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A
friend recently purchased Microsoft common stock. He paid about $28.45 per share, representing a price-to-earnings ratio of almost 42 and, more important, a price-to-book value (or stockholders’ equity) of 4.33. Certainly, the accounting convention of book value had no bearing on what my friend paid, which reflected a substantial premium over reported stockholders’ equity.
What
accounts for this difference between reported or carried book value
and the company’s market valuation?
The answer: Intangible assets that haven’t been accounted for
historically. But the rules for accounting for these assets are
changing, and the changes are fast becoming the responsibility of
accountants. In this article, we’ll show you how to do this at your
desk for at least a quick review by remembering two silly words:
MACCT and SLERT. You won’t be an expert, but you can begin to
make better sense of your clients’ working papers.
No
one expects all accountants to become skilled at appraisal, but they’ll
need to become much more knowledgeable about the valuation process.
Uncovering these unidentified layers in a company’s value is like
peeling an onion. There are many separate layers to be considered.
The
Financial Accounting Standards Board (FASB) has placed a major
emphasis on better balance sheet accounting after years of income
statement emphasis. In June, FASB met to discuss fair value
disclosures, extending the earlier changes they made to purchase price
allocation and goodwill asset treatment. There was considerable
discussion about “current market value” versus “fair value,”
and I suspect there was additional debate about “fair value” in
contrast to “fair market value.” For now, let’s consider the
easier issue of what is in the different layers before considering
nomenclature and refinements.
The
way that we have been accounting for assets is slowly changing from an
historical cost perspective to a present value perspective. This will
require that the accountant has more knowledge about valuation theory
and practice.
The
balance sheet has drifted away from reality. In the early 1900s, most
companies focused on turning tangible raw materials into finished
goods, and business assets were dominated by real property holdings,
plant, and equipment. Today, the largest and fastest-growing companies
are dominated by unique ideas and concepts, by intangible assets that
we’ve failed to capture in their balance sheets. This change has
made it more difficult to use balance sheets for business management
or analyses.
In
the article “Blue Sky Blues,” in the July/August 2004 issue of
Valuation Strategies (Warren Gorham Lamont/Thomson RIA),
we discuss how merger and acquisition professionals should begin to
apply the tools offered in Statement of Financial Accounting Standard
(SFAS) 141 so that both buyers and sellers of a business are more
knowledgeable about the subject business.
For
too long, even the language of business assets has been constrained.
Accountants have not had the verbal tools to readily describe and
identify — much less quantify — important asset classes. While
business owners maintained detailed schedules of their real estate and
machines, including depreciation and reinvestment entries carried out
to the penny, other assets, such as repeat customers and brand name
investments, were poorly accounted for, hence the term “blue sky.”
But while that term carried negative connotations, these intangible
assets are very real, and in many cases provide companies with most of
their value.
SFAS 141 Guide
Appendix
“A” of SFAS 141 provides an excellent guide for accountants to
begin asset identification and classification. This standard and its
related appendix should be the first step toward better understanding
a client’s balance sheet. The appendix lists five distinct
categories:
-
Marketing-related
intangible assets, such as trademarks and Internet domain names
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Artistic-related
intangible assets, such as literary and musical works
-
Customer-related
intangible assets, such as customer lists and order backlogs
-
Contract-based
intangible assets, such as licensing, lease, and franchise
agreements
-
Technology-based
intangible assets, such as technology (both patented and
unpatented) and computer software
At
the Minnesota Business Valuation Group we’ve reduced these five
asset classifications to an acronym: MACCT, short for marketing, artistic, customer, contract, and technology.
If the accountant simply turns to the appendix in the standard and
uses it as a guideline with the client company, he or she will be able
to identify important asset groups or classes.
Does Asset Stand Alone?
After conducting the interview and beginning the process of identifying some potential intangible assets, the accountant must ascertain which of those identified are in fact correctly classified as intangible assets and which are not. The test for this is to ask whether the asset that has been identified can be sold
separately. Can the asset be separated from the company and transferred to another
owner?
If the asset can stand on its own, it probably should be identified and valued separately. At that point, the accountant will determine if the asset has a defined or finite useful life or if it has an indefinite useful life. If the asset’s useful life is reasonably certain and the client company purchased the asset (as opposed to developing it internally), the accountant may elect to amortize the asset. If the asset’s useful life is indeterminate (such as goodwill), the asset may be reported but amortized only subject to annual impairment testing.
