Allocation of business assets into tangible and intangible components: A new lexicon. (Features).
Allocation of total appraised value for certain operating properties between tangible and intangible components, if not required by investors, is mandated by USPAP and required for taxation, underwriting, and condemnation. Not well covered in the appraisal literature, the dialogue has been complicated by contradictions among the meanings of terms used by the various appraisal subgroups. Because the terms business enterprise, business enterprise value, going concern, going concern value, and goodwill are so confounded, new terms were coined coincident with developing the Appraisal Institute's Course 800. This article defines these new terms and introduces a methodology for allocating tangible and intangible asset values.
Allocating the assets of operating properties into tangible and intangible components is a timely topic for discussion and examination due to the frequency with which this topic is now being confronted in journal articles, case law, appraisal standards, and state statutes. Examples of the currency of this issue include:
* Senate Bill 5286, amending the Revised Code of Washington (RCW) to exempt intangible property from ad valorem taxation, enacted on July 27, 1997. (1)
* California Revenue and Tax Code, [degrees][+ or -]110, specifically exempting intangible property from ad valorem taxation by stating in part, "[t]he value of intangible assets and rights to the going concern value of a business using taxable property shall not enhance or be reflected in the value of the taxable property."
* California Code of Civil Procedure, [section]1263.510, requiring that an "owner of a business conducted on the property taken, or on the remainder if such property is part of a larger parcel, shall be compensated for loss of goodwill if the owner proves...." (2)
* Courts awarding compensation for the "going concern value" of a business located on property condemned through the exercise of eminent domain. (3)
* Differences in depreciable lives for tangible and intangible business assets (4) requiring separate value estimates for numerous property classes and categories.
* USPAP SR 1-2(e) and 1-4(g) requiring appraisers to "identify and consider the effect on value of any personal property, trade fixtures, or intangible items that are not real property but are included in the appraisal."
* Numerous journal articles published over the past decade debating "business enterprise value" issues for operating properties and retail malls in particular. (5)
Because most viable operating enterprises trade as going concerns and inasmuch as most investors are not interested in allocating the value among the components, issues of the existence and magnitude of the non-real estate components and how they are to be allocated pose problems to anyone analyzing such transactions. This dilemma notwithstanding, for reasons such as proper assessment valuations, condemnation and lending requirements, and tax issues, allocations must be made. Unfortunately, there has been little definitive direction in the appraisal body of knowledge as to composition of the intangibles or how the allocation of the components of the operating enterprise could be performed.
To a great extent, dialogue concerning these issues has been hampered by a lack of a common language among various disciplines such as accounting, business, and property valuation. In particular, participants in the ongoing debate have adopted differing terminologies and assigned disparate meanings to terms commonly used in a variety of contexts. What is meant by going concern, going concern value, going value, business enterprise, business value, business enterprise value, or goodwill depends on the root discipline of the user of the term, the authoritative source consulted, and/or the legal citation referenced. As the following will show, there is no consensus concerning which term to apply to a given situation nor the appropriate definition to assign to a given term.
Welcome to Babylon
Business Enterprise Value
A limited search of the literature reveals at least five different definitions of business enterprise and/or business enterprise value. Examples of varying perceptions of what these terms mean include:
* The Appraisal of Real Estate (6) refers to business enterprise value (BEV) as:
a value enhancement that results from items of intangible personal property such as marketing and management skill, an assembled work force working capital, trade names, franchises, parents, trademarks, non-realty related contracts or leases, and some operating agreements.
* The Dictionary of Real Estate Appraisal (7) provides the following definition of "business value":
a value enhancement that results from items of intangible personal property such as marketing and management skill, an assembled work force, working capital, trade names, franchises, patents, trademarks, contracts, leases, and operating agreements.
* The IAAO Glossary for Property Appraisal and Assessment (8) defines BEV as:
a term applied to the concept of an intangible, nonrealty component of a property's value probably ascribable to supramarginal management competence. Different from goodwill and going concern value.
* In Journal of Property Tax Management, Fisher d Kinnard (9) describe BEV as:
an intangible asset.... the measurable and transferable present worth of the business organization, management, assembled workforce, skills, working capital, and legal rights (trade names, business names, franchises, patents, trademarks. contracts, leases, and operating agreements) that have been assembled to make the business a viable and valuable entity in its competitive market.
