SFAS No.141, 142, and Taiwan SFAS Rule 35 on Asset Impairment Yea-Mow Chen, Ph.D., AVA. San Francisco State University March 21, 2005

Outline Introduction SFAS 141: Determining Goodwill and Other Intangible Assets SFAS 142:Impairment of Goodwill and Other Intangible Assets Taiwan’s SFAS No. 35 Asset Impairment 5. Valuation of Goodwill and Other Intangible Assets

Section 1: Introduction

Introduction SEC’s concerns on overvalued non-amortized intangible assets and goodwill: The SEC is very concerned that the assets are recorded at their fair value on the financial statements. Company management should be concerned that overvaluation of non-amortizable assets increased the potential of being subject to impairment losses.

Introduction How severe is the overvaluation problem? As of September 30, 2001, there were 409 publicly listed companies with reported goodwill of $10m or more and whose shares were trading at discounts to their book values. The goodwill of 228 companies was potentially totally impaired, and another 95 companies had potential impairment in excess of 50%. The implied impairment would exceed $1b for 14 companies, would range from $1b to $100m for 108 companies, and would range from $100m to $10m for 261 companies. (Source: Mercer, Crow, and Patton, “Goodwill Valuation Under SFAS 142”, the CPA Journal, 2002)

Introduction If an asset’s value is impaired, how should the impaired value be taken into account? What is the appropriate way for calculating values impaired? Many companies carry large amount of tangible and intangible assets with volatile prices, how should their values be appraised?

and Other Intangible Assets in a Business Combination Section 2: SFAS No. 141, Goodwill and Other Intangible Assets in a Business Combination

Statement 141: Business Combinations All business combinations initiated after June 30, 2001 must use the PURCHASE METHOD Pooling-of-Interests method is no longer permitted

Statement 141: Business Combinations Requires disclosure of the primary reasons for a business combination and the allocation of the purchase price paid to the assets acquired and liabilities assumed by major balance sheet caption.

Statement 141: Business Combinations Application of the purchase method requires identification of all assets of the acquiring enterprise, both tangible and intangible. Any excess of the cost of an acquired entity over the net amounts assigned to the tangible and intangible assets acquired and liabilities assumed will be classified as goodwill.

Statement 141: Business Combinations Fair Value is defined in SFAS No. 141 & 142 as “The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” It is more of an “Investment Value” concept as the benefits of synergies and attributes of the specific buyer and specific seller are included. The ability of a controlling shareholder to benefit from synergies and other intangible assets that arise from control might cause the fair value of a reporting unit as a whole to exceed its market capitalization.

Intangible Asset Recognition An intangible asset shall be recognized as an asset apart from goodwill: If it arises from contractual or other legal rights If it is separable; that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged.

Intangible Asset Recognition An acquired intangible asset (other than goodwill) with an indefinite useful economic life should not be amortized (regardless of whether it has an observable market) until its life is determined to be no longer indefinite If no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of an asset, the useful life of that asset should be considered indefinite.

Intangible Asset Recognition “The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity.”

Intangible Asset Recognition A number of pertinent factors that should be considered in deciding the useful life of an asset: Expected use of the asset by the entity Legal, regulatory, contractual limits to useful life Ability to renew/extend contractual or legal life Effects of obsolescence, demand, competition and other economic factors Level of maintenance expenditures required to realize expected future cash flows Useful life of another asset (or asset group) to which useful life of intangible relates

Intangible Asset Recognition Separable intangible assets that have finite lives will continue to be amortized over their useful lives. A recognized intangible asset that is not amortized must be tested for impairment annually, and on an interim basis if an event or circumstance occurring between annual tests indicates that the asset might be impaired.

Intangible Asset Recognition The FASB has classified intangible assets into five categories: 1. Marketing-related intangible assets 2. Customer-related intangible assets 3. Artistic-related intangible assets 4. Contract-based intangible assets 5. Technology-based intangible assets

Marketing-Related Intangible Assets Trademarks, trade names Service marks, collective marks, certification marks Trade dress (unique color, shape or package design) Newspaper mastheads Internet domain names Noncompetition agreements

Customer-Related Intangible Assets Customer Lists Order or Production Backlog Customer Contracts and Related Customer Relationships Non-Contractual Customer Relationships

Artistic-Related Intangible Assets Plays, operas, ballets Books, magazines, newspapers, other literary works Musical works such as compositions, song lyrics, advertising jingles Pictures, photographs Video and audiovisual material, including motion pictures, music videos, television programs

