Post on 25-Apr-2022
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INTRODUCTION
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What are intangible assets?
• ICAI Valuation Standard 302 define intangible assets as “an identifiable non-monetary asset without physical substance.”
• Lacks physical properties and represents legal rights developed or acquired by an owner;
• An entity for the purpose of recognition of an item as an intangible asset requires to demonstrate that theintangible
• Meets definition of intangible asset AND
• Meets the Recognition criteriao Probability of future economic benefitso The cost of the asset can be measured reliably.
INTRODUCTION
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When to value intangible assets?
• Purchase price allocation• Fair valuation of intangible assets acquired in course of an acquisition• Impairment testing
Financial reporting
• Transfer of intangible asset to related party (Transfer pricing)• Estate or gift planning
Taxation support
• For the purpose of providing the asset as collateralFinancing support
• Determination of fair value for purpose of sale or purchase of such asset• Determining the licensing terms with respect to such asset
Transaction support
• Infringement• Bankruptcy/ Insolvency and Bankruptcy code• Martial and family dissolution
Dispute resolution
IDENTIFYING INTANGIBLES ACQUIRED
SeparableContractual OR
Capable of being
• separated or divided• transferred• licensed• rented• exchanged
Arises from
• contractual or other legal rights
Transferability or separability not relevant to establish if an contractual assets is an intangible asset
Intangible assets that do not qualify for the separability criterion or the contractual-legal criterion are subsumed into goodwill.
Some of the intangibles merged with goodwill are assembled workforce, buyer specific synergies, distribution channels, technical knowledge,customer base, training and recruitment programs, customer service capability, product or service support, effective advertising programs etc.
How do we identify intangible assets
IDENTIFYING INTANGIBLES ACQUIRED
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How do we identify intangible assets
No
No
Is there a restrictionon the transfer
or sale of the asset?
Recognise separateintangible asset
at fair value
Yes
NoYes
Yes
Identify intangibleassets that may qualify
for separate recognition
Does the intangibleasset meet the
contractual-legalcriterion?
Does the intangibleasset meet the
Separability criterion?
Do not recognisea separate
intangible assetCustomer list with a confidentiality term
prohibiting information exchange
IDENTIFYING INTANGIBLES ACQUIRED
Intangible assetContractual- legal
criterion Separability criterionMarketing related:- Trademarks, trade names ✓
- Service marks, collective marks, certification marks ✓
- Trade dress (unique colour, shape, or package design) ✓
- Newspaper mastheads ✓
- Internet domain names ✓
- Noncompetition agreements ✓
Customer related:- Customer lists ✓
- Order or production backlog ✓
- Customer contracts and related customer relationships ✓
- Noncontractual customer relationships ✓
Artistic-related:- Plays, operas, ballets ✓
- Books, magazines, newspapers, other literary works ✓
- Musical works, such as compositions, song lyrics, advertising jingles ✓
- Pictures, photographs ✓
- Video and audio-visual material, including motion pictures, music videos, television programmes
✓
IDENTIFYING INTANGIBLES ACQUIRED
Intangible assetContractual- legal
criterion Separability criterionContract based:- Licensing, royalty, standstillagreements ✓
- Advertising, construction, management,service or supply contracts ✓
- Lease agreements ✓
- Construction permits ✓
- Franchise agreements ✓
- Operating and broadcast rights ✓
- Use rights, such as drilling, water,air, mineral, timber cutting, and route authorities ✓
- Servicing contracts (e.g., mortgage servicing contracts) ✓
- Employment contracts ✓
Technology based:- Patented technology ✓
- Research and development ✓
- Computer software and mask works ✓
- Unpatented technology ✓
- Databases ✓
- Trade secrets, such as secret formulas, processes, recipes ✓
IDENTIFYING INTANGIBLES ACQUIRED
No
No
Identify intangibleassets that may qualify for separate
recognition
Does the intangibleasset meet the contractual-legal
criterion?
Does the intangibleasset meet the separability
criterion?
Do not recognisea separate intangible asset
Individual employees may haveemployment agreements with theacquiree, the entire assembledworkforce does not have such acontract
An assembled workforce is notconsidered separable, because itcannot be sold or transferredwithout causing disruption to theacquiree’s business
Valuation of assembled workforce
IDENTIFYING INTANGIBLES ACQUIRED
Customer Or
TechnologyTechnology
Customers Goodwill
Tech
no
logy
CustomersExisting
New
Exis
tin
g
New
What would be your primary intangible asset?The following table helps identify where value resides for a firm with both technology and customer relationships that generate cash flow.
• Discussion with the management, • understand the business,• Look at due diligence reports, • look at public filings of similar
companies
VALUATION PRINCIPLES
Definition of fair value under Ind AS 113
“Price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between MARKET PARTICIPANTS at the measurement date”
Description Comments
Sell an asset Exit price
Orderly transaction It is not a forced or a distressed sale
Between market participants It is a market-based measurement and not entity specific
VALUATION PRINCIPLES
Market participant assumption
What is market participant?