* International Valuation Standards 2000 (10) doesn't define BEV, per se. A definition of business enterprise, however, is offered: [a] commercial, industrial, service or investment entity pursuing an economic activity; generally a profit-making enterprise.
These five perspectives on business enterprise and business enterprise value differ in substantive ways. First, none specifically includes the value of entrepreneurship in the traditional sense of excess, economic, or entrepreneurial profit (a topic discussed in more detail later), although the International Valuation Standards may be construed to include this under the rubric of "generally a profit-making enterprise." It is unclear, however, whether the definition is referring to accounting profit or economic profit, (11) which is fundamental in determining the extent to which revenue should actually accrue to the entrepreneur. Second, the IAAO definition fails to recognize that supramarginal management expertise must be paid a supranormal management fee. In a competitive market for management, the supranormal management fee would be sufficient to exhaust any revenue derived from the activities of a supranormal manager, leaving no revenue to ascribe to BEV. Third, the Dictionary of Real Estate Appraisal defi nition seems to include the value of all forms of leases. However, real property lease revenue has always been ascribed to the value of the realty, not the intangibles.
In addition to uncertainty regarding the definitions of "business enterprise" and "business enterprise value," confusion exists concerning the degree to which these terms are synonymous with "going concern" and "going concern value." Desmond and Kelley, writing from a business valuation perspective, hold that "going concern [value] is an intangible that attaches to the tangible assets of some businesses." (12) This position is echoed in Northern Natural Gas Company, et al. v. United States of America (13) and appears in Real Estate Appraisal Terminology (14):
It (going concern value) is an excess of value over cost, which arises as a consequence of a complete and well-assembled operation production mechanism; it is the value of an efficient layout and operational control system resulting in the most desirable synchronization of the merchandising, production, or distribution activities of the enterprise.
Conversely, other authoritative sources hold that going concern includes all of the assets of a business, tangible or intangible, with the proviso that the value of the business in continuing operation exceeds the liquidation value of the business assets, less liquidation costs. As an example of mainstream thinking in financial accounting, Ingram and Baldwin (15) hold that a going concern is:
an organization with an indefinite life that is sufficiently long that, over time, all currently incomplete transformations [transforming resources from one form to a different, more valuable, form] will be completed.
The unencumbered value of the organization (corporation, partnership, or sole proprietorship) would presumably include the value of all of the organization's assets, which would likely include tangible and intangible property.
As with business enterprise, there are also many differing viewpoints concerning what goodwill is and how it is defined. Five examples follow:
* The Business Valuation Handbook (16):
those elements of a business or person which cause customers to return to that business or person and which usually enable a firm to generate profit in excess of that which is required for a reasonable return on all of the other assets of the business.
* Financial Accounting, (17) a financial accounting textbook:
the value of all favorable attributes that relate to a business enterprise. These include exceptional management, desirable location, good customer relations, skilled employees, high-quality products, fair pricing policies, and harmonious relations with labor unions.
* Ingram and Baldwin provide a different financial accounting-based definition:
the excess of the purchase price of a company over the fair market value of its net assets (assets-liabilities) ... value that is nor recognized on the balance sheet.
* The American Society of Appraisers:
an intangible asset that arises as a result of name, reputation, customer patronage, location, products, and similar factors that have not been separately identified and/or valued but that generate economic benefits. (18)
* International Valuation Standards 2000:
an intangible but marketable asset based on the probability that customers will continue to resort to the same premises where the business is carried on under a particular name, or where goods are sold or services provided under a trade name, with the result that there is likely to be continuing prospect of earning an acceptable profit.
arises as a result of name, reputation, customer patronage, location, products and similar factors that have nor been separately identified and/or valued but which generate economic benefits.
