When accounting for business combinations under IFRS 3, it is important to be aware of issues of double counting asset values in a way which could affect unduly future profitability. Using a single valuation specialist, such as Intangible Business, to manage the whole process can often prevent expensive mistakes.

Inventory step-up
Inventory step-up can be an expensive headache. Typically, inventory is accounted for at cost in a company’s balance sheet. On acquisition, IFRS 3 states that the inventory price should be stepped-up to fair value, or what it can be sold for. The difference between inventory’s production cost price and what it can be sold for is often substantial and as this hits the bottom line directly it is important to get it right.

Inventory step-up issues impact most business acquisitions and most types of inventory, from clothing to pharmaceuticals, fragrance to engineering. It is particularly marked in the spirits industry where the margins are high, brands play a very important role and the inventory is often laid down for many years. For instance if the cost of a bottle of whisky in the balance sheet is at £5 per bottle, the value it would sell for would be about £20. An IFRS 3 implementation might value each bottle at £20 meaning its new owner would lose the opportunity to make £15 per bottle, effectively making no profit whatsoever.

This value of the inventory, however, is double counting the brand value, which is valued elsewhere. As well as the brand, the difference between cost price and its fair value often includes other assets also valued elsewhere. These issues are key to understanding an appropriate level of step-up for the inventory which would be a lot lower than £15.

Property and plant & machinery valuations
Inventory is not the only asset category at risk of double counting brand value and other intangible value. Property valuations also often include a brand valuation. For example, when a property-based business such as a care home, hotel or shop is valued, it is generally valued on an ongoing business basis. This property valuation therefore assumes the use of other assets beyond simply the bricks and mortar, such as the brand, workforce, customer relationships and contracts.

Plant & machinery valuations also often include the contribution of other assets which are valued elsewhere, such as the workforce which operates it, the software which runs it or patents which protect it.

Property naming rights present another layer of complication when valuing property. The status of the property dictates its suitability for inviting sponsorship attached to its name. For instance, the amount a second division football club could command for naming rights for its stadium would increase dramatically if it were to enter the Premiership. This has nothing to do with the property itself, just its occupiers, although this can be worth a significant amount. This is also relevant for other types of property such as music stadiums, shopping malls such as Westfield or Bluewater, hotels or shops such as The Ritz or Harrods and offices such as the Gherkin or Shard of Glass - all of which could benefit from future naming rights as well as benefiting from the strength of their brand name and occupiers.

Where to place brand value?
In many instances it can be most appropriate to include some element of brand value in the value of property or plant & machinery as well as separately accounting for the remainder. There are also advantages of brand value being included in the property value; it is easier to borrow against property, it is less exposed to impairment charges and it is seen as a ‘safer’ asset by the investment community. However, management should be aware of this potential for double counting to avoid the problems it can create. Having a debate about where to put brand value is an important process to go through.

Conclusion
In reality all business are run using a mix of assets which operate in concert. Using a single valuation firm, such as Intangible Business, to value and oversee the valuation of all asset categories, as required by IFRS 3, can result in a more efficient, joined-up process which avoids the potential pitfalls of double counting.

If you have an acquisition you would like advice on, or for more information, please call us on + 44 (0) 20 7089 9236 or send us an email.