BRANDS ON THE BALANCE SHEET
Jan Lindemann
The debate about the value of brands became the driver for the recognition of intangible assets on balance sheets around the world. In 1988, Rank Hovis McDougall (RHM), a leading British food group listed on the London stock exchange, recorded its non-acquired brands as intangible assets on its balance sheet in a defense against a hostile bid by Australian takeover specialist Goodman Fielder Wattie (GFW). The bid came at a time when value focused investment vehicles exploited the value gap created by the relatively low market values of many companies with strong brands. For example, in 1986 the Hanson Trust had acquired Imperial Group for UK£2.3 billion. It then sold the group’s undervalued food portfolio for UK£2.1 billion and retained a highly cash generative tobacco business which net acquisition costs were just about UK£200 million for a business that generated an operating profit of UK£74 million.1
At the time accountants and equity analysts were substantially undervaluing companies with valuable brand assets. RHM therefore decided as part of its defense against the GFW bid to have its brand portfolio valued and included on its balance sheet. The results were quite remarkable. While RHM’s tangible assets amounted to about UK£400 million the brand portfolio was valued at UK£678 million. Based on the value of the brand investors reassessed the value of RHM which led to a significant increase in its share price which soured the deal for GFW and prompted a withdrawal of the bid. In the same year RHM was fighting off GFW’s takeover bid, the UK drinks conglomerate Grand Metropolitan, which later merged with Guinness to become what is today Diageo, reported the value of its acquired brands on its balance sheet. Quite clearly brand-owning companies felt the need to deal with their intangible assets on their balance sheets. The accounting treatment of intangibles assets revealed that accounting standards had neglected the main wealth creating assets in companies and that their regulations could disadvantage companies purchasing businesses with strong brands or other intangibles. Accounting rules had focused predominantly on tangible assets as they could be easily assessed on a cost base and expected to have value in case of a liquidation of the business. This followed the tradition that value creation was mainly a result of the efficient purchase and use of land and manufacturing facilities. This was reflected in the stock markets by relatively low price to book values. However, the financial transactions of the 1980s and rising price to book values of many companies indicated that intangible assets became increasingly important for corporate value. As a result, acquisition prices of companies included an increasingly significant premium over the net assets of the acquired business. The result was what the accountants called goodwill. Goodwill was the catch-all for intangible assets and wealth creating items that were hard to value and negligible relative to the tangible assets. As long as the differences between acquisition prices and net assets were small, goodwill was a minor accounting issue. However, as the goodwill on acquisition increased the issue of dealing with this ever increasing accounting item became important to management and financial markets.
At the time, accounting standards in most markets including the US and Europe required companies to write-off goodwill from acquisitions against reserves. As a result a company could, through the acquisition of a business with valuable brands or other intangible assets for which it had to pay a significant premium over and above net assets, end up with significantly reduced equity as it has to write-off the goodwill against reserves. Clearly, accounting standards were out of sync with business reality.
Initially, accounting bodies were strongly opposed to recognizing intangible assets on the balance sheet. Only in Australia and New Zealand did accounting regulations allow capitalizing intangible assets (acquired and internally generated) on the balance sheet. Prominent companies in these markets made use of this opportunity. Lion Nathan (a leading beer and drinks group in the region), Fontera (a leading dairy conglomerate), and Telecom NZ capitalized their internally generated brands on the balance sheet. For example, in Lion Nathan’s September 2005 financial statements brands accounted for NZ$2.4 billion of the total assets of NZ$4.1 billion which was more than half of the company’s reported asset base. Fonterra, reported intangibles of NZ$1.47 billion, including goodwill of NZ$220 million and purchased brands of NZ$1.2 billion. Telecom NZ published the value of its brand assets in the supplementary information of its 1998 financial statements. In that year, brands constituted 36 percent of the total assets and 14.6 percent of Telecom’s enterprise value. Although these were exceptions they demonstrated that brands accounted for a substantial part of corporate wealth and they could be reliably valued, independently audited, and recognized on companies balance sheets.2
It was, however, the valuation of brands and their inclusion in the balance sheet of RHM and other brand-owning companies in the UK that triggered the accounting debate on the treatment of intangible assets. It took nearly a decade for accounting bodies around the world to adjust to the new business paradigm. In 1997, the UK Standards Board was the first to react by issuing FRS (Financial Reporting Standard) 10 and 11 on the treatment of acquired goodwill on the balance sheet. A year later, the International Accounting Board followed suit with IAS (International Accounting Standard) 38 superseding the UK standards. In 2001 the US Accounting Standards Board introduced FAS (Federal Accounting Standard) 141 and 142 abandoning the pooling of accounting and laying out detailed rules on the treatment of acquired goodwill on the balance sheet. Today most companies follow either the rules of the IAS or ASB. Although the IAS and the FAS are similar in most aspects when dealing with intangible assets including brands there are two significant differences.3 They clearly differentiate between internally generated and acquired intangible assets. As a result acquired brands appear on the balance sheet but internally generated brands do not. So the Burger King brand appears on the accounts of Burger King Holdings because it was acquired while the McDonald’s brand does not appear on the company’s balance sheet as it was internally generated.
