

With valuations down, many business owners have simply decided to wait for a more advantageous time to sell their companies. Buyers are conserving cash and wary of investing in declining businesses that may not have reached bottom. Then there’s the practical issue of how to negotiate and perform due diligence while adhering to social distancing guidelines.

It’s not a question of if this trend will reverse, but when. Until it does reverse, rationalizing the value of acquired assets has never been more important.

We offer the following guide related to accounting for acquired intangible assets, appraisal methodologies and some thoughts about how COVID-19 might impact asset values.

Acquisition Method and Elements of Purchase Price

FASB rules for purchase accounting are provided in ASC 805 Business Combinations, which requires use of the acquisition method. The first, most basic step is to determine whether the transaction involves the acquisition of a business or a group of assets.

The discussion in ASC 805 of what constitutes a business is complicated, and practitioners deemed the original guidance that a business involves “inputs, processes and outputs” confusing and overly vague. Additional guidance released in 2017 was only slightly more helpful, referring still to the three ambiguous elements, but it generally narrowed the definition of a business to include those entities that generate revenue in the form of sales of goods and services or investment income.

Whether you purchased a business or a group of assets, accounting rules dictate that you identify and value both tangible and intangible assets. The purchase of a “business” requires consideration and possible recognition of a goodwill asset—the amount of excess purchase price over the value of net assets acquired—while acquiring a group of assets does not.

On very rare occasions, the value of acquired net assets may exceed the purchase price, resulting in a “bargain purchase” transaction. We believe such events almost never occur since a seller would not relinquish a business for a price less than the fair value of its underlying assets.

Even in the case of a distressed company, the prevailing opinion of most accounting and valuation professionals is that the two sides will negotiate a price approximating fair value. Virtually the only exception we have witnessed is when the transaction is deemed not be at arms-length (for example, in the case of a related party transaction). In the case of a true bargain purchase, no goodwill asset is generated, and the buyer will instead recognize a one-time gain.

As outlined in ASC 805, the transaction purchase price is based on three separate elements:

  1. Consideration transferred;
  2. Equity interest in the seller prior to the acquisition;
  3. Non-controlling interest in the seller held by third parties.

Consideration paid by the buyer may take any number of different forms. Cash is easily determined, as is the value of publicly-traded company stock. Determining the fair value of stock in a private company acquirer may require an appraisal of the shares. In such cases, appraisers may need to adjust stock values for the potential synergistic impact of the combination.

Buyers today tend to be quite imaginative in how they structure acquisitions, and it is not unusual for deals to include some element, or multiple elements, of contingent consideration such as an earn-out. Valuing these provisions can be tricky and will often require the services of an experienced professional appraiser who is familiar with appropriate valuation techniques.

The more complex contingent pricing arrangements might include more than one underlying business fundamental (e.g., revenue and a measure of profitability). Alternatively, they may contain various minimum or maximum payment thresholds (non-linear payouts). Those situations will likely require use of a stochastic valuation model capable of measuring a range of possible future outcomes. Contingent consideration should raise a red flag that sophisticated (and more costly) valuation work is required.

Identification of Intangible Assets

Intangible assets, by definition, lack physical substance. They must also meet certain criteria to be recognized and valued. Under ASC 805 an intangible asset exists if it’s derived from contractual or legal rights, or if it may be separated from the business and transferred.

The list of possible intangible assets acquired in a business combination is a long one. FASB has developed a taxonomy for the more common intangible assets, classifying them as contract-related, technology-related, etc. Some industries have intangibles unique to their particular type of business, such as franchise agreements or newspaper mastheads, but nearly every business we have encountered has some form of customer-related intangible asset.

Intangibles may be indefinite lived, but the vast majority are assigned a useful life. In the past, trademarks and trade names were often considered to have an indefinite life, but this has changed over time, and most are now assigned a useful life and amortized. The exception may be well-known brand names (think “Kleenex” or “Coca-Cola”) that we can expect will be perpetuated by their owners. Regardless of what life is placed on them, trademarks and trade names represent a common intangible asset recognized in connection with a business transaction.

Customer-related intangibles deserve special mention because of their ubiquity and the fact that they often take different forms. At least three separate types of customer intangibles can be distinguished:

  • Customer contracts may be evidenced by long-term contractual arrangements and reflect what we might call “backlog.” Government programs are a source of revenue for many contractors and meet the legal criterion for valuation.
  • At the other extreme, a customer intangible may simply be a list of names, email addresses and phone numbers. Customer lists are more common with retail businesses, and their value is usually limited, but they still meet the criterion for identification.
  • Most common are customer relationships under short-term contracts or purchase orders. If such customers have a history of repeat purchases, they almost certainly meet the criteria for separability and should be valued as an intangible asset.