Critical examination uncovers several problems with these definitions. First, one of the financial accounting definitions includes assets common to some of the definitions of business enterprise such as exceptional management, an assembled work force, and business name. Second, the Desmond and Kelley definition refers to "those elements of a business, which cause customers to return." Couldn't such elements be tangible? If so, are they goodwill? Third, several of the definitions include "location." Location seems to imply that goodwill is an attribute of real property, since location is meaningless in any sense other than spatial. Is goodwill an element of realty? Finally, what is meant by an "acceptable profit" or "profit in excess of what is required for a reasonable return on all of the other assets of the business"? Are the definitions referring to accounting profit or economic profit? Is a "reasonable return" to be interpreted in an opportunity cost context? The definitions are imprecise and unclear.
A New Lexicon
Language is the means by which we communicate what we are doing and precisely what is being valued. Because the terms business enterprise, business enterprise value, going concern, going concern value, and goodwill are so confounded, new terms were coined coincident with developing an Appraisal Institute course dealing with tangible and intangible business assets. The new course, Separating Real and Personal Property from Intangible Business Assets (Course 800), covers the theory of the firm, entrepreneurship, an introduction to business valuation, measuring intangible asset capitalization rates, and provides procedural examples--all of which rely on the new lexicon. It introduces methodology for estimating the value of the total assets of the business (TAB); and, using a case study of a full-service hotel, illustrates how the tangible and intangible components of value can be allocated. The real property residual model illustrated in the course hotel example is summarized as follows:
+ Value of total assets of the business
- Furnishings, fixtures, and equipment value
- Cash and equivalents value
- Skilled workforce value
- Name/reputation/affiliation value
- Residual intangible assets value
= Real property value as a residual
Figure 1 shows some of the bases for development and discussion of the new terminology. It breaks down the asset side of a firm's balance sheet into underlying tangible and intangible property components. By ignoring the liability side of the balance sheet, it looks at a firm or business as if it has no accounts payable, no other short-term or long-term debt, and concentrates solely on business assets.
The following discussion begins by precisely defining the going concern, the entity owning all of the business assets. The new definition comes from a financial accounting perspective, enabling clearer dialogue with financial market professionals.
A going concern is an established and operating business having an indefinite future life.
A going concern is a business that can own tangible and intangible assets. The definition's phrase "indefinite future life" distinguishes going concerns from businesses that have no future, requiring valuation under an alternative liquidation premise rather than the going concern premise applicable to businesses having an indefinite future life. The term "going concern value" should be abandoned for two reasons. First, there is little agreement as to the term's meaning; second it is a sloppy construct. More often than not, when we say "going concern value" what we really mean to say is "market value of the going concern," but the imprecise going concern value phrase could just as easily be interpreted as "investment value of the going concern" or "insurable value of the going concern." In order to precisely identify what is being valued, Course 800 introduced the term "market value of the total assets of the business." This term is consistent with valuing all of the assets shown in Figure 1, and it is clearly different from "business value," used by business valuers when estimating business value net of short-term liabilities.
Market Value of the Total Assets of the Business (MVTAB)
Market value of the total assets of the business is the market value of all of the tangible and intangible assets of a business as if sold in aggregate as a going concern. (19)
As Figure 1 shows, total business (going concern) assets are divided into two primary categories- tangible property and intangible property. Tangible property consists of items that can be seen, touched, and felt. Tangible business assets are further divided into real property and personal property, such as inventory, furnishings, fixtures, and equipment. No new terminology is needed to precisely describe the tangible business assets.
Intangible property includes numerous ethereal assets such as cash, (20) a workforce, contracts, business name, patents, copyrights, and potentially numerous other assets. Three new terms are being adopted to enable better appraisal-client communication: total intangible assets, identified intangible assets, and residual intangible assets.
Total Intangible Assets (TIA)
Total intangible assets are all of the intangible assets owned by a business (going concern), which can be further divided into two categories for valuation purposes: identified intangible assets and residual intangible assets.
Identified Intangible Assets (IIA)
Identified intangible assets are those intangible assets of a business (going concern) that have been separately identified and valued in an appraisal.
Residual Intangible Assets (RIA)
Residual intangible assets are those intangible assets of a business (going concern) that have not been separately identified and valued in an appraisal. The value of residual intangible assets equals the value of total intangible assets minus the value of identified intangible assets.