The recognition of intangible assets happens within the overall allocation of the purchase price to all of the acquired assets and liabilities in proportion to their fair value. This is known as the Purchase Price Allocation (PPA). This requires the different assets to be identified and valued. The standards have defined intangible assets according to several categories. These are described in Table 8.1.
From an accounting view the marketing related intangible asset represent the brand. As the definitions are driven by legal title and separability the list does not necessarily fit with the more holistic marketing and management view of brands. However, for accounting purposes the brand is sufficiently represented by the marketing related intangible assets. In practice, the marketing related intangibles are rarely separately valued and mostly bundled and valued as brand assets because a meaningful separation and valuation is in most cases neither possible
TABLE 8.1 Intangible asset categories
nor practical. Once the assets are defined their fair value is assessed according to valuation methods prescribed by the standards. Various valuation approaches, each of them based on several different methods, can be employed.
While the fair value of the assets and liabilities already reported in the balance sheet of the acquired business is relatively easy, the valuation of intangible assets such as brands, patents, customer relations, or technologies is more difficult as no recorded and audited value exists. The identified intangible assets need to be valued according to the fair value approach. Fair value is defined as the amount at which an asset could be exchanged between knowledgeable willing parties in an arm’s length transaction. With intangible assets accounting for about threequarters of corporate wealth, they tend to constitute the central value drivers of the acquired company and are, therefore, most important to the acquiring company in the acquisition process. The fair value of these intangible assets must then be determined in accordance with prescribed valuation approaches and methods.
The favored approach is the market approach where the fair value represents the value of a comparable asset in an active market. Alternatively, the price of a comparable market transaction can be used, subject to comparability criteria regarding the similarity between the two intangible assets. The key problem of this approach is the fact that for most intangible assets an active market does not exist and comparable market transactions are scarcely available, if at all. This is a particular issue for brands as they are rarely sold without an underlying business and the number of such transactions is very small. Most brands are sold in the context of an active business. Second, the unique nature of brands makes any comparable approach problematic as discussed in Chapter 5.
The secondary, but in practice most often employed valuation approach, is the income approach. The value of the intangible asset is determined by discounting the future cash flows expected to accrue during the estimated remaining economic useful life. There are two types of income approaches. The first is called the multi-period excess earnings method which values an intangible asset in the context of other tangible or intangible assets. By subtracting fictitious payments for the supporting assets the remaining “excess” cash flows are attributed to the asset to be valued. The second income approach is the incremental cash flow method where the cash flows of the acquired company with the relevant intangible asset are compared to a fictitious company without this asset. The difference represents the “incremental” cash flow attributed to the intangible asset. In both cases the cash flows are discounted to their NPV. Both approaches are problematic. The multiperiod approach relies on the quality and reliability of the charges for the supporting assets which is difficult to obtain and prone to questionable assumptions. The incremental cash flow approach, as discussed in Chapter 5, is not suitable for valuing brands as there are almost no unbranded offers available against which the brand could be compared.
Due to the difficulties involved in the market and income approaches most accounting firms use the relief from royalty method for valuing brands. It is based on the assumption that an external third party would be prepared to pay a license fee for the use of a brand or a patent that it does not own. The value of the intangible asset is then calculated as the NPV of the unpaid license fee. The validity of this approach is based on the assumption that reliable comparable royalty payments for brands can be obtained. However, as the example of the Coca-Cola and Pepsi-Cola brands demonstrates, even brands that are so similar with respect to product, target group, distribution, and price can vary significantly in value. While comparability may work for some of the other intangible assets listed is certainly fails to capture the fair value of brands. In addition, using reported royalty rates is very problematic as these differ by use and markets. Additionally, in many cases there are hidden costs or conditions which are not disclosed but affect the economic benefit generated by the brand license.4
The most suitable approach to valuing brands values the brand according to its assets specific value creation (see Chapter 7). It is interesting to note that the accounting profession has also recognized the limitations of the other valuation approaches. In 2007, the International Standards Valuation Committee (ISVC) published a discussion paper on determining the fair value of intangible assets for IFRS reporting, providing a more detailed approach to intangible assets and their valuations. They suggest different valuation approaches depending on the comparability of these assets. The ISVC recognizes that some intangible assets such as brands are so unique in their nature that they cannot be valued by comparison but only according to the specific cash flow they can produce. This is in line with the valuation approach framework detailed in this book.
