SFAS Nos. 141 and 142: Up close and personal

For many industries, hard assets and historic costs have become antiquated metrics of financial health. Instead, today’s analysts and investors want more information on intangible assets and market values.

The Financial Accounting Standards Board (FASB) has slowly begun to remedy the gap between what generally accepted accounting principles (GAAP) financial statements offer and what analysts and investors want. As a result, the FASB has passed several new standards — including Statement of Financial Accounting Standards (SFAS) Nos. 141 and 142 — that require business valuation and intangible asset expertise.

Understanding SFAS No. 141 - SFAS No. 141 (Business Combinations) eliminated the option of recording mergers and acquisitions with the pooling-of-interest method. Instead, companies that merge with or acquire another company after June 2001 must use the purchase method, which entails allocating the purchase price to the entity’s tangible and intangible assets based on their respective fair values. (See the sidebar “Calculating fair value.”)

As a result of SFAS No. 141, companies that merge with or acquire another company must give investors and analysts a better idea of their intangible assets’ market values.

Purchase price allocations under SFAS No. 141 are also more complex than in the past. Now companies must differentiate goodwill from other identifiable intangible assets, such as software, noncompete agreements, customer lists and brand names.

Getting to know SFAS No. 142 - In the years after a merger or an acquisition, SFAS No. 142 (Goodwill and Other Intangible Assets) kicks in. Formerly a dumping ground for intangible value, goodwill is no longer amortizable under SFAS No. 142. But other identifiable intangibles continue to be amortized over their useful lives.

In lieu of amortization, companies must periodically estimate the fair value of goodwill and other intangible assets. If an intangible asset’s fair value has fallen below its book value, the company may need to reduce the amount shown on its balance sheet and lower its earnings to reflect the impairment. SFAS No. 142 also calls for enhanced footnote disclosures on intangible asset impairment.

Clarifying confusion - Issued in 2001, SFAS Nos. 141 and 142 continue to raise questions and concerns from financial professionals and require ongoing clarification from the FASB. These valuation assignments differ in many ways from traditional business valuation engagements.

Here are some reasons that SFAS Nos. 141 and 142 confound financial professionals:

Determining the appropriate purchase price - The first step in allocating a purchase price under SFAS No. 141 is estimating the cash equivalent price paid in a business combination, including any cash payments and liabilities incurred. But when a transaction involves payments other than cash, this seemingly simple step becomes complicated.

For instance, valuators may find it more difficult to determine a reasonable purchase price for deals that involve contingent payments or exchanges of private company stock. Furthermore, a seller under duress may accept a discounted price. In this case, the purchase price may be significantly less than the combined fair value of the entity’s assets.

Using the appropriate valuation method - The FASB has established a three-tiered hierarchy of valuation techniques to help valuators estimate fair value:

Level 1. The active market to which a company has immediate access.

Level 2. Quoted prices for similar assets traded on an active market.

Level 3. Other valuation techniques, such as the market, income and cost approaches.

As evidenced by this hierarchy, the FASB endorses the guideline-public-company method for determining fair value.

Timing impairment tests - At a minimum, SFAS No. 142 requires companies to annually assess goodwill and other intangible asset impairment. But after a company has established a reporting unit’s fair value, it needn’t be recomputed in the future if:

• The reporting unit’s components remain unchanged,
• When originally measured, the reporting unit’s fair value significantly exceeded its book value, and
• No evidence exists that the reporting unit’s fair value has diminished over the year.

On the other hand, some situations may require more frequent tests for impairment. For example, an interim impairment test may be necessary if the company loses a key person, a competitor introduces an innovative new product or a public company’s market capitalization drops substantially below its net book value.

Choosing the right valuation professional - When selecting valuation professionals for their SFAS Nos. 141 and 142 compliance needs, clients should inquire about the experts’ experience with allocating purchase prices, testing for impairment and valuing intangible assets.

Not only can experienced valuators prevent misleading financial reports, but their superior accuracy and efficiency also cost companies less money in the long run.

Sidebar: Calculating fair value

Most traditional valuation assignments call for an estimate of “fair market value.” But this term is not synonymous with “fair value,” the standard of value required under SFAS Nos. 141 and 142.

For instance, as defined by accounting literature, fair value is always calculated on a controlling basis. Unlike fair market value, fair value is also net of selling costs and should include any tax amortization benefits.

In addition, when estimating fair value, valuators consider only market participants — as opposed to the entire universe of hypothetical buyers.