website-name.lbi C. P. Schumann, P.C.
Business Valuation, Accounting, and Litigation Support

Valuing Intellectual Property for Impairment Purposes

Intellectual Property

The value derived from intangible assets has increased significantly in today’s knowledge-based economy. The book value of many publicly quoted companies is significantly less than their market value. Stock market value is derived, to a large extent, from assets that do not appear on the balance sheet. Recent public stock prices imply a 50% value for Intellectual Property.

The following examples are not exhaustive, but provide a useful framework for the categories of intangible assets.

Intangible Asset Categories Examples
Marketing-related intangible assets Trademarks, trade names, service marks, newspaper mastheads, internet domain names and non-competition agreements.
Customer-related intangible assets Customer lists, order or production backlogs, customer contracts, and customer relationships including non-contractual relationships.
Artistic-related intangible assets Plays, operas, ballets, books, magazines, newspapers, pictures, and photographs.
Contract-based intangible assets Licensing and royalty agreements, advertising, construction, service or supply agreements, lease agreements, franchise agreements, and employment contracts.
Technology-based intangible assets Patented technology, computer software, unpatented technology (know-how), databases, trade secrets such as secret formulas, processes and recipes.

Attributes that Distinguish Intellectual Property

IP is a special class of intangible assets. IP manifests all of the economic existence and economic value attributes of other intangible assets. However, because of its special status, IP enjoys special legal recognition and protection.

Because of this unique creation process, IP is generally registered under, and protected by, specific federal and state statutes. The protection of this legal registration provides economic motivation for IP innovators during the creative process. This legal registration also provides protection for IP creators during the commercialization process. It is believed that the information content of IP requires this special protection in order for an IP owner to realize economic value of these special intangible assets.

Valuation Techniques

Following the identification of intangible assets, the next step is to determine the fair value of the intangible assets. The main valuation methodologies used are:

  1. Market methods – value intangible assets by reference to transactions that occurred recently in similar markets, or benchmarks of comparable assets.

    This methodology can provide the best evidence of fair values because it relies on evidence from actual market transactions. However, outright sales and purchases of intangible assets are infrequent and details of those that take place are rarely fully available. It can be difficult to ensure that the asset under consideration and the market transaction are sufficiently comparable. Therefore, this methodology can be difficult to apply in practice.
  2. Income methods – value intangible assets on the basis of the future economic benefits derived from ownership of the asset. The income approach seeks to identify and quantify, in present day terms, the future earnings attributable to the asset. We have used this method to value brands, customer relationships, patented technology and unpatented technology (know-how).

    The income-based valuation of an intangible asset has two distinct components:
    • identification, separation and quantification of the cash flows (or earnings) attributable to the intangible asset; and
    • capitalization of those cash flows (or earnings).

    The main income methods are the Relief from Royalty Method and the Excess Earnings Method. Relief from Royalty is a methodology based on estimating the price a business would pay for the use of an intangible asset if it did not own the asset, or the cost savings of not having to pay a royalty.

    The basis of the Excess Earnings methodology is that the value of an intangible asset is the present value of the earnings it generates, net of a reasonable return on other assets also contributing to that stream of earnings.
  3. Cost methods – value intangible assets by assessing the development or replacement cost of the asset.

    The cost approach is used for valuing internally developed assets e.g. software. Cost based approaches should be viewed with caution, as the cost of recreating or replacing an asset of this nature is not necessarily an accurate indication of the future value of that asset. However, cost methods can be a useful benchmark for a valuation.

The appropriateness of each of these valuation methodologies varies according to the type of asset, available data, and the specific circumstances of different industries.

Valuation Issues

Common valuation issues include:

  • Identification of intangible assets. There may be varying opinions within management concerning the key intangible assets acquired.
  • Choosing an appropriate valuation methodology. Although market methods are best where available, the lack of market evidence means that income methods are more often applied.
  • The determination of appropriate assumptions requires experience and judgment due to the subjectivity involved.
  • One of the key challenges of accounting for intangible assets is selecting appropriate economic lives for each item or category. Some assets, such as strong brand names, may have a relatively long or even indefinite life; while others, such as customer relationships or databases, may be amortized over a shorter period.
  • The process of selecting an appropriate royalty rate range based on market evidence needs to be rigorous, as the value implications of a small change in the royalty rate can be significant.
  • The determination of the cost of capital requires experience and judgment. The cost of capital should be consistent with the risks and rewards of the intangible asset being valued.
  • Projections need to be carefully reviewed as this will impact the value of the intangibles and will have a bearing on future impairment reviews pursuant to FASB 141.
  • Avoiding double counting of an intangible value as two or more intangible assets may contribute to the same stream of earnings e.g. a well-known trademark and the underlying technology.
  • Impact on EPS. The reduced amortization charge will initially have a positive impact on EPS. However, the annual impairment reviews required by FASB 141 may lead to volatility of earnings. If the revenue from particular brands or customers is less than the initial projections, a significant write-down is necessary.
  • Long-term implications of identifying certain intangibles. In the event that a brand name is changed post acquisition, this could lead to a substantial write-down.
  • Taxation implications – it is necessary to identify situations where intangible assets are being used by other members of a group of companies and that a market value charge is made for them.

Many companies involved in acquisitions will require the assistance of external independent advisors in valuing and accounting for the intangible assets purchased as part of a business.

Request a consultation or submit a question.