Many acquisitions include provisions for non-competition agreements with management and other key employees. The buyer may acquire existing agreements or enter into new agreements in connection with the transaction. Either way, these are normally considered acquired intangible assets (meeting the legal/contractual criterion) and their value is recorded on the balance sheet.

Other contracts may meet the criteria for asset recognition. Supply contracts and even lease agreements may be identified and valued, particularly if their payment terms are determined to be above or below market.

The value of a company’s assembled workforce may be huge—particularly for a service-oriented business. It is often thought to meet the requirements for recognition as an intangible asset; after all, most employees sign an employment agreement when joining the company (thus meeting the legal criterion). Under current guidance, however, workforce is not recorded as a separate intangible asset in business combinations (it is considered part of goodwill), though it may be recognized in the case of asset acquisitions.

Evolving Rules for Asset Recognition

In 2014, FASB issued Accounting Standards Update (ASU) 2014-18 related to the recognition of certain intangible assets acquired in business combinations. The guidance was developed in response to the private company council (PCC) mandate to simplify the purchase accounting rules (and thereby reduce costs) for small companies.

Under ASU 2014-18, the following assets are not required to be recognized (or valued):

  • (i) customer-related intangible assets, unless they are capable of being sold or licensed independently from the other assets of the business; and
  • (ii) non-competition agreements.

While adoption of the alternative should be considered where appropriate, it must also be viewed with some level of caution. Certain customer-related intangibles, particularly those like mortgage servicing rights that are contractual in nature, do not meet the exception criteria. You should consult with your valuation or accounting advisors concerning the appropriateness of adopting the simplified rules.

The treatment of in-process research and development (IPR&D) has undergone change over the years. Currently, IPR&D is recognized as an identifiable asset in a business combination and recorded at fair value with an indefinite useful life. The asset is subsequently written off at the time all research and development activities are completed. However, when acquired as part of an asset purchase, IPR&D may be expensed at the time of the transaction.

Valuing Intangible Assets

Intangible assets are assigned a portion of purchase price based on “fair value,” which is defined in ASC 805 as:

the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Probably the most important element of the definition is the “market participant” standard, which simply means the valuation of the intangible assets should not be performed on the basis of how a “specific” acquirer would use the asset, but should instead reflect how a “typical” company in the industry might treat the asset.

For example, a given buyer may decide to use a customer list in a manner different from how other companies might use it. This could be a function of the fact the buyer already has access to the list of customers, or otherwise finds little value in the list. The point is, if other companies would choose to utilize the asset to its utmost potential (often referred to as “highest and best use”), then it should be valued on that basis.

In valuing intangible assets, the appraiser may employ any of the three standard methodologies common to business valuation:

  • Income Approach;
  • Market Approach;
  • Cost Approach.

Facts and circumstances, especially those relating to the underlying nature of the particular asset being valued, dictate the selection of methodology. Where the appraiser can draw a straight line between the asset and the way in which revenue is generated—such as with customer relationships—an income approach will be the obvious choice.

Alternatively, in the case of certain intellectual property assets like trade names or patents, it is much more difficult to quantify the extent to which the asset contributes to income. Appraisers may still determine an income approach is appropriate, but qualitative considerations become extremely important.

In our experience, the market approach is not often used to value intangible assets because most types of intangible assets (particularly intellectual property) are unique. The market approach requires a comparative analysis of the subject asset with similar assets for which pricing evidence is available. This is typically not possible with intangible assets.

The cost, or asset approach, is rarely used in the valuation of going-concern businesses, but it is widely applied in valuing intangible assets. In most cases, this means a “cost to recreate” the particular intangible asset. Use of this approach though requires special considerations (for example, how do you treat taxes when measuring total costs?).

Special Considerations for Valuing Different Types of Intangible Assets

Fortunately, best practices have developed over time in the appraisal industry to assist with various valuation complexities.

Valuing company trade names is relatively straightforward, at least with respect to methodology. Most often, a “relief from royalty” method is used. The analyst discounts a future stream of hypothetical royalty revenue that the owner is “relieved” from paying (since he/she owns the asset). The estimated royalty rate becomes a tricky question and requires a qualitative assessment. This is a case where some market evidence (trade name royalties) is useful.

We believe there may often be a tendency to overestimate the value of trade names. COVID-19 has demonstrated the weakness of many names in the retail sector where centuries-old brands like Macy’s and JCPenney were not enough to save those companies. Since value is tied to revenue, we should expect the value of most trade names has declined in the current environment.

