The SEC and
SFAS 141 and 142
I.
Introduction
The Playfair Group provides consulting and valuation
services with respect to compliance with SFAS 141 and 142
(see Appendix I for more details). We are based in Atlanta,
Georgia, and are comprised of accountants, lawyers, and
business appraisers. On average, each of our consultants has
over 20 years of experience.
We recognize that many of those entities who are impacted by
SFAS 141 and 142 are also public companies, and must
therefore also comply with SEC regulations with respect to
recognizing, valuing, and reporting business combinations and
intangible assets.
Our reading of SFAS 141 and 142 leads us to conclude that
although the expressed method of valuation is fair value, in
point of fact it is investment value, because the preferred
approach is that of the market. We believe that the
appropriate person to conduct such a valuation is a
certified business appraiser specializing in intangible
assets. Do you agree?
II. Areas for discussion
We have identified a number of areas of divergence between
the FASB and SEC, and seek SEC guidance on their resolution:
1. Business Combinations—Purchase Method Procedures
In SFAS 141, paragraph 13, FASB affirmed the principles of
historical-cost accounting. At its heart is the use of fair
value to measure asset acquisition. However, at the FASB
Board meeting on June 19, 2002, the Board discarded the cost
approach in favor of the market approach: (also, what is the
SEC’s position on the income approach?)
The measurement of identifiable assets and liabilities
initially recorded at fair value by the acquirer in a
business combination should be determined:
1. By
reference to an observable market transaction (for example,
an exchange of cash for the same or similar item at or near
the transaction date).
2. If (1) is not available, through valuation methods or
techniques (such as present value, option pricing models, or
appraisals) using market-based assumptions with the
objective of determining the item’s fair value. Market-based
assumptions are assumptions that market participants would
consider in assessing the fair value of an asset or a
liability when the fair value cannot be directly observed in
the market.
3. If neither (1) nor (2) is available, through valuation
methods or techniques (such as present value, option pricing
models, or appraisals) using assumptions not contrary to
market (in instances in which market-based assumptions are
not available, as a practical matter an entity can use its
own assumptions). Assumptions are not contrary to market
assumptions (that is, they are compatible with the fair
value measurement objective) as long as there is no contrary
information indicating that market participants would use
different assumptions. If such information is available,
assumptions that incorporate market information should be
used.
Adoption of
the hierarchy is expected to (1) result in general
principles that can be applied to all identifiable assets
and liabilities that are required to be measured at fair
value at the date of acquisition, (2) clarify when
entity-specific considerations are appropriate in
determining fair value, and (3) assist in greater
comparability and consistency in financial reporting for
business combinations.
Question: Will the SEC also support the use of the
market approach with regard to the determination of the
purchase price of a business combination? If so, when would
registrants have to adopt the use of the market rather than
cost approach?
2. Fair Value
At the FASB Board meeting on June 19, 2002, the Board also
expressed the view that fair value was “value in exchange”
rather than “value in use.”
Question: Will the SEC also adopt this interpretation of
fair value?
3. IPR&D
In the past, the SEC has criticized registrants for
“excessive” classification in the purchase price of IPR&D as
expense rather than goodwill.
Question: In light of the support provided in SFAS 141,
paragraph 42 for expensing IPR&D that has no alternative
future use, will the SEC now stop criticism of the practice?
4. Customer Relationships
The SEC perspective is different from that of the FASB. The
FASB as a matter of policy is focused on accurately
reflecting the pattern in which the economic benefits are
consumed or otherwise used up. The SEC approach reflects a
reliance on traditional consumer patterns rather than for
example Hi-Tech, which is far more volatile in the
competitive phase of the development of the market, but
characterized by enormous customer loyalty once a dominant
entity comes to the fore. Thereafter, while the dominant
party may experience profit erosion, their market share
remains relatively uniform. On the other hand, its
competitors experience both erosion in revenues, customer
share and market share, along with a high degree of
volatility as they fight over the balance of the
marketplace. Consequently, the majority of customers served
by non-dominant companies tend to be highly transitory,
always migrating to where the best deal and terms are to be
found. Whereas the majority of customers found in the market
remain a constant for the dominant player. Whenever new
innovation arises the dominant player often enjoys the
greatest benefits in terms of revenues and new customers.
Question: With
respect to customers of Hi-Tech firms, does the SEC agree
and therefore expect registrants to value their customer
relations in a manner consistent with the above-mentioned
market characteristics?
5. Useful Life
SFAS 142, paragraph 11 defines the useful life of an
intangible asset to an entity, as “the period over which the
asset is expected to contribute directly or indirectly to
the future cash flows of that entity.”
Question: In the past, the SEC has expressed the view that
technology based intangible assets should have a useful life
of no more then twenty years. Does the SEC still believe
this to be the case?
6. Amortization
Under SFAS 142, paragraphs 11 and 12 provide that
amortization should occur over the useful life of the
intangible asset to the reporting entity. The method of
amortization is to reflect the pattern in which the economic
benefits are consumed or otherwise used up.
In commenting on APB Opinion 17, the SEC has expressed
concerns about goodwill generating above average earnings
beyond ten years after the acquisition in an industry that
enjoys little earnings variability and low barriers to
entry. The SEC has also indicated “there remain few examples
of intangible assets that have retained material revenue
generating capacity after 40 years without alteration or
enhancement.”