Referring to SFAS 141, MBVG uses another acronym to remember which assets should be considered.
SLERT means sold, licensed, exchanged, rented, or transferred. In other words, any asset that can be sold, licensed, exchanged, rented, or transferred from the subject company to another entity should be considered a separable intangible asset.
Setting the
Value(s)
After identifying the intangible asset classifications (including useful life), the accountant is ready to look for an appraisal.
Each accounting firm will set forth its own policies and rules with respect to how the valuation work should be done, but in a post-Enron environment and with the advent of Sarbanes-Oxley, MBVG believes that most accounting firms are willing to assist the client in conducting preliminary testing but require outside, independent help for an actual purchase price allocation and/or step 2 impairment testing.
The new standards for SFAS 141 and 142 set forth a new concept of reporting units. While these units fit closely with the previously used business segments, the definitions are probably somewhat clearer and certainly require a more careful examination by the auditor. MBVG has experienced differences from one accounting firm to the next, but most firms are rigorous in defining units; they generally discourage combining unlike subsidiaries and divisions into one unit.
The valuation process works as follows: The valuation firm first develops an overall appraisal of the business on a controlling interest or enterprise basis. The company’s reported equity is then examined and adjusted by subtracting all carried goodwill and other intangible assets.
The net tangible asset value is then compared to the company’s going concern aggregate value. If there’s a difference, such as an aggregate value that’s smaller than the net tangible book value, it’s likely that the firm has suffered from tangible asset impairment. If the difference is larger than the net tangible book value, then the difference should be attributable to intangible assets that aren’t carried on the balance sheet. Or the difference may be attributable to an increased value in the tangible assets.
The accountant or analyst should begin by examining the tangible assets for potential revaluation and then use the MACCT and SLERT process to identify intangible assets that may be contributing to the aggregate company value.
Slicing
and Dicing
Once the accountant/analyst has obtained a value for the company as a whole, divided it into the appropriate reporting units, revalued the tangible assets and marked them to market, and specifically identified the intangible assets that contribute value to the business, he or she is ready to value those assets.
Clearly this is the step
for which an outside professional is most important. On a simplified basis, however, the process is much like the excess earnings method that was used in the early days of valuation by the U.S. government to appraise breweries that were closed during the prohibition. In short, the appraiser slices and dices the revenue stream, allocating portions of the income to pay expenses relative to discrete asset categories. Thus, the appraiser will make assumptions about the required rate of return on real property, equipment, and similar tangible assets, as well as the required rate of return on certain intangible asset classifications.
Just as the valuation community has pointed to the difficulty of obtaining and assigning rates to discrete asset categories using the excess earnings method, appraisers are employing this very method to estimate the values of intangible classifications.
MBVG believes it’s unlikely that the appraisal industry will soon find any strong “empirical” data to support the rates they assign to these asset classifications, but appraisers can substantiate that the more speculative or uncertain the future cash flow from an asset, the higher the required rate of return. In addition, when all of the rates of return are combined and weighted for the proportionate amount of cash flow that is generated by the business, the combined rate of return should equal the rate of return the analyst used to value the company as a
whole.
Conclusion
In this article, we’ve explained how an accountant can identify certain asset classifications at his or her desk to help the client better understand what constitutes value in a business. We’ve also discussed how this information can be used to ascertain what makes up the difference between a firm’s going concern and its reported book value. Finally, we’ve explained how an accountant can use this information to reduce time and expense with an outside appraiser and better judge the appraiser’s work during an audit or review engagement.
Randall Schostag is President of the Minnesota Business Valuation Group, Minneapolis, Minnesota. MBVG provides valuation services for both tangible and intangible assets, for accounting, transaction, and compliance purposes, such as ESOP, gift and estate, and regulatory. For more information, visit
www.BusValGroup.com or call 1.800.303.2889. Mr. Schostag can be reached at
RSchostag@BusValGroup.com.
For a copy of the article, contact Brian O'Neil, managing editor of Valuation
Strategies, at 1-212-807-2837 or Brian.O’Neil@thompson.com.
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