Determining the fair value of assets acquired and liabilities assumed in a business combination is a critical step when preparing a post-transaction opening balance sheet, and there is an ever increasing amount of guidance related to determining the fair value of intangible assets. The impact that intangible assets ultimately have on the acquirer’s post-transaction income statements is addressed much less frequently in accounting literature. That impact depends on the determination of an indefinite or finite life; on an assessment of the asset’s appropriate remaining useful life (“RUL”), if finite; and on decisions regarding an appropriate amortization methodology. This article addresses each of those considerations.
Financial Accounting Standards Board Accounting Standards Codification (“ASC”) Topic 350-30-35, General Intangibles Other than Goodwill — Subsequent Measurement (“ASC 350-30-35”), outlines generally accepted accounting principles (“GAAP”) in the United States for determining the useful life of an intangible asset and, if necessary, how to subsequently apply amortization. The guidance is relatively lacking, however, compared with literature that exists for other accounting topics. Further, comments by the Securities and Exchange Commission (“SEC”) indicate that RUL and amortization determinations frequently lead to SEC Comment Letters, and the topic has been a concern dating as far back as 2003. Given regulators’ focus on the area and the general lack of interpretative guidance, reporting entities should consider intangible asset life and amortization methods during the purchase accounting process.
The first decision to be made when determining an intangible asset’s remaining useful life is whether there should be one at all. An intangible asset is considered to have a finite life expectancy if there is a foreseeable limit on the period over which the asset is expected to contribute to cash flow. Conversely, an intangible asset has an indefinite life when there is no foreseeable limit on the period of time over which the intangible asset is expected to provide cash flows, and when there are no legal, regulatory, contractual, competitive, or other factors that limit the useful life of the asset. Note that this guidance does not indicate the asset has an infinite life, only that the life extends beyond the foreseeable horizon. That said, only a small group of assets — most commonly marketing-related intangibles such as trade names, but also certain licenses, franchise rights, and other assets with unique industry-specific factors — can realistically be determined to have an indefinite life. Usually, customer-based intangibles and assets that are reliant on patents and technology are generally thought to be wasting in nature and thus definite-lived, or finite. An indefinite life should be assigned to in-process research and development (“IPR&D”) activities but only until they are completed or abandoned.
The determination that an asset has an indefinite useful life carries several accounting consequences, most notably the lack of a regular impact on the income statement due to amortization expense. An indefinite-lived intangible asset, however, is subject to annual impairment testing, and the reporting entity must regularly reassess its determination regarding useful life. When the indefinite life determination no longer remains appropriate, amortization of the asset will commence. For definite-lived intangible assets, regular amortization expense beginning on the transaction date will result in lower net income, all else being equal.
Because amortization is a noncash expense, entities that focus on net income — unlike entities focused on other measures of earnings such as earnings before interest, taxes, depreciation, and amortization (“EBITDA”) — may generally prefer the determination of an indefinite life in order to avoid an impact on earnings per share. However, some entities may also appreciate the consistency of known amortization expense versus the potential for one-time impairment charges. Regardless of the reasoning behind the determination of useful life, reporting entities should use the criteria outlined in ASC 350-30-35 to document support for selecting an indefinite life for an intangible asset.
For intangible assets that have finite lives, ASC 350-30-35 outlines the following factors that should be considered when estimating the RUL:
In practice, the application of the previous considerations can leverage several key inputs to a purchase accounting analysis in order to determine an appropriate useful life. The following table outlines several commonly recognized intangible assets and the corresponding variables that may be used to indicate appropriate RULs:
When cash flows are calculated in order to determine the fair value of an asset, a common rule of thumb is that the remaining useful life should approximate the time frame over which approximately 80% to 95% of the cash flows are expected to be realized. Although this method is not endorsed in U.S. GAAP, often it can be used as a supplemental calculation to support the reasonableness of the useful life determined using the aforementioned factors.
After estimating the RUL of an intangible asset, the reporting entity must determine the method by which that asset will be amortized. To calculate the amortization of any wasting asset, the entity must consider whether the asset will have any residual value; however, an intangible asset is generally assumed not to have residual value unless it is expected to continue to have a useful life to another entity and either (1) the reporting entity has a commitment from a third party to purchase the asset at the end of its original useful life or (2) the residual value can be determined by reference to an exchange transaction in an existing market. Thus, residual value rarely exists for intangible assets.
ASC 350-30-35 stipulates that the method of intangible asset amortization shall reflect the pattern in which the economic benefits of the asset are consumed or otherwise used. If that pattern cannot be reliably determined, straight-line amortization is appropriate and, in practice, is the most commonly adopted method of amortization. In fact, limited guidance exists for alternative methods, although if the economic benefits indicate it is appropriate to do so, aligning the amortization expense with the expected cash flows for an asset that was valued using an income-based approach is one way to accelerate the expense.
Customer-related assets lend themselves to alternative amortization methodologies more than other intangibles do as they are often the primary assets acquired (leading to an income-based valuation methodology) and because the attrition rate is usually applied multiplicatively (leading to higher cash flows in the initial periods, even before present value considerations). Accordingly, the higher the attrition rate, the more the asset’s indicated amortization may deviate from a straight-line method. Figure 1 illustrates how the cash flows used to determine the fair value of a customer-based asset could be leveraged to calculate appropriate amortization expense. It is important to note, however, that this highly simplified example is presented to illustrate how one might calculate amortization in a manner that differs from straight-line amortization. In practice, however, a shorter RUL and straight-line amortization can be used to determine amortization expense that isn’t materially different from a calculation using the highly simplified method presented here.
The figures used to determine the customer relationships value are the end result of a multi-period excess earnings method (“MPEEM”) and reflect 10% attrition, a deduction for income taxes, contributory asset charges, and present value factors. As indicated, the summation of the cash flows and the addition of the present value of the tax benefit from amortization result in a fair value of $40,500. If a 10-year RUL is determined to be appropriate based on the attrition factor of 10%, the first 10 years of cash flow can be used to calculate the amortization curve. (Note that a period of 10 years also captures approximately 92% of the pretax benefit cash flows, consistent with the rule of thumb previously described for determining useful life.) As illustrated in this example, more than half of the fair value would be amortized in the first three years.
The post-transaction accounting impact of business combinations on an acquirer’s income statements greatly depends on the determination of an appropriate RUL and, if necessary, the selected amortization methodology. Although this article highlights several ways in which a purchase accounting analysis can help determine these inputs, ultimately RUL and amortization methodology determinations are accounting policy decisions that the acquirer must make. When conducting their analysis, valuation specialists should be aware of any accounting policies that a reporting entity has in place to the guide post-transaction impact, and management of the reporting entity should understand how the valuation analysis aligns with its accounting policies.