Figure 1 includes an item labeled CEP (an acronym for capitalized economic profit) as one possible intangible business asset. CEP is based on economic theory dating from Richard Cantillon (1680-1734) and contributed to over time by highly regarded scholars such as Joseph Schumpeter (The Theory of Economic Development, 1912) and Frank Knight (Risk, Uncertainty and Profit, 1921). (21) Briefly, economic profit is what remains after all productive agents (land, labor, and capital) have been paid the full opportunity cost of their contribution to the firm's production process. Economic profit differs dramatically from accounting profit because opportunity cost is not considered in the computation of accounting profit. Economic profit can be, and usually is, fleeting due to the effects of competition. Thus, it is capitalized at a very high rate indicative of the uncertainty associated with its future continuation. Because economic profit is often temporary in nature, any value attributable to it is apt to exist for a finite period until it is fully eroded by market competition. Nevertheless, economic profits do occur, and expectations of continuing future economic profits are valuable intangible assets. Since economic profits are nearly impossible to isolate and value separately, CEP is included in the figure as an element of residual intangible assets for valuation purposes. The new definition for CEP follows.
Capitalized Economic Profit (CEP)
Capitalized economic profit is the present worth of an entrepreneur's economic (pure) profit expectation from being engaged in the activity of acquiring an asset, or collection of assets, at a known price and then selling, or being able to sell, the same asset or collection of assets at a future uncertain price. The amount of the entrepreneur's expected economic profit, and consequent CEP, is determined by the nature of the risks taken and/or the expected return to the entrepreneur's innovation. CEP is the value of a residual claim, which is subordinate to the opportunity cost daims of all agents of production employed by the business (e.g., land, labor, and/or capital).
Course 800 introduces five new terms and six new definitions to the valuation lexicon, dispensing with vague and confusing terminology including going concern value, business enterprise, business enterprise value, and goodwill (which remains a valid, yet ill-defined, term in a financial accounting sense). Going concern is precisely defined, making it clear that the going concern is the business, which may own both tangible and intangible assets.
The five new terms introduced are market value of the total assets of the business, total intangible assets, identified intangible assets, residual intangible assets, and capitalized economic profit. This new lexicon will enable appraisers to precisely describe what is being included in the various asset categories when separating real and personal tangible business asset values and intangible business asset values. This will go a long way toward clearing up confusion resulting from the current multitude of meanings for commonly used and commonly misinterpreted business asset valuation terminology. The new definitions provide a linguistic foundation, applying the theory of the firm to the real world problem of separating the values of tangible and intangible business assets in a logical and systematic way.
Marvin L. Wolverton, PhD, MAI, has been appraising real property since 1976. He is currently a visiting associate professor at the Department of Finance, University of Nevada-Las Vegas. He previously held the position of Alvin J. Wolff Distinguished Professor of Real Estate at Washington State University. He holds a PhD in Business Administration from Georgia State University in Atlanta Georgia and a MS in economics from Arizona State University. His bachelor's degree is from New Mexico Tech, Socorro, New Mexico, in mining engineering.
David C. Lennhoff, MAI, SREA, CRE, has been appraising real estate in the Washington, DC, metropolitan area since 1973. He is currently president of the Appraisal Division of Delta Associates, a Transwestern Company. He specializes in litigation valuation.
James D. Vernor, PhD, MAI, is the Chairman Emeritus and Associate Professor Emeritus of Real Estate at Georgia State University. Mr. Vernor received his PhD at the University of Wisconsin-Madison in real estate and urban land economics. He has published article is numerous publications such as The Appraisal Journal, Assessment Journal, Valuation Insights & Perspectives, The Journal of Property Tax Management, Economic Development Review, The Quarterly Byte, Real Estate Review, Appraisal Review Journal, Real Estate Issues, and Real Estate Appraiser/Analyst.
Richard Marchitelli, MAI, CRE, is a director in the real estate valuation/consulting practice of PricewaterhouseCoopers LLP, where he counsels private and public sector clients on use, capital deployment, valuation, dispute resolution, litigation support, and strategic asset management issues. He is a former Editor-in-Chief of The Appraisal Journal (1989-1994) and is a past contributor. He has chaired various Appraisal Institute committees and has been a recipient of several awards of that organization including the Lum Award (1998), the Wagner Award (1995), and the George L. Schmutz Memorial Award (1984).
