A New Scorecard for Intellectual Property; Pay Attention to Purchase Price Allocations in Financial Statements
Donohue, James, Vallario, Cynthia Waller, Journal of Accountancy
Auditors and finance executives are charged with helping companies make sure they appropriately disclose intangible assets, acquired either separately or as part of a business combination, to financial statement users. Now that FASB Statement no. 141, Accounting for Business Combinations, and Statement no. 142, Accounting for Goodwill and Other Intangible Assets, are in effect, companies can no longer combine goodwill with other intangible assets such as intellectual property (IP) on their balance sheets. Instead they must report goodwill and intangibles separately, must disclose intangible asset classes--such as patents and trademarks--and must provide the estimated useful lives of such intangible assets in financial statement footnotes. (For more information see "Say Good-bye to Pooling and Goodwill Amortization," JofA, Sep.01, page 31).
By specifically identifying patents, trademarks, trade secrets, licensing agreements and other IP involved in a business combination as intangible assets that require a separate valuation apart from goodwill, FASB has highlighted the importance of IP in the allocation process (see "FASB Changes Accounting for IP on Balance Sheet"). As a result, auditors and corporate finance executives must be aware of a significant distinction in the accounting treatment of business combinations: While goodwill no longer will be amortized, certain intangibles (those with finite lives) must be. Since companies generally are reluctant to report an item that may have a negative impact on earnings, such as depreciating intangibles, CPAs must recognize when a purchase price allocation might raise questions from the SEC to ensure their clients are not surprised after the business combination is completed. Unless companies can support their accounting decisions, regulators will question allocating the entire purchase price to goodwill rather than part of it to IP and other intangible assets. Here's some guidance for CPAs on how to handle these IP accounting issues to ensure the success of a business combination.
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. …