Shareholders none the wiser as SFAS 141 has a minimal impact

Some corporations have overpaid for acquisitions and that overpayment has usually been reflected in the goodwill figure. This usually comes to light in subsequent years and management is usually reluctant to admit that such mistakes have been made.  A recent example indicating the potential for this is Google’s acquisition of YouTube for $1.2 billion in 2006 which created headline news in the brand valuation market. Of the total acquisition, only $0.2 billion was allocated to intangible assets and 92% remained as goodwill. We all know that the success of YouTube is largely down to its brand name’s ability to attract subscribers, yet the valuation given for its brand name is extremely low at only 8% of the total acquisition price. Without analysis and explanation of the goodwill figure it does look like there is a significant unaccounted for overpayment:

The numbers of acquisitions for which a Purchase Price Allocation was reported by the S&P 100, including groups of smaller acquisitions reported in aggregate, averaged only just over 40% of all acquisitions made for the five years from 2002 to 2006.There are a small number of US corporations that do report PPAs for small acquisitions. The reason given for this inconsistency is that the application of materiality varies from one company to another.  There is no strict definition on what constitutes materiality and no baseline has been set to suggest that companies should report a PPA on an acquisition if it is above a certain limit.  Therefore there seems to be a great deal of latitude on whether or not a PPA should be reported on smaller acquisitions.

Wells Fargo, a financial services company with a market capitalisation of $117 billion concluded that acquisitions priced at $6.8 billion and $4.1 billion in 2002 and 2003 respectively were immaterial and therefore did not require disclosure of PPAs.  A materiality level of 6% of market capitalisation may be deemed immaterial by Wells Fargo but investors may not think the same. General Electric (market capitalisation $353 billion) deemed that two acquisitions costing more than $11 billion in 2005 and 2006 were immaterial and reported no PPAs.

Hope for future improvement?
Some might find these view challenging or upsetting, but they need to be expressed as a first step towards recognising problems, so that improvements can be made. So SFAS 141 should not be dismissed as useless. Of the reports that we reviewed, there were a handful of corporations that demonstrated a good grasp of the concept of transparent reporting and adopted it through a more robust application of SFAS 141.

There are six categories that intangible assets must be identified: 1) contract, 2) customer, 3) marketing, 4) technology, 5) mixed and 6) artistic related. A company is thus able to categorise its intangibles into relevant areas. We found that US corporations have been better at allocating value to these categories than in the UK, with 9% mixing categories compared with its UK counterparts at 13%. This is encouraging and raises some hope of achieving better reporting of intangible asset values.

In 2003, Lehman Brothers acquired private wealth and asset management group Neuberger Berman for $2.9 billion. Customer relationships were valued at $0.8 billion, other intangibles a further $0.2 billion and goodwill $1.9 billion. Although goodwill represents 66% of total intangibles, Lehman Brother recognised that customer relationships are a substantial asset.

Similarly Sprint’s merger with Nextel for $45 billion showed a better application of SFAS 141.  Under SFAS 141 rules, Sprint was deemed as the acquiror and in the purchase price for Nextel, $41 billion represented intangible assets. Of the $41 billion, 62% was identified as contract and customer related intangibles. Judging by this, it is not all doom and gloom. There is plenty of reason to believe that corporations will look towards achieving improvements in the future reporting of the value of intellectual property. 

Where financial reporting should go
The following three pyramids visually capture the treatment of goodwill and intellectual property and the impact the financial standards have had as well as the opportunity for the future. (see pdf below)

It is interesting to see the progression of the quality of reporting of intangibles over time.  Prior to the introduction of SFAS 141 in 2002, goodwill engulfed the whole pyramid where there was no quantification of intangibles, making it difficult to recognise the commercial value of intangibles such as brand names.  Since the inception of SFAS 141, there have been some attempts to quantify and value intangibles and reduce the proportion of goodwill and this is recognised.  However, the reporting of intangibles could be much better than it is today. 

The proportion of goodwill sitting at the top of the pyramid in Present SFAS 141, representing an average of 48% across a range of industries shown in our study after applying the accounting standard has great room for improvement.

There were few examples that illustrated a good application of SFAS 141 found in our study.  Such a handful of good examples cannot really prove that the inception of SFAS 141 has made the accounting for intangibles more explicit. There are several gaping holes in the standard that desperately need addressing.  The lack of requirement to describe and analyse what is in goodwill is a fundamental flaw in the standard.  This paves the way for accountants to be creative in their valuations. An incentive for accountants to minimise amortisation and impairment charges is almost like a get out clause for under valuation of intangibles or overpayment in acquisitions. In addition, it gives scope for disguising over payments in unexplained goodwill. Such attractive incentives need to be removed.

For those reasons, it is no surprise that the proportion of goodwill remains painfully high.  Our findings show that overall: 1) US Corporations have not been better at reporting intangibles, hence resulting in amounts of goodwill that are too high: and the level of analysis of goodwill is too low. 2) The quality of reporting is similar to that of their UK counterparts under IFRS 3.  The reasons for this are wide ranging. Intangibles are not all being properly identified and some may be allocated low valuations.  Overpayment for acquisitions is almost certainly to be applicable in some cases and nothing given which helps recognise or identify this.

On a lighter note and worth paying attention to is that there is always hope for better reporting, especially whilst there is an accounting standard in place.  Admittedly, we do not live in a perfect world and whilst corporations are still getting to grips with fully adopting SFAS 141, we must give them time to implement properly this accounting standard.  Five years may seem like a long time but a new standard will take time to be fully embraced, especially in an industry which routinely avoided placing values on intangibles.

SFAS 141 certainly has the potential to grow into a more effective accounting standard and once fully appreciated, accountants will be able to apply the standard more easily and be able to offer management and investors a much higher quality of reporting of intangibles.  Transparent reporting will henceforth answer more questions about mergers and acquisition activities. Management and investors will have high level information to fully justify and understand strategic business combinations. 

One day we hope that this type of analysis will become the rule. It would be quite a milestone. The major accounting initiative designed to improve the reporting of intangible value in the US was supposed to bring greater clarity. But a new study shows that SFAS 141, like IFRS 3, has failed to live up to the hype