Questions:
A. Will the
SEC from now on, with respect to amortization, consider
economic use rather than looking at earnings?
B. With regard to technology, where product life cycles are
so short (sometimes as little as six to eighteen months),
what guidance are you willing to give as to an appropriate
amortization period?
C. Would the SEC deem as the exception to the rule revenue
generating capacity associated with the trade secret for
Coca-Cola?
7.
Impairment
The SEC has in the past questioned the timing and
appropriateness of impairment charges. In light of the
provision in SFAS 142, paragraph 28 to test for impairment
testing where “more likely that not” there may be an
impairment, does the SEC feel that the FASB guidance on the
indicators of such an impairment are sufficient?
Reporting Unit
A reporting unit is an operating segment (as described in
FASB Statement 131 (141?), paragraph 10 Disclosures about
Segments of an Enterprise and Related Information) or one
level below an operating segment (referred to as a
“component”). A component of an operating segment is a
reporting unit if the component constitutes a business (as
described in Emerging Issues Task Force Issue 98-3,
"Determining Whether a Non-Monetary Transaction Involves
Receipt of Productive Assets or of a Business"), for which
discrete (stand-alone) financial information is available
and segment management (FASB Statement 131 (141?), paragraph
14) regularly reviews the operating results of that
component (FASB Statement 142, paragraph 30-31).
The SEC is on record as stating that: “the evaluation of
enterprise-level goodwill cannot occur at a level which does
not include all of the operations which benefit directly
from that acquired intangible.”
Question: Clearly, the FASB’s method of testing for
impairment does not take into account all of the benefiting
operations of the goodwill, whether as a result of synergies
or direct input. How does the SEC expect registrants to
resolve this clear difference of approach?
8. “Material Impairment”
The SEC on June 12, 2002 announced that it now requires in
the 8K, the disclosure of a “material impairment.”
Question: What constitutes a “material impairment?”
9. Transitional Impairment
As the SEC is well aware, 59 public companies reported that
in the first quarter of 2002 they were forced to write off
$210 billion in goodwill in compliance with SFAS 141 and
142. Part of the reason they did this was because the FASB
indicated that if they did this in the first quarter after
adoption (i.e. first quarter, 2002), it would be deemed a
change in accounting principle and therefore not a charge
against earnings.
The SEC has indicated that: “The impairment charge should be
presented as a change in estimate within operating income
(or loss) and not as the cumulative effect of a change in
accounting principle.”
Question: What do you want registrants to do?
III. The ball is in the SEC’s court
We believe that regardless of what the FASB requires, for
most organizations they will only feel compelled to follow
SFAS 141 and 142 if they know that the SEC will enforce its
provisions. Thus, in the final analysis the SEC is the
arbiter of what SFAS 141 and 142 means. Accordingly, we
would appreciate the opportunity to ensure that our
work is consistent with your requirements.
Appendix I - TPG Products and Services
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Audit services
– identification, capture, and classification of intangible
assets including trade secrets, as well as goodwill; gap
analysis with respect to protecting intellectual property;
risk assessment as to IP liability exposure
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Regulatory
guidance – cost and purchase-price allocation, determination
of reporting units, the identification and assignment of
intangible assets and goodwill, useful life testing,
amortization of an intangible asset with a definite useful
life, impairment testing, FASB and SEC financial disclosures
of intangible assets
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Best
practices, policies and procedures (documentation and
templates) – purchase price and cost allocation, determining
reporting units, determining intangible assets and goodwill,
determining the useful lives of intangible assets,
determining the existence or not of indicators of
impairment, FASB and SEC disclosures of intangibles,
maximizing the value of intangibles to increase shareholder
value and enhance the balance sheet
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Valuation
Services – real estate, equipment, business and intangible
asset valuations
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Useful life
and impairment tests – evaluation of indicators of
impairment; useful life analysis
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Software
application – process flow application and database to
provide the necessary documentation of the compliance
process
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Education
services – seminars, workshops, individual & group classes
on intangible asset management, best practices and
procedures for compliance with SFAS 141, 142, and 144
Value
Proposition
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Accurate
knowledge of intangible assets will increase a company’s
bottom line, market capitalization, shareholder value, and
cash flow.
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Accurate
knowledge of intangible assets will reduce a company’s tax
exposure and provide compliance with the new rules.
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Accurate
knowledge will provide investors with confidence in a
company and a greater likelihood that they will invest in
it.
Why TPG?
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End-to-end
solution. Benefit: One solution provider to resolve the
issues relating to compliance with the new regulations.
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Standardized
methodologies, best practices, policies and procedures.
Benefits: Everyone knows what to do, what is expected of
them and how to do it. As a result, the job gets done
faster, costs less, and the work product has a higher level
of integrity and accuracy than a non-standardized, non-structured alternative.
-
Software tool
to provide a framework, process, and system for compliance.
Benefits: A simple, easy to use tool that allows the user to
navigate through all of the issues and processes an
organization must address to be in compliance with the new
regulations. The tool provides a faster and less expensive
process than the manual alternative.
-
Greater
transparency assured through the use of the tool in
conjunction with established procedures by certified
experts. Benefit: The software tool provides a clear audit
trail and easily accessible repository of the history,
process, and results of a corporation’s compliance. Only such
a demonstrable facility will meet the demands for accuracy
and transparency now being required by the SEC and investors.
