Intangible assets and their valuation
August 2nd, 2016 by Parik Bhandiwad - Manager
Most private companies in the UK report under UK GAAP, mainly due to the reduced reporting criteria in general as compared to IFRS. One key area where UK GAAP and IFRS differ is accounting for business combinations.
Under IFRS 3(R), an acquiring company is required to recognise the intangible assets acquired as a result of a business combination (provided the intangible assets are material to the acquiror’s financial statements). These intangible assets are separate from the goodwill recognised as a consequence of the business combination. However, under UK GAAP, there exists no such requirement, although acquirors reporting under UK GAAP may disclose the intangible assets acquired as part of a business combination, only if they choose to do so. So, in essence, under IFRS the recognition of intangible assets (other than goodwill) as part of a business combination is mandatory; whereas under UK GAAP it is a matter of choice rather than a mandatory requirement. It is no wonder then that most private businesses that report under UK GAAP tend not to disclose intangible assets on completing an acquisition. After all, why should they go through all that trouble of identifying, valuing and reporting intangible assets separately, if they are permitted to just aggregate it all together under acquired goodwill?
But in reality, going through the trouble of valuing intangible assets may actually be worthwhile. Whilst this is mandatory for businesses reporting under IFRS, it may be beneficial even for companies reporting under UK GAAP for the following reasons:
- Intangible assets are amortised over the useful life of the asset, and (unlike depreciation) amortisation on certain intangibles can be deductible for tax purposes, (there are special rules for acquisitions from connected parties). So businesses can save on corporation tax by recognising intangible assets;
- For intangible assets that are not amortised a tax deduction can still be claimed, at an annual rate of 4%;
- Just like tangible assets, intangibles can be transferred between group members on a no gain / no loss basis, deferring corporation tax on the transfer until the asset is sold outside the group;
- Again as with tangible assets, where proceeds from the sale of an intangible asset (including certain goodwill) are reinvested, a claim can be made to defer the taxable gain arising on the first sale by rolling it over against the reinvestment;
- There is a move towards bridging the gap between UK GAAP and IFRS, so it may be possible that UK GAAP might make it mandatory to recognise intangible assets as part of a business combination. By starting early, private companies currently reporting under UK GAAP would be able to ‘stay ahead of the game’; and
- Disclosing intangible assets in the accounts brings about greater transparency and helps quantify acquisition rationale, thereby instilling confidence in the shareholders.
Now that we have outlined a few potential benefits of valuing intangible assets, the first question is likely to be: ‘What are intangible assets?’
IFRS defines intangible assets as ‘identifiable non-monetary assets without any physical substance’. In other words, any asset other than physical assets, which is important for business performance is an intangible asset. To be recognised as an intangible asset, it should be ‘separately identifiable’ and ‘measurable’ i.e. be able to be measured reliably. Some common examples of intangible assets are:
- Customer relationships or contracts
- Technology / software
- In process research & development
- Brand / trade names
- Patents and licences
Intangible assets may be patented or non-patented. For example, customer relationships and brand are non-patented. Technology on the other hand may be patented or non-patented. Some other intangible assets that are valued include domain names, favourable customer or supplier contracts, non-compete agreements and order backlog.
Identification of intangible assets should tie in with the competitive advantage of the business and the key acquisition rationale. So now that we have identified the intangible assets, the next question is: how does one value such assets?
Valuing intangible assets at the outset may seem tricky, since they lack physical substance. However, luckily there are a few time tested methodologies to value most of the common intangible assets. The most common valuation methodologies are – the income method, royalty based approach and cost approach.
The income method relies on estimating future economic benefits that the firm would derive as a result of owning this intangible asset. This approach is suitable for most kinds of intangible assets. The royalty approach, on the other hand, is based on an imputed royalty rate and the economic benefits the firm would derive by owning this intangible asset. This approach is more suited for assets such as technology or brand/ trade names. The cost approach is based on the ‘costs to recreate’ the asset. Whilst this approach may seem straight forward, it is less frequently used as the costs to recreate an asset that lacks physical substance is not easy to estimate.
The impact of deferred tax also needs to be considered.
The above serves as a brief guide to identifying and valuing intangible assets; however, professional judgement is of paramount importance, as is the case with all valuation related matters. Should you have any questions, or wish to discuss requirements for intangible asset valuations, feel free to get in touch with any member of the Corporate Finance & Forensics team at Ensors.
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