Once the intangible assets have been identified and valued they are capitalized according to their fair value. The difference between purchase price of the acquired business and the sum of the fair values of the acquired assets and liabilities is capitalized as goodwill. The capitalized values are subject to annual impairment tests. The purpose of the impairment test is to assess whether the asset value is still fair or needs to be adjusted. Intangible assets with a definite (limited) life are amortized according to their remaining economic useful life on a scheduled basis mostly at the same annual amount. Intangible assets with an indefinite life are also subject to a regular impairment test, and are thus exposed to the risk of unscheduled impairment charges. According to IAS 38, intangible assets have an indefinite life when “there is no foreseeable limit to the period over which the asset is expected to generate net cash flows for the entity.”5 Brands qualify in most cases as intangible assets with an indefinite life. This is fair as many brands have demonstrated an astonishing durability. Of the leading 100 brands covered in the annual BusinessWeek survey about 70 percent have been in existence for more than 50 years. The value of the intangible asset is adjusted according to the impairment test. If the value is higher or the same no impairment has occurred and the asset value on the balance sheet remains unchanged. The value cannot increase. If however, the impairment value is lower the balance sheet value of the asset needs to be reduced and the impaired value amount is expensed through the income statement. Despite these elaborate valuation rules the actual detail of the reporting on intangible assets tends to be rather thin. Even companies such as The Coca-Cola Company or P&G that are mainly brand driven disclose very little about their acquired brands compared to their tangible assets and other investments. Although the values of intangible assets and goodwill are reported there is little or no detail as to which specific brands and assets they refer. Overall, the reporting detail on tangible and financial assets by far outstrips the reporting on acquired intangible assets.
The debate about brands on the balance sheet has had a significant impact on the treatment of intangible assets on the balance sheet. However, the resultant changes in the accounting standards have been more a pragmatic solution for the accountants to deal with the increasing goodwill in acquisitions than an alignment of the balance sheet with commercial reality. The accounting rules on acquired goodwill are a half-way house in their dealings with brands as well as with other intangible assets. They only recognize those brand assets that have been subject of an acquisition. As a result, internally generated intangible assets are still not recognized. While this may be convenient and understandable from a technical accounting point of view, it is clearly at odds with economic reality.
The new standards have also blurred the valuation principles of the balance sheet. By putting values on the balance sheet that are based on the expected future cash flows, accounting standards have changed the nature of the balance sheet which used to be a costs-based record of historical investment. While the acquisition price is the cost a company paid for the purchase of another business it is based on a NPV of future expected earnings. Splitting up the value of intangible assets such as brands according to this principle means putting DCF-based fair values next to pure asset cost values such as land, buildings, and machinery.
The question then arises: Why are the acquired assets fairly valued and the internally generated not? From an accounting aspect, the answer is relatively simple. For the acquired intangible assets a transaction-based cost value provides a fair market value. For internally generated assets this is not the case. While this helps to balance the books it is unsatisfactory from an economic value perspective as the majority of corporate value is not accounted for on the balance sheet. The original idea of the balance sheet was to record the cost of assets the firm uses to generate revenues and profits. It also provided a basis for the liquidation value of the business. For the majority of businesses this is now of little use as the business value is mainly generated by intangible assets not accounted for on the balance sheet. The same is true for analysts and investors. Changes in the accounting regime that are not cash flow effective have little impact on investors’ and analysts’ views on companies’ share prices.
Intangible assets account for the majority of business value as evidenced by an average price to tangible book value of the S&P 500 over the past 25 years of 3.9. Brands are among the most important intangible assets accounting, on average, for about one-third of shareholder value. In many leading companies, brands are the single most important and valuable asset. As such the new accounting standards exacerbate the conceptual problem with the current logic of the balance sheet. It is supposed to represent the fair value of a company’s assets but fails to account sufficiently for the majority corporate value.
Due to the permanent revaluation of share prices there will always be a difference between book and market value. The question about the best approach to fill this gap in order to align financial reporting with economic reality remains. The current balance sheet treatment of brands and other intangibles provides very little information on these assets. Goodwill and intangible assets have now a clear place on the balance sheet but there is little information beyond the actual figures. If the balance sheet is supposed to give capital providers an insight about the brand as an economic asset then the reporting is doing a rather poor job. There is also an issue with the depth and quality of the valuations. In particular for brands the most widely used approach is the royalty relief method which relies on the quality of comparable royalty rates. While this may be suitable for some intangible assets it is certainly not for brands which by their very nature are different. Another issue is the fact that the purchase price allocation easily becomes a regulatory required administrative task rather than a source of valuable information for investors. The majority of brand valuations conducted by accounting firms are performed in a bundled valuation of all intangible assets with a focus on the allocation issue.
The fact that companies with high brand values have significantly higher price to book ratios than companies with little or no brand value provides clear evidence of the systematic under-reporting of assets.6 Consequently, the balance sheets of companies with high brand values are unlikely to represent their asset base due to the omission of some measure of brand value. Accounting standards may need to consider including reliable measures of intangible assets, like brand value, to enhance the representational integrity of balance sheets. The current regulations are insufficient in that respect. Due to the important nature of brands there needs to be reflection of their value creation based on a suitable asset specific valuation approach. This does not have to be the balance sheet but an additional form of reporting that provides sufficient information on the value and health of companies’ brands and other intangible assets could be suitable. This will not explain the value gap between balance sheet and market value but will improve the disclosure of one of the single most important and valuable business assets.
NOTES
- Lord Hanson, 2004; Hope Lambert, 1987; “Lord of the Raiders,” 2004.
- Lloyd Austin, 2007, pp. 64–5.
- KPMG, 2007.
- KPMG, 2007; PwC, 2008.
- IAS 38.
- Philip Little, David Coffee and Roger Lirely, 2005.
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