Contract-Based Intangible Assets Licensing, royalty, standstill agreements Advertising, construction, management, service or supply contracts Lease agreements Construction agreements Franchise agreements Operating and broadcast rights Use rights such as drilling, water, mineral, timber cutting and route authorities Servicing contracts such as mortgage servicing contracts Employment contracts

Technology-Based Intangible Assets Patented technology Computer software and mask works Unpatented technology Databases, including title plants Trade secrets, such as secret formulas, processes, recipes

Guidelines on Valuation Approaches Asset Valuation Approach Marketable Securities Fair Values Receivables Present values of amounts to be received determined at appropriate current interest rates, less allowances for uncollectibility and collection costs, if necessary Inventories – Finished Goods Estimated selling prices less the sum of (a) costs of disposal and (b) a reasonable profit allowance for the selling effort of the acquiring entity Inventories – Work in process Estimated selling prices of finished goods less the sum of (a) costs to complete, (b) costs of disposal, and © a reasonable profit allowance for the completing and selling effort of the acquiring entity based on profit for similar finished goods Inventories – Raw Materials Current replacement costs

Guidelines on Valuation Approaches Asset Valuation Approach Plant and Equipment – to be used Current replacement cost for similar capacity unless the expected future use of the assets indicates a lower value to the acquiring entity Plant and Equipment – to be sold Fair value less cost to sell Intangible asset that meet the criteria in paragraph 39 Estimated fair value Other assets – Land, natural resources, and nonmarketable securities Appraised values

Guidelines on Valuation Approaches Liability Valuation Approach Accounts and notes payable, long-term debt, and other claims payable Present values of amounts to be paid determined at appropriate current interest rates A liability for the projected benefits obligation in excess of plan assets or an asset for plan assets in excess of the projected benefit obligation of a single employer defined benefit pension plan Amounts determined in accordance with paragraph 74 of FASB Statement No. 87, Employers’ Accounting for Pensions A liability for the accumulated postretirement benefits obligation in excess of plan assets or an asset for fair value of the plan assets in excess of the postretirement benefit obligation of a single employer defined benefit postretirement plan Amounts determined in accordance with paragraph 86-88 of FASB Statement No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions

Guidelines on Valuation Approaches Liability Valuation Approach Liabilities and Accruals Present values of amounts to be paid determined at appropriate current interest rates Accruals for warranties Deferred compensation Vacation pay

Guidelines on Valuation Approaches Liability Valuation Approach Other liabilities and commitments Present values of amounts to be paid determined at appropriate current interest rates Unfavorable leases Contracts Commitments and plant closing expense incident to the acquisition Preacquisition contingencies Amounts determined in accordance with paragraph 40 of this Statement (Opinion 16, paragraph 88)

Guidelines on Valuation Approaches Asset Type Valuation Approach Software Technology-based Cost approach (cost to recreate) Customer relationships Customer-related Assembled workforce Goodwill Noncompete agreement Contract-based Income approach (before and after DCF) Technology Income approach (multiperiod excess earnings) In-process research and development Trade name Market-related Income approach (relief from royalties) N/A Residual

Allocation of Purchase Price Goodwill equates with the residual intangible asset that generates earnings in excess of a normal return on all the other tangible and intangible assets. The present value of future cash flows contributing to goodwill at the time of acquisition can be calculated by summing the future excess earnings, then discounting to present value.

Allocation of Purchase Price Assuming all of the tangible and intangible assets have been identified and valued at the acquisition date, this process is simplified by use of the residual method. Under the residual method, the present value of the future excess earnings, or goodwill, is calculated by subtracting from the adjusted purchased price the fair value of all the identified tangible and intangible assets. The remainder or residual amount equates with goodwill.

Allocation of Purchase Price Valuation of Goodwill as of Dec. 31, 2005 ____________________________________________________________________ Cash and Acquisition costs $80,000 Debt-free Current Liabilities 15,000 Current Maturities of Long-Term Debt 10,000 Long-term Debt 45,000 Adjusted Purchase Price $150,000 Less: Fair Value of Current Assets (25,000) Less: Fair Value of Tangible Assets (8,000) Less: Fair Value of Intangible Assets Software (10,000) Customer Base (5,000) Trade Name (12,000) Noncompete Agreement (6,000) Technology (30,000) In-Process Research and Development (4,000) __________ Residual Goodwill $30,000

