Buyers (and sellers): beware of new rules. (Accounting).

In an interview, noted appraisal expert Alfred King talks about the impact of new accounting standards and offers advice to companies weighing or actually doing transactions.

It's been more than a year since the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 141, "Business Combinations," and No. 142, "Goodwill and Other Intangible Assets." All companies were required to adopt these standards at the beginning of their fiscal year, starting with the first fiscal year after Dec. 31, 2001. The first effects of these new standards were felt earlier this year, when companies began announcing goodwill "impairment" charges, such as AOL Time Warner Inc.'s huge first-quarter impairment charge of $54 billion.

These new accounting standards will definitely affect merger and acquisition strategy, because they will govern how companies have to account for new acquisitions. A key factor in deciding what to bid for a company will be how to value and account for its intangible assets.

Alfred King, vice chairman of Valuation Research Corp., has been a professional appraiser for more than 30 years and does half or more of his work representing buyers or sellers. William Sinnett, research manager at the FEE Research Foundation, recently sat down with King to discuss how the valuation of tangible and intangible assets will affect buyers and sellers.

Please review briefly the new rules affecting M&A transactions.

King: Most readers are probably familiar with SFAS No. 141 and No. 142. Pooling of interest accounting is dead. All M&A transactions must be treated under purchase accounting rules. This means that every purchase requires a valuation of all the assets acquired, both tangible and intangible. In theory, the old rules of APB 16 and APB 17 did not change, but previously most firms did not look closely at acquired intangible assets. Now they have to,

And, of course, what is charged to goodwill no longer has to be written off periodically over periods up to 40 years. The quid pro quo that the FASB put in was to force companies explicitly to examine intangibles directly, since, for the most part, these intangible assets do have to be amortized.

The Board recognized -- and companies are now discovering -- that there will be great pressure to maximize goodwill and minimize intangibles. Because companies want to maximize reported earnings per share (EPS), there is a tremendous incentive to place as low a value as possible on intangible assets.

How did the FASB hold companies' "feet to the fire" to maximize amounts charged to intangible assets?

King: The new FASB Standard 141 actually has language very similar to the old APB 16 and 17. In fact, the original generally accepted accounting principles (GAAP) requirements, developed in the early 1970s, called for companies to identify and value all intangible assets. But because goodwill had to be written off, and the intangible assets also had to be written off, most acquirers took the easy way out and allocated most of the excess purchase price to goodwill.

Their rationale was that the impact on P&L [profits and losses] was going to be minimal because either amortization of goodwill or amortization of specific intangibles would affect earnings essentially the same. It cost a lot less time and money to put everything into the goodwill basket. In practice, the SEC did not seem to care. Consequently, auditors did not pursue making clients rigorously follow the language of the old APB requirements. And, of course, companies were not interested in committing resources in an area that appeared to have virtually no payback.

That has all changed. The new rules lay out a list of some 29 separate intangibles (see SPAS No. 141, Appendix A). Companies, appraisers, public accountants and the SEC are all using this as a checklist. For the first time, the difference between intangible assets and goodwill is real, and the new rules are, in practice, being followed. What may not be so well known is that the rules do provide a degree of flexibility in valuing the various types of intangible assets.

What are some of the traditional ways that companies have valued their assets, especially intangible assets?

King: There were no financial reporting requirements for appraisals in pooling transactions, although in some cases there were tax requirements in a pooling for some valuation work. Appraisal companies over the years have developed consistent procedures in allocating the purchase price in those M&A transactions treated as a purchase. We, and most valuation firms, are maintaining those same procedures for SPAS No. 141 and No. 142.

Very briefly, we usually accept working capital (current assets and current liabilities) amounts based on the audited financial statements, although there are circumstances where we take a close look at inventories. Property, plant and equipment (PP&E) are revalued on the assumption that the assets will continue in use for the purpose for which they were acquired. If a company plans to dispose of assets fairly soon, we value those assets at net realizable value.

For ongoing PP&E, we essentially look at the current cost of replacement, then adjust those amounts by our estimate of depreciation from all causes. Note that we do not use financial reporting depreciation. Rather, our appraisers physically inspect the assets and evaluate physical and functional depreciation or loss in value. In some cases, particularly in poorly performing product lines, we also make an assessment of economic depreciation, which values the assets at no more than [a figure] supported by the income generated from those assets.

For intangible assets, we essentially look at the income stream generated. For example, a patent might be valued based on the cost savings generated from a unique technology. A customer list might be valued based on the rental income it can generate -- for example, if Land's End rented its list to L. L. Bean and others.

The new accounting rules have not affected appraisers' actual methodologies. What has changed is the vastly increased emphasis on identifying, and then valuing, each of the 29 different types of intangibles.