Customer relationships are valued using a variant of the income approach descriptively called the “multi-period excess earnings model” (MPEEM). As with the better-known DCF technique used to value business entities, the MPEEM begins with a projection of future earnings. However, the earnings in this case are specifically tailored to represent only the amounts directly attributable to the customers. Application of this technique usually requires several adjustments:

  • Revenue and earnings are reduced for the expected attrition of customers over time. Thus, unlike a DCF model which likely reflects business growth over time, the future cash flows eventually trail off to an inconsequential amount. Estimating customer attrition requires extensive analysis of past trends and future expectations.
  • Deductions are taken for the required returns on other assets that contribute to producing cash flows, including inventory PP&E and other intangible assets. Therefore, the results are “excess earnings” solely attributable to the customers. Rates of return will vary depending on the riskiness of each asset class.
  • Other adjustments may be required to reflect market participant assumptions as opposed to company-specific assumptions. Synergies embedded in the forecast must be examined carefully and must consider the market participant assumption described earlier.

In the end, the future cash flows are present valued, just as in the case of a DCF model for businesses. The selected discount rate used to value customers should reflect the riskiness of the asset, and not the overall business. Assessing the level of risk requires consideration of the contractual versus non-contractual nature of the customers, along with other factors.

We expect to see a significant deterioration of customer-related intangible asset values as a result of the disruptions of COVID-19. The methodology used to value this asset relates mostly to future cash flows, and, to the extent an acquired company has lost customers, earnings derived from the asset will decline.

Note that assembled workforce is not recognized as a separate intangible asset in business combinations, but it may still need to be valued because workforce contributes to the generation of customer revenue and profits. It is a “contributory asset,” and a return on that asset must be deducted from customer cash flows.

Assembled workforce is typically valued on the basis of a cost to recreate the asset. If employees have been laid-off or furloughed prior to the transaction, we would expect to see a reduction in the value of this asset, which is (hopefully) only a short-term phenomenon. Note, this may have an offsetting impact on customer value as the deduction for workforce charges is decreased.

In our experience, technology assets are among the most difficult intangible assets to value because they take such different forms: no patents or software programs are the same. There are some general guidelines for how to consider technology assets:

  • Patents represent intellectual property that is often embedded in a product. Consequently, valuing patents should look at the future revenue and profits generated from the sale of those products and a relief from royalty approach (like that used with trade names) will often apply. The trick becomes determining what royalty to use and what portion of the overall product sales relates specifically to the patents.
  • Software programs can be considered in a number of ways. They are typically monetized through sales or subscription agreements, so an income approach may be appropriate. Perhaps more often, software is valued using the cost approach. What would the buyer have to expend (in programming man-hours, hardware costs, etc.) over what period of time, in order to replicate the software product or obtain a reasonably similar facsimile?

COVID-19 has had an interesting impact on technology assets. Future revenue and profits may decline with customer losses, but the demand for automation software programs is likely to increase as employee costs are rationalized. The huge uplift in the value of ZOOM during spring 2020 may be a short-term trend, or it may be indicative of what technology investments are most attractive in the post-pandemic business environment. Our crystal ball is cloudy.

Non-competition agreements are valued using a form of income approach, but one that requires more than usual consideration due to subjectivity involved. The “with and without” technique is most commonly used. In this method, two DCF models are developed: one assuming the non-compete agreement in place, one assuming the agreement is not in place. The differential between the two is a measure of the asset’s value. Note that, given the individual nature of the non-compete asset, this technique may have to be performed for virtually every employee covered by an agreement.

Reconciling Asset Values and Purchase Price

After identifying and valuing all the intangible assets in a purchase price allocation, more remains to be done. The analyst typically prepares a pro forma balance sheet using the indicated fair values to determine the residual goodwill amount. Judgement may be used to determine whether the goodwill, measured as a percentage of purchase price, appears reasonable.

Comparison with statistics from publicly available deal evidence might also be performed. Some industries naturally reflect higher levels of intangible assets, including goodwill, than others. For example, high-growth technology companies might be expected to have more goodwill than a mature consumer products company.

Appraisal industry best practices dictate other considerations, such as reconciling asset rates of return with the internal rate of return (IRR) implied by the deal. These quantitative exercises may get complex since a market participant IRR may differ from the implied transaction IRR due to company-specific synergies or other factors. The point is that some sort of additional analysis is required in order to rationalize the intangible asset values.

If you have questions about the information mentioned above, contact your Warren Averett advisor or ask a member of our team to reach out to you.

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