Allocation of Purchase Price Target Company – Valuation Summary as of Dec. 31, 2005 Fair Value ___________________________________________________________________________ Cash $20,000 Marketable Securities 5,000 Accounts Receivable 15,000 Inventory 8,000 Prepaid Expenses 2,000 Land and Buildings 30,000 Machinery and Equipment, Net 20,000 Total Current and Tangible Assets $100,000 Software 15,000 Customer Base 12,000 Trade Name 8,000 Noncompete Agreement 5,000 Technology 30,000 In-Process Research and Development 4,000 Assemble Workforce 1,500 Total Intangible Assets $75,500 Goodwill (excluding assemble workforce) $40,000 Total Assets $215,500 __________________________________________________________________________-

Impairment of Goodwill and Other Intangible Assets Section 3: SFAS No. 142, Impairment of Goodwill and Other Intangible Assets

Statement 142: Goodwill and Other Intangible Assets This Statement addresses how intangible assets that are acquired individually or with a group of other assets (but not those acquired in a business combination) should be accounted for in financial statements upon their acquisition. This Statement also addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements.

Statement 142: Goodwill and Other Intangible Assets Goodwill and intangible assets that have indefinite useful lives will not be amortized but rather will be tested at least annually for impairment. Intangible assets that have finite lives will continue to be amortized over their useful lives, but without the constraint of an arbitrary ceiling.

Statement 142: Goodwill and Other Intangible Assets Goodwill will be tested for impairment at least annually using a two-step process that begins with an estimation of the fair value of a reporting unit. The first step is a screen for potential impairment, and The second step measures the amount of impairment, if any.

Statement 142: Goodwill and Other Intangible Assets This statement requires disclosure of information about goodwill and other intangible assets in the years subsequent to their acquisition. Information to be disclosed: The changes in the carrying amount of goodwill from period to period, The carrying amount of intangible assets by major intangible asset class for those assets subject of amortization and for those not subject to amortization, and The estimated intangible asset amortization expense for the next five years.

Statement 142: Goodwill and Other Intangible Assets The provisions of this Statement are required to be applied starting with fiscal year beginning after December 15,2001. This Statement is required to be applied at the beginning of an entity’s fiscal year and to be applied to all goodwill and other intangible assets recognized in its financial statements at that date.

Impairment of Goodwill and Other Intangible Assets SFAS No. 142 mandates that goodwill and intangible assets without a defined live shall not be amortized over the defined period; rather they must be tested for impairment at least annually at the “reporting unit” level.

Impairment of Goodwill and Other Intangible Assets All acquired goodwill should be assigned to reporting units. This will critically depend on the assignment of other acquired assets and assumed liabilities. The amount of goodwill allocated to a reporting unit is contingent upon the expected benefits from the synergies of the combination. This goodwill allocation is required even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit.

Impairment of Goodwill and Other Intangible Assets The measurement of the fair value of intangibles and goodwill can be performed at any time during the fiscal year as long as the timing is consistent from year to year.

Impairment of Goodwill and Other Intangible Assets The annual impairment test is to be accelerated and goodwill of a reporting unit should be tested for impairment on an interim basis if an event occurs that would more likely reduce the fair value of a reporting unit below its carrying value.

Impairment of Goodwill and Other Intangible Assets Impairment Test Triggering Events: A significant adverse change in legal factors or in the business climate An adverse action or assessment by a regulator Unanticipated competition A loss of key personnel A more-likely-than-not expectation that a reporting unit will be sold or otherwise disposed of The testing for recoverability under SFSA No. 144 of a significant asset group within a reporting unit Recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of re reporting unit

Goodwill Impairment Test The Two-Step Impairment Test: Compare estimated fair value of each reporting unit to the carrying amount of the unit. If FV > Carrying Amount, no need to perform Step 2 If FV < Carrying amount, then Step 2.

Goodwill Impairment Test If the carrying amount of a reporting unit goodwill exceed the implied fair value of that goodwill, then an impairment loss must be recognized for an amount equal to that excess. In order to determine the implies fair value of the goodwill, all assets must be valued. The impairment loss cannot exceed the carrying amount of the goodwill. Only the value of goodwill is adjusted through this process. The adjusted carrying amount of goodwill will be its new accounting basis. Goodwill cannot be increased to its original carrying amount in the future. Once written down, it stays down.

