Shân Kennedy undertook this exercise on behalf of the FRC and, in this article, she reviews the survey results and ways in which companies could improve their accounting for acquisitions through effective use of the guidance available from different sources.

A copy of the FRC report entitled ‘FRC Study: Accounting for Acquisitions January 2010’ is available from the FRC website. Some of the key findings are listed below.

• On average, the total of purchased goodwill and recognised intangible assets amounted to 100% of the purchase price with net tangible assets arising being £nil. Thus, accounting for goodwill and intangible assets is critical to an understanding of the transaction.
• On average, two thirds of the purchase price was represented by purchased goodwill and one third by intangible assets. The seemingly low amount allocated to intangible assets suggests that companies are omitting to identify all their acquired intangibles.
• There was little consistency between the commentary from the directors at the front of the annual report regarding the reasons for the acquisition and the intangible assets actually recognised in the accounts. For instance, there were cases of customer contracts being identified as key to the transaction by the directors but not recognised as intangible assets in the accounts.
• Companies appeared to encounter particular difficulty in identifying which customer relationship intangible assets to recognise separately from goodwill.
• The guidance available from the International Valuations Standards Council, (IVSC) may assist companies with intangible asset valuation issues. ‘Guidance Note 4: The Valuation of Intangible Assets, February 2010’ may be downloaded from the ivsc.org.

Some of the steps that companies could take to address the weaknesses highlighted by the FRC study are considered below.   
Identification of the intangible assets arising is a critical first step and requires a good understanding of the acquired business and rationale for the acquisition. The following sources may assist the following.

1. The Illustrative Examples to IFRS 3 provide examples of different types of intangible assets:
   1. marketing-related such as trademarks, newspaper mastheads, domain names
   2. customer-related such as customer lists, contract & related relationships, non-contractual customer relationships
   3. artistic-related such as plays, books, musical compositions, pictures
   4. contract-based such as licences, permits, franchises
   5. technology-based such as patented technology, software, databases.
2. IVSC Guidance Note 4 provides similar categories although it does not identify contract-based intangibles separately from the other categories.
3. The sale and purchase agreement – details of specific technology, customer lists and patents are often listed in an appendix.
4. Discussions with purchasing management including the reasons to be cited for the acquisition in the directors’ annual report commentary.
5. If possible, discussion with selling management.

In order to fall into the category of being distinct from goodwill, an intangible asset must, under IAS 38, Intangible Assets, be either (or both) separable or legally secured.  An intangible asset is separable if it can be licensed or sold separately from the underlying business. Many intangible assets that are not legally secured, such as unpatented technology or software and certain non-contractual customer relationships, fall into this category. The appropriate unit of account needs to be identified.

• For a portfolio of customer contracts, this may be the full portfolio as a single intangible asset.  In some cases, the portfolio may require stratification for valuation purposes, such as by high and low value contracts.
• If, however, a portfolio of drinks brands were acquired, it is likely that each brand would need to be valued separately as a result of the unique characteristics of brands. 

Paragraph 37 of IAS 38 provides useful guidance allowing the aggregation, for valuation purposes, of several components of an intangible asset if they have similar useful lives. For instance, a brand name may comprise several components such as underlying technology, trade name and packaging – these may be combined into a single composite intangible asset provided all components have similar useful lives. This paragraph can be used to good effect in practice to reduce the volume of valuation work required.

Customer-related intangible assets provide particular challenges and arise in many acquisitions.  The key to accounting for them is to decide what the different intangible assets are and whether they should be recognised separately or combined. 

• Customer lists are identified in the Illustrative Examples to IFRS 3 as intangible assets as a result of their being separable. 
• Customer contracts arise frequently and treatment of their renewal causes difficulty … IFRS guidance being seemingly inconsistent. Appendix B40 to IFRS 3 provides pragmatic guidance that the renewals should be valued together with the underlying contract as a single intangible asset. In contradiction to this, paragraph 71(b) of the Basis for Conclusions to IAS 38 states that contract renewals are intangible assets distinct from the underlying contract!

A good sense check to undertake before finalising any IFRS 3 intangible asset valuation exercise is to review the draft annual reports and accounts in their entirety. Do they provide a coherent and consistent account of the transaction, with the purpose of the acquisition as described by the directors in the narrative dove-tailing with the intangible assets recognised in the accounts?

About the author
Shân Kennedy is an independent IFRS and valuation expert.  In 2007 and 2008, she was engaged by the IVSC to draft guidance on the valuation of intangible assets. The views expressed in this article are the author’s own and should not be taken to represent the views of the FRC, IVSC, or the ICAEW. shankennedy.co.uk

March 2011
Valuation Group