(1.) See RCW 84.36.070, Intangible Personal Property-Appraisal, for a detailed list of assets considered to be intangible and exempt under this newly enacted legislation.
(2.) The owner must satisfy four requirements (requisite proofs) in order to be eligible for compensation for goodwill. Interested readers are referred to the code for additional detail. The code defines goodwill as "the benefits that accrue to a business as a result of its location, reputation for dependability, skill or quality, and any other circumstances resulting in probable retention of old or acquisition of new patronage." For further clarification and interpretation of this statute, see People v. George H. Muller, et al, 36 Cal.3d 263 and P. M. Millar, "Understanding Goodwill Appraisals," Right of Way (May/June 2000): 14.
(3.) See City of Detroit v. Michael's Prescriptions, N.W.2d, 1985 Mich. App LEXIS 2772, July 1, 1985; which relied on Grand Rapids and Indiana Railroad Company v. Weiden, 38 NW 394 (1888).
(4.) See IRS publication 946, How to Depreciate Property.
(5.) See David C. Lennhoff, ed., A Business Enterprise Value Anthology (Chicago: Appraisal Institute, 2001).
(6.) Appraisal Institute, The Appraisal of Real Estate, 11th ed. (Chicago: Appraisal Institute, 1996), updated in the 12th edition.
(7.) Appraisal Institute, The Dictionary of Real Estate Appraisal, 3rd ed. (Chicago: Appraisal Institute, 1993).
(8.) International Association of Assessing Officers, Glossary for Property Appraisal and Assessment (Chicago: International Association of Assessing Officers, 1997).
(9.) Jeffery D. Fisher and William N. Kinnard, "The Business Enterprise Value Component of Operating Properties," in A Business Enterprise Value Anthology, David C. Lennhoff, ed. (Chicago: Appraisal Institute, 2001).
(10.) International Valuation Standards Committee, International Valuation Standards 2000 (London: International Valuation Standards Committee, 2000).
(11.) Accounting profit is computed in accordance with generally accepted accounting practices, whereas economic profit includes deductions for additional implicit business expenses and opportunity costs such as uncompensated or under-compensated owner work effort.
(12.) G. M. Desmond and R. E. Kelley, Business Valuation Handbook (Los Angeles: Valuation Press, 1980): 168.
(13.) 407 F2d 1107, 1973.
(14.) B. N. Boyce, Real Estate Appraisal Terminology (Cambridge, MA: Ballinger, 1975).
(15.) Robert W. Ingram and Bruce A. Baldwin, Financial Accounting: A Bridge to Decision Making, 3rd ed. (Cincinnati: South-Western College Publishing, 1998).
(16.) Desmond and Kelley.
(17.) J.J. Weygandt, D. E. Kieso, and P.D. Kimmel, Financial Accounting, 2nd ed. (New York: John Wiley & Sons, 1998).
(18.) As cited in S.P. Pratt, Business Valuation Body of Knowledge (New York: John Wiley & Sons, 1998).
(19.) This means that the "going concern premise" applies. i.e., the business is expected to continue operating well into the future. A value estimate made under the going concern premise assumes that the entire business would change hands if it were sold at a price equal to the value estimate.
(20.) The concept of money being an intangible asset is sometimes difficult to grasp because money can be seen, touched, and felt. However, physical money is intrinsically worthless. According to P. A. Samuelson and W. O. Nordhaus, Economics, 13th ed. (New York: McGraw-Hill, 1989), money "is an artificial social convention." Since we abandoned our commodity money (gold) standard, money has been valued for what it can purchase and-the degree to which society honors the statement that its paper money is "legal tender." Thus, cash and equivalents are classified as intangible assets. For in-depth reading on this topic see Samuelson and Nordhaus, "History of Money," 226-230; D. Foley, "Money in Economic Activity," Money, J. Eatwell, M. Miligate, and P. Newman, eds. (New York: W. W. Norton, 1989): 248-262; and B. T. McCallum, "Monetary Standards: Fiat Versus commodity Money," Monetary Economics: Theory and Policy (New York: Macmillan, 1989): 22-24.
(21.) For a more complete discussion of this concept, see the essay on the theory of profit in M. Blaug, Economic Theory in Retrospect (Cambridge: Cambridge University Press, 1985): 458-465.