Stout’s response to the FASB’s ITC on identifiable intangible assets and subsequent accounting for goodwill.

October 22, 2019

The information below is excerpted from Stout's recent comments sent to the FASB. See related commentary to the FASB here

The Financial Accounting Standards Board (FASB), on July 9, 2019, issued an invitation to comment (ITC), soliciting feedback from users, preparers, and practitioners regarding identifiable intangible assets acquired in a business combination and subsequent accounting for goodwill related to public business entities. At the heart of the ITC are two issues:

  • Whether to Modify the Recognition of Intangible Assets in a Business Combination
  • Whether to Change the Subsequent Accounting for Goodwill  

While we believe the current practice for identifying and valuing acquired assets and liabilities under Topic 805 should be left unchanged, we support two modifications to the current impairment model that would further reduce cost and complexity. The first change is to require an impairment assessment only when a triggering event has occurred. The second change is to perform the goodwill impairment test for reportable segments rather than reporting units.

The below excerpts from Stout’s response to the Invitation to Comment – Identifiable Intangible Assets and Subsequent Accounting for Goodwill (File Reference No. 2019-720) provide our perspective on these important issues, specifically on the topic of modifying the recognition of intangible assets in a business combination.  

The analysis of a company considers several factors depending on the nature of the company, the type of analysis being performed, and the objective of the analysis. However, the company’s net earnings and cash flow commonly receive a significant amount of attention, particularly in cases where the analysis is focused on assessing the long-term growth and financial viability of the company. 

Depreciation and amortization expenses give rise to key differences between net operating earnings and cash flow. For a company that grows organically through investment in tangible assets or capitalized software development costs, it is important to show depreciation of those assets over lives that reflect the time periods of their respective economic benefits. The analysis would be compromised if the company depreciated all tangible assets and capitalized software development costs over prescribed time periods (which may or may not accurately reflect the time period of economic benefit). For a company that grows through business combinations, it is equally important to separately identify, value, and amortize the acquired tangible and intangible assets over lives that reflect the time periods of their respective economic benefits, while at the same time only amortizing those assets that have a finite life.

In both cases, it is important for the analyst to assess whether management’s decisions regarding investment of company resources generate appropriate returns on investment (ROI). In order to assess ROI, it is critical to have accurate net operating earnings and cash flow figures that appropriately reflect the economic benefits generated from the investment.

For these reasons and others outlined herein, we believe the current practice for identifying and valuing acquired assets and liabilities under Topic 805 should be left unchanged.

Please describe what, if any, cost savings would be achieved if certain recognized intangible assets (for example, non-compete agreements or certain customer-related intangible assets) were subsumed into goodwill and amortized. Please be as specific as possible. For example, include specific purchase price allocation or subsequent accounting cost savings. Please list any additional intangible items the Board should consider subsuming into goodwill.

Third-party appraisal costs for business combinations may decline in certain instances if non-compete agreements or certain customer-related intangible assets were subsumed into goodwill and amortized. We see evidence of this occurring under the private company GAAP [generally accepted accounting principles] election. However, it has been our experience that the reduction in cost may not be significant, as preparing the valuation models for these particular assets is only a small part of any valuation engagement performed in accordance with Topic 805. 

We would also note that when customer-related intangibles are not the primary intangible asset in a business combination, these assets often must be valued as a contributory asset supporting the primary income-generating intangible. Further, even when customer-related intangibles are the primary intangible asset, we are often asked to determine their fair values in support of weighted average return on asset (WARA) analyses and excess profit analyses to assess the reasonableness of royalty rates or other inputs to valuation methodologies employed for other intangible assets.

Please describe what, if any, decision-useful information would be lost if certain recognized intangible assets (for example, non-compete agreements or certain customer-related intangible assets, or other items) were subsumed into goodwill and amortized. Please be as specific as possible. For example, include specific analyses you perform that no longer would be possible.

In most instances, no decision-useful information would be lost if non-compete agreements were no longer recognized, but customer-related intangibles continued to be recognized. While non-compete agreements can be, and are, measured as separately identified assets, one can also view the existence of a non-compete agreement as a separate legal agreement that ultimately supports and protects other identifiable intangible assets, such as technology or customer-related intangibles. When non-compete agreements are valued, they are then used as a contributory asset charge against the income streams protected by the non-compete agreements. If non-compete agreements were excluded from the recognition criteria in Topic 805, most often the associated value would be subsumed into other intangible assets and not goodwill, thus resulting in limited information loss to financial statement users. We would further note that non-compete agreements are rarely significant intangible assets in a business combination, and they have been rendered unenforceable in certain jurisdictions.