• Group of a 4 – 5 comparable companies operating in the same industry or offering similar products and services
Example 1: Debt to capital ratio
Example 2– Company A is acquired and has a trade name that was used previously. Buyer intends to discontinue the name in the near future. Further analyses suggests that other strategic buyers may no to discontinue the use of trade name. In this case, the valuation of the trade name without an assumption of discontinued use would seem appropriate.
• Synergies to be excluded. Form a part of GOODWILL
VALUATION PRINCIPLES
Highest and best use assumption
• A market participant’s use that maximizes the value• By using the asset on a stand-alone basis• By using it with a group of assets• By using it in a business, or • By selling it to another market participant who would use it in the highest and best manner
• Use must be physically possible, legally permissible and financially feasible.• Current use is presumed to be highest and best unless evidence to the contrary.
Illustration
• Excess office space, used as exhibition centre for discontinued products• No economic benefits• Leased out to generate income• Valued assuming leased out – Highest and best use
VALUATION METHODS
Approach
Hierarchy
Cost approachIncome approachMarket approach
Methods
Price/ Valuation multiples/ Capitalization rates
Multi period excess earning method
Reproduction cost method
Relief from royalty method
With or without method
Replacement cost method
Distributor or greenfield method
Not commonly used Preferred approach
No connection to future financial benefits
Guideline pricing method
VALUATION METHODS
Factors to be considered
Sufficient data is available
Appropriateness
Number and subjectivity of adjustments to
inputs
Multiple valuation
techniques
VALUATION METHODS
INTANGIBLE ASSET COMMONLY USED METHODS COMMENTS
Customer relationships/ Customer contractsANDSoftware/ Intellectual property/ Technology
Income approach: MPEEM Most commonly identified intangible asset. Assumption affecting value: Attrition rate; Cost savings on SGA, Value of other intangible assets
Tradename/ Technology Income/ Market approach: Relief from royalty
Royalty rate, Probability of discontinuing use
Non compete agreements Income approach: With or without approach
Probability of leaving and competing
Technology/ Customer list Cost approach Time spent, obscelesence factor
Assembled workforce Cost approach Time spent
VALUATION METHODS – VALUE DRIVERS
Discount rate
Attrition rate
Expectation of cash flows for
the asset being valued
VALUATION METHODS – VALUE DRIVERS
Value of other
intangible assets
VALUATION METHODS – VALUE DRIVERS
- Royalty rate
- Discount rate
- Probability of continuing/Discontinuing the
use of the tradename
VALUATION METHODS – VALUE DRIVERS
Revenues lost due to
competition
Probability of
employee leaving and competing
VALUATION METHODS – VALUE DRIVERS
Time and cost of
development
CONSIDERATION FOR VALUING INTANGIBLE ASSETS
Defensive assets
An intangible asset acquired in a business combination that an entity does not intend to actively use. However, prevents others from using it
Unlikely to be classified as an indefinite lived intangible asset
That is likely to increase the value of other assets owned by the entity
CONSIDERATION FOR VALUING INTANGIBLE ASSETS
Valuation of assembled workforce
Company A acquires Company B along with its workforce.
To arrive at the fair value of the primary intangible (which is valued using MPEEM where the charges on and of the other intangibles are reduced), we
need to value the AWF using “replacement cost method”
The contributory asset charges on AWF are reduced from the cash flows to arrive at the cash flow attributable to the customer relationship
Particulars 20XX 20XX 20XXAssembled workforce adjusted average balance XX XX XX Assembled workforce required return XX XX XX Allocation to customer relationship XX XX XX
Illustration Calculation of contributory charge on assembled workforce:
CONSIDERATION FOR VALUING INTANGIBLE ASSETS
Prospective financial information
MARKET PARTICIPANT
Synergies
Deal model
CONSIDERATION FOR VALUING INTANGIBLE ASSETS
Discount rate
The calculation of the appropriate discount rate to estimate an intangible asset’s fair value requires some additionalconsiderations as follows:
The discount rate should be determined considering the market-participant assumption
Both the IRR and the WACC are to be considered when selecting discount rates used to measure the fair value of tangible and intangible assets
The discount rate should reflect the risks commensurate with the intangible asset’s individual cash flows
Patents, Backlogcontracts
Trademarks, Publishing rights, Brands
Copyrightsinformation database, Software
Trade-secrets, Developed technology
Know-how, Customer relationship, IPR&D
Goodwill
Spectrum of risk:
Least MostRisk
CONSIDERATION FOR VALUING INTANGIBLE ASSETS
Economic life
The useful life of an intangible asset is the period over which the asset is expected to contribute directly or indirectly to thefuture cash flows of the entity.