Goodwill Impairment Test Ex: Assume a company has a reporting unit with a fair value of $10,000,000 including goodwill of $3,000,000. further assume that the relative fair values of the assets have been valued and recorded on the books of the acquirer as: ______________________________________________ Recognized tangible assets $5,000,000 Recognized identifiable intangible 2,000,000 assets (with definite life) Goodwill 3,000,000 ========== $10,000,000

Goodwill Impairment Test After one year assume the carrying amount of certain assets after amortization are: ______________________________________________ Recognized tangible assets $3,500,000 Recognized identifiable intangible 1,500,000 assets (with definite life)

Goodwill Impairment Test Assume that an impairment test is performed at this time one year later and the fair value of the reporting unit is $9,000,000. A new asset allocation must be performed to determine the new goodwill amount: ______________________________________________ Recognized tangible assets $3,800,000 Unrecognized tangible assets 1,000,000 Recognized identifiable intangible assets 1,400,000 Unrecognized identifiable intangible assets 800,000 Goodwill 2,000,000 ___________ Fair Value of the reporting unit $9,000,000

Goodwill Impairment Test Net Carrying amount Fair Value Impairment Amount SFSA Citation Recognized tangible assets $4,000,000 $3,800,000 200,000 142 Unrecognized tangible assets 1,000,000 Recognized identifiable intangible assets (with a defined life) 1,800,000 1,400,000 400,000 144 Unrecognized identifiable intangible assets 800,000 Goodwill 3,000,000 2,000,000 Total $10,000,000 $9,000,000 $1,600,000

Taiwan’s SFAS No. 35 on Asset Impairment Section 4: Taiwan’s SFAS No. 35 on Asset Impairment

Taiwan’s SFAS No. 35 on Asset Impairment On 1 July 2004, the Accounting Research and Development Foundation (ARDF) of the Republic of China issued a new standard, Statement of Financial Accounting Standards No. 35 Accounting for Impairment of Assets. The objective of this statement is to prescribe the procedures that an entity applies to ensure that its assets are carried at no more than their recoverable amount.

Taiwan’s SFAS No. 35 on Asset Impairment SFAS No. 35, which is in line with International Accounting Standard No. 36 Impairment of Assets, should be applied to financial statements for the fiscal year beginning on or after 1 January 2005, with earlier application permitted. It applies to the valuation of all assets, including fixed assets, recognizable intangible assets, goodwill, and long-term equity investment

Taiwan’s SFAS No. 35 on Asset Impairment If an asset’s carrying amount is greater than the recoverable value, then the asset value is impaired. The impairment value will then have to be recognized as a loss. The recoverable value is determined to be the larger of fair value and market value of an asset. Fair value is to be calculated as the present value of future cash flows from an asset. Except for goodwill, the impaired losses can be reversed if market conditions improved.

Taiwan’s SFAS No. 35 on Asset Impairment Example: Firm X has a rented property worth $3,000,000 on its book. But the center of businesses has been shifted to the other part of the city which might have reduced its value. An impairment test is done to find its appraised value to be $2,400,000 and its prevent value of future rents to be $2,000,000. Taking the higher value of these two values as the carrying amount, the property value is impaired for $600,000 (= $3,000,000 – max(2,400,000, 2,000,000)).

Taiwan’s SFAS No. 35 on Asset Impairment Example 2: Firm X has acquired Firm Y as its subsidiary, which resulted into an increase in goodwill of $2,000,000. Based on a firm valuation, the Firm Y’s market value is 1,800,000, while its fair value is estimated to be 1,700,000, then firm X has to recognize an impaired loss of $200,000 ($2,000,000 – max($1,800,000, $1,700,000).

Taiwan’s SFAS No. 35 on Asset Impairment Companies that are more likely to have impaired assets: Companies or their reporting units that have been losing money from operation continuously for the last few years Companies with large long-term equity investments that are substantially higher than the net book value of the invested entities.

Taiwan’s SFAS No. 35 on Asset Impairment Companies with large amount of vacant properties Companies with excess production capacity due to relocation of operation to a foreign country Companies in an industry that is declining Companies with assets that are subject to rising interest rates

Differences between SFAS No. 141/142 and No. 35 The U.S. FASB Impairment Testing requires to be done in a two-step procedure: the first step is a screen for potential impairment, and the second step measures the amount of impairment. SFAS No. 35 in Taiwan will recognize impairment losses in one-step: comparing the carrying amount with its recoverable value. If the carrying amount is higher than the recoverable value, then the amount impaired is to be recognized.

Differences between SFAS No. 141/142 and No. 35 2. Except for goodwill, the impaired losses for assets can be recovered if the values of assets improve according to Taiwan’s SFAS No. 35. SFAS 141/142 in the U.S., however, would not allow for reversal of the impaired losses on assets. The impaired losses on goodwill cannot be reversed based on both sets of accounting rules.

