Valuation of intangibles for financial and tax purposes ... or EPS vs. the IRS.

• Author: Andreoli, Brian
• Position: Earnings per share

Difficult problems often emerge from collisions of competing interests. Under certain circumstances, intangibles assets must be valued for both financial accounting purposes and income tax purposes. Financial Accounting Standards (FAS) 141 through 144 provide a set of rules to value purchased intangibles for financial statement purposes. And sections 482 and 6662(e) of the Internal Revenue Code and the related regulations also require that the taxpayer determine the value of purchased intangibles to the extent that those intangibles are related to cross-border payments. The best results for book purposes may well create severe tax problems, while the best results for tax purposes could produce a drag on reported earnings.

Purchased assets will first be valued for financial purposes. If the corporate tax department later produces a contemporaneous documentation report designed to avoid penalties under section 6662(e) that is at variance with the financial valuations, either the SEC, the IRS, or both could find these dueling reports a fertile ground for unpleasant discussions with the company. When one of the authors was a young boy, his aunt gave him a sign that defined an expert as "one who knew more and more about less and less." Companies that make acquisitions of targets with valuable intangibles can be placed at risk if the company hires experts whose focus has narrowed to the point where they fail to realize that financial accounting valuations have tax effects and vice versa. The more narrow the outside expert's silo, the more dangerous that expert's advice can be.

The IRS, SEC, and Congress are all focusing more attention on areas where financial and tax accounting overlap. The latest tax shelter rules focus on transactions that produce sizable "book/tax" differences (i.e., transactions reported on Schedule M of Form 1120). Congressman Lloyd Doggett of Texas has introduced legislation, the Corporate Accountability Tax Gap Act of 2003 (H.R. 1556), that would require public companies to disclose and explain their book/tax differences. In the near term, the focus on such crossover issues can only increase. The purpose of this article is to cast light on the competing forces at work in valuations, rather than to divine the "correct" answer.

"All generalizations are incorrect...."

The market capitalization of the average company on the New York Stock Exchange is five times the value of the book assets. The major factor that causes market value to exceed book value is the presence of intangibles, not irrational exuberance.

Nearly all types of intangibles leave only a fleeting mark on the financial records of most companies. At one end of the business spectrum, Microsoft's obvious intangible assets cannot be found on the Microsoft balance sheet. These assets were created by costs like R&D or advertising that have been expensed rather than capitalized, leaving no trace on the reported financials. In addition, the cost of an asset does not necessarily bear any relationship to its value. At the other end of the business spectrum, there is at least one entertainment company that has assigned no value to the multi-release recording contract of an artist whose last release sold more than 25 million units worldwide. This variance in how different companies account differently for their intangibles is permissible under Generally Accepted Accounting Principles (GAAP) because the U.S. Financial Accounting Standards Board (FASB) does not require the valuation of self-developed intangibles.

In contrast, when a company purchases an intangible asset, or purchases a target company with intangible assets, an entirely different set of rules applies. FAS 141 mandated the end of "pooling" and requires that the purchase method of accounting be used. The purchasing company must assign a value to all of the tangible and intangible assets purchased and record these asset values on its balance sheet.

The value of the purchased intangible must be allocated between goodwill and the intangible assets other than goodwill. To be recognized as separate from goodwill, the intangible assets must stem from legal or contractual rights, or be capable of being separately sold or transferred. This value must then be entered on the acquirer's balance sheet. The dichotomy is that the Coca-Cola secret formula or trademark need have no entry on the company balance sheet, but if Coca-Cola were to purchase Snapple, it would have to record an entry for the Snapple trademark and formulas.

The Best Result: Financial Reporting

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