Substantive decision-useful information would be lost, however, if other identifiable intangible assets were subsumed into goodwill, including customer-related intangible assets. In an increasingly intangible-oriented economy (including technology companies in which intangibles and goodwill can exceed the purchase price), we believe that measuring and recognizing intangible assets in a business combination provides financial statement users with the only viable answer to the question “what did you buy?” that cannot be addressed through a narrative disclosure. The relative importance of brand, technology, customers, other intangibles, and goodwill, as separately measured and identified, provides investors and other financial statement users with a snapshot view of what to expect from the acquisition. For example:

  • A greater share of customer-related intangible assets relative to goodwill implies that the acquisition target is mature and may experience growth in line with the industry overall. The acquisition is lower risk, and perhaps lower reward. 
  • Limited customer-related intangibles, a greater proportion of technology-related assets, and a majority of goodwill indicates significant opportunity and growth is expected, but at the same time investment will likely be required to build a customer base and fully exploit the underlying technology. The acquisition is higher risk, and perhaps higher reward. 

To gauge the market activity, are you aware of instances in which any recognized intangible assets are sold outside a business acquisition? If so, how often does this occur? Please explain.

Recognized intangible assets are not commonly sold outside of a business combination in large part because employing identifiable intangible assets in conjunction with working capital, tangible assets, and an assembled workforce generates more value than on a standalone basis. 

The above notwithstanding, when independent transactions do occur, they often include intangible assets that are somewhat specialized, including:

  • Player contracts in the context of professional sports teams, including esports
  • Customer lists
  • Patents / patent portfolios
  • Certain licenses
  • Trade names and trademarks
  • Film / content libraries

Of the possible approaches presented, which would you support on a cost-benefit basis? Please rank the approaches (1 representing your most preferable approach) and explain why you may not have selected certain approaches.

  • Approach 1: Extend the Private Company Alternative to Subsume Certain CRIs and all NCAs into Goodwill
  • Approach 2: Apply a Principles-Based Criterion for Intangible Assets
  • Approach 3: Subsume All Intangible Assets into Goodwill
  • Approach 4: Do Not Amend the Existing Guidance

We rank these options as follows:

  • Approach 4: Do Not Amend the Existing Guidance
  • Approach 2: Apply a Principles-Based Criterion for Intangible Assets
  • Approach 1: Extend the Private Company Alternative to Subsume Certain CRIs and all NCAs into Goodwill
  • Approach 3: Subsume All Intangible Assets into Goodwill

The recognition and subsequent valuation of identifiable intangible assets should be based on principles rather than strict rules or formulas, as doing so provides appropriate alignment between the economic and strategic underpinnings of the transaction (and purchase price paid) to the values of the acquired assets recorded in purchase accounting.

That being said, we believe a principles-based criterion must be sufficiently broad such that customer-related assets are recognized, consistent with the existing guidance. Customer-related assets have taken on a high degree of importance for investors and other users of financial statement data. This is particularly true for companies that offer products and services on some form of subscription or pay-as-you-go basis. Many companies routinely disclose supplemental financial data in that regard, including monthly (or annually) recurring revenue, customer acquisition costs, customer churn rates, etc. Subsuming customer value into goodwill would negatively impact the information available to financial statement users and public disclosures around acquisitions.

As it relates to Approach 2 (a principles-based criterion), please comment on the operability of recognizing intangible assets based, in part, on assessing whether they meet the asset definition.

The existing asset definition in Concepts Statement 6 may be operable. For example, within the asset definition “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events,” non-contractual customer-related assets maintain the following characteristics:

  1. “Probable future economic benefits” refers to the expectation that past customers will continue to be customers in the future
  2. “obtained or controlled by a particular entity as a result of past transactions or events” refers to previous sales, marketing, and other business development activities by the reporting entity that gave rise to the relationship and maintains the relationship

Approaches 1-3 assume that subsuming additional items into goodwill would necessitate the amortization of goodwill. Do you agree or disagree? Please explain why.

We generally agree. While not amortizing goodwill in approaches 1-3 is an option, doing so would be an even greater departure from reality as it relates to amortizing goodwill derived under the current model. The higher goodwill recorded in approaches 1-3 would include known intangible assets which have finite lives and should be amortized accordingly.