Valuation of Goodwill and Other Intangible Assets Section 5: Valuation of Goodwill and Other Intangible Assets

SFAS No. 141 Valuation Requirements SFAS No. 141 mandates that an acquiring company must record the fair value of the assets acquired in a business combination.

SFAS No. 142 Valuation Requirements SFAS No. 144 contains similar language as SFAS No. 142 regarding the determination of fair value, stating a preference for quoted market prices but allowing other valuation techniques. SFAS 142: “A present value technique is often the best available technique with which to estimate the fair value of a group of net assets (such as a reporting unit)”

SFAS No. 142 Valuation Requirements “If goodwill and another asset (or asset group) of a reporting unit are tested for impairment at the same time, the other asset (or asset group) shall be tested for impairment before goodwill. For example, if a significant asset group is to be tested for impairment under Statement 121 (now 144) (thus potentially requiring a goodwill impairment test), the impairment test for the significant asset group would be performed before the goodwill impairment test. If the asset group was impaired, the impairment loss would be recognized prior to goodwill being tested for impairment.”

Complexities in a Purchase Price Allocation Determining the purchase price – contingent considerations (e.g., contingent events, earnouts, restricted or nonmarketable securities tendered, etc.) muddy waters Performing a valuation of the acquirer to determine the value of its stock if the purchase price includes the payment of stock of a privately held acquirer Identifying all acquired assets, tangible and intangible Identifying if the sum of the fair values of the assets may exceed the purchase price Dealing with situations where data for valuing or estimating the useful life of certain assets may be limited or not available.

Approaches to Estimating Fair Value Market Approach: Estimates an asset’s value by analyzing the characteristics of recent sales of comparable assets Income Approach: Estimates an asset’s value by determining the future cash flows to which the owner of the asset is entitled. This cash flow stream is discounted to the present by a rate that considers the time value of money and the uncertainty inherent in the asset. Asset/Cost Approach: Estimates an asset’s value by determining the cost of replacing the asset with a comparable asset.

Application of Market Approach Valuation of Reporting Units: Find the pricing multiples (the most common multiples are price to earnings, price to cash flow after tax, price to equity and total capitalization to EBITDA) at which companies in the same industry as the reporting unit recently sold. Valuation of Intangible Assets: The data needed to implement a market approach is rarely available because detailed information about the value of intangible assets in transactions is rare.

Application of Income Approach Valuation of Reporting Units: Do a projection of the reporting unit’s future cash flows after allowances for capital expenditures and discount those cash flows back to the present at the appropriate rate. Valuation of Intangible Assets: Estimate the amount by which the intangible asset contributes to the reporting unit’s cash flows reduced by any expenses that are necessary to maintain the intangible asset and discount those cash flows back to the present at the appropriate rate.

Application of Asset/cost Approach Valuation of Reporting Units: This approach is usually applied by estimating the amount that would be available to an owner of the reporting unit after liquidating all of its assets and satisfying all liabilities. Valuation of Intangible Assets: Estimate the cost to purchase or recreate the intangible asset.

Application of Asset/cost Approach Primary Secondary Weak Patents and Technology Income Market Cost/Asset Trademarks & Brands Copyrights Information Software Product Software Distribution Networks Core Deposits Franchise Rights Corporate Practices and procedures

Some Good References 1. FASB: SFAS No. 141, Business Combination (June 2001) & No. 142, Goodwill and Other Intangible Assets (June 2001), http://www.fasb.org/ Mard, Hitchner, Hyden, and Zyla, Valuation for Financial Reporting: Intangible Assets, Goodwill, and Impairment Analysis, SFAS 141 and 142, John Wiley & Sons, Inc. 2002. Mercer Capital, Valuation for Impairment Testing, Peabody Publishing, LP, 2001. Mercer, Crow, and Patton, “Goodwill Valuation Under SFAS 142” The CPA Journal, 2002. PriceWaterHouseCooper, “SEC Reporting Matters and Pro Forma Financial Information Related to FASB Statements No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets”, Capital Markets Accounting Developments Advisory 2001-29, September 28, 2001.

Thank You Very Much! My Contact Numbers: In San Francisco Tel: 415-338-2106 Fax: 415-338-0997 E-mail: ymchen@sfsu.edu In Taipei Tel: 02-2363-5596 Fax: 02-2363-2195 E-mail: yeamowchen@hotmail.com