Given the new accounting rules, what are some valuation strategies for buyers?

King: Buyers are clearly focusing on what intangible assets the prospective target may have. Then they want to estimate both the dollar amount that will have to be allocated and the time period during which the amortization must take place. While generally not appreciated, the new GAAP requirements do not automatically allow straight-line amortization.

If the asset's value diminishes more rapidly in the early years, then more must be written off early on. An example might be a non-compete covenant with a five-year life. Obviously, if after four years the competition has not started, the likelihood in year five is further diminished. Thus, for that asset, the buyer would have to use some sort of accelerated amortization.

Buyers are trying to anticipate the impact on reported earnings and EPS, just as much as on projected cash flows. Sometimes they can do it themselves; at other times, they will ask their valuation adviser to prepare a preliminary estimate. If there is a large amount of identifiable intangibles with an inordinately short life, buyers may actually reduce their [bid]. Publicly traded companies are very sensitive to reported earnings per share, which will be affected by intangible asset amortization.

We have found that privately held companies focus more on cash flow and less on reported EPS. Whether this means that in a bidding contest, a privately held firm would be willing to pay more has yet to be seen.

Keep in mind that for tax purposes, all intangible assets, including goodwill, must be written off over 15 years -- no more and no less. This means that for intangible assets, there is a total disconnect between financial reporting and taxes.

Conversely, what are some strategies for sellers?

King: Sellers want to maximize the potential value of their business. The best way to do this is to explicitly identify their real intangible assets, regardless of the required accounting treatment called for in SFAS 141.

For example, there is a real question how much value must be ascribed to "customer relationships," given the exact working of SFAS No. 141. In practice, it sometimes turns out that relatively few dollars have to be identified as such. Nevertheless, perhaps the most valuable assets most sellers bring to the table, even though they are never on the balance sheet, are the actual customers they do business with and are likely to keep in the future.

Prospective sellers should let buyers know what assets they really have. Accounting entries for the buyer are important, but even more important is a good business fit, with good products and a good customer base. GAAP presently does not allow companies to put self-developed intangibles on their balance sheets, and our professional recommendation to the FASB is that this should not be permitted. But there is a difference between identifying and valuing actual intangible assets, off the books, and putting those same dollars on the balance sheet.

Effectively, we tell sellers, "Know what you really are worth. Don't pay attention to GAAP. Pay attention to the real economics of your business and what a buyer will actually get."

Our recommendation here is for the company, either on its own or with outside assistance, to determine the real value of all its assets. Forget for the moment financial reporting and GAAP requirements. As a seller, if you have this information in advance of any negotiations, you likely will be able to obtain a higher price than if you wait for the buyer to decide what your assets are worth. Certainly, the buyer has no incentive to tell the prospective seller how valuable its technology or customers are. We strongly recommend a valuation of intangibles and goodwill before a possible acquisition, and to have all resulting documentation in writing. A potential buyer may simply accept the seller's valuations.

Will public companies and privately held companies have similar strategies, or will they be different?

King: GAAP requirements are identical for privately held buyers and publicly traded buyers. The difference is that virtually all publicly traded firms are interested in doing everything possible, within the rules, to maximize reported earnings and EPS. Most privately held firms put a much higher priority on cash flow, usually by minimizing taxes, and GAAP statements are usually prepared only for their lenders.

Goodwill and intangible assets, as well as any related amortization, are usually discounted by lenders, so privately held firms are essentially indifferent to the new requirements -- that is, unless they plan to go public shortly. Then they are even more concerned about reported EPS. But that is a different story.

In general, what is the tax strategy for privately held companies involved in a merger?

King: In a "business combination," which is how the FASB describes a merger, privately held companies want to maximize amounts allocated to PP&E. These are usually written off over less than the 15-year requirement for all intangibles as shown in Section 197 of the Internal Revenue Code. In effect, private firms want to minimize intangibles and goodwill. One exception might be if they expect, or hope, to be acquired by a public company in the near future or have an initial public offering, in which case they would have no reason to minimize intangibles.

So in most M&A transactions, there will be differences between income as reported for tax purposes and income as reported according to GAAP?

King: Yes. Financial reporting considerations are usually more important for public firms. Private firms seem to have greater flexibility in their approach to the actual purchase price allocation process. But the new accounting rules, now part of GAAP, do not directly or indirectly affect tax accounting.

RELATED ARTICLE: Strategies Under New Rules

BUYERS

* Focus on intangibles, amortization

* Anticipate impact on earnings

* Cash flow key for private companies

SELLERS

* Identify real intangible assets

* Focus on real economics, not GAAP

* Get a valuation in writing