Factors determining useful life
• Entities' historical experience• Expected use of asset• Legal, contractual or regulatory provision limiting life• Expected useful life of related asset• Effects of obsolescence, demand, competition, and other economic factors
Useful life is an important determinant in allocation of value between identified intangibles and goodwill.
CONSIDERATION FOR VALUING INTANGIBLE ASSETS
Illustration: Here the useful life of the customer - related asset is concluded to be 7 years
Particulars 1 2 3 4 5 6 7Present value of cash flows 1,496 1,283 1,098 854 587 326 234 Sum of present value of cash flows 5,644 5,878 Tax Savings of amortization 1.2 1.2
Fair value of customer relationship 6,773 7,054 PV as a % of fair value 5% 3%
Management discussions
Weighted average
contribution of PV of cash
flows
Attrition rate
Benchmarking (Lives
reported by other
companies)
Economic Life vs Accounting Life
CONSIDERATION FOR VALUING INTANGIBLE ASSETS
Tax amortization benefit is the amount that represents the present value of income tax shield benefits from theamortization of the value of the intangible assets. The tax jurisdiction of the country the asset is domiciled in should drivethe tax amortization benefit calculation.
Amortization benefit is applied when using the income approach and not applied when using the market approach.
Market-based data used in the market approach is assumed to include the potential tax benefits resulting from obtaining anew tax basis.
TAB factor using adjusted WACCAdjusted WACC 17.34% PV Mid-pointTax life 8.00 Year 1 4.62 0.5Value of asset 100.00 Year 2 3.93 1.5Amortization/year 12.50 Year 3 3.35 2.5Tax rate 40% Year 4 2.86 3.5Amortization benefit/year 5 Year 5 2.44 4.5Sum of present values 22.55 Year 6 2.08 5.5Asset value pre amortization benefit 77.45 Year 7 1.77 6.5Tax amortization premium 29% Year 8 1.51 7.5TAB factor 1.29 Annuity 22.55
For example:
Tax amortization benefit
VALUATION METHODS – ILLUSTRATION
DescriptionManagement projections for the years ending December 31, Extended projections
2020 2021 2022 2023 2024 2025 2026 2027 2028Total revenue (from existing customers) 10,738 12,976 15,569 17,986 20,207 22,497 24,637 26,550 28,392Surviving revenue from existing customers 7,730 7,583 7,429 7,241 6,988 6,702 6,358 5,972 5,565Ratio of surviving revenue to total revenue 0.72 0.58 0.48 0.40 0.35 0.30 0.26 0.22 0.20Cost of services for surviving customers (3.93) (4.11) (4.00) (3.86) (3.71) (3.56) (3.37) (3.17) (2.95)Gross profit 7,726 7,579 7,425 7,237 6,984 6,699 6,355 5,968 5,562
Compensation for selling and marketing (498) (506) (508) (491) (459) (446) (424) (398) (371)Compensation for operations and shared services (3,107) (3,335) (3,092) (2,921) (2,725) (2,750) (2,608) (2,450) (2,283)Administrative (552) (426) (369) (330) (299) (356) (338) (317) (296)Shared services (826) (274) (254) (237) (222) (324) (307) (289) (269)Membership offering (410) (372) (348) (327) (307) (319) (303) (284) (265)Total operating expenses (5,394) (4,912) (4,569) (4,305) (4,013) (4,195) (3,980) (3,737) (3,483)EBITDA 2,332 2,667 2,856 2,932 2,972 2,504 2,375 2,231 2,079Less: Depreciation (128) (61) (64) (66) (60) (55) (51) (47) (44)Less: Amortization-AWF (43) (35) (28) (24) (20) (18) (15) (13) (12)Earnings before interest and taxes 2,162 2,571 2,764 2,842 2,891 2,431 2,309 2,170 2,024
Plus/(Minus): Favourable/(Unfavourable) lease terms 20 28 24 21 19 17 7 - -
Minus: Hypothetical charge for use of trade name @ 3% (232) (227) (223) (217) (210) (201) (191) (179) (167)Earnings before interest and taxes – Adjusted 1,949 2,372 2,565 2,646 2,700 2,247 2,125 1,991 1,857Less: Income taxes @ 40% (780) (949) (1,026) (1,058) (1,080) (899) (850) (796) (743)After-tax earnings 1,170 1,423 1,539 1,588 1,620 1,348 1,275 1,195 1,114Add : Depreciation 128 61 64 66 60 55 51 47 44Add : Amortization-AWF 43 35 28 24 20 18 15 13 12Cash flow 1,501 1,654 1,759 1,778 1,780 1,491 1,398 1,300 1,207
Descriptions
Management projections for the years ending December 31, Extended projections
2020 2021 2022 2023 2024 2025 2026 2027 2028
Cash flow 1,501 1,654 1,759 1,778 1,780 1,491 1,398 1,300 1,207
Contributory charges to customer relationships
Less: Fair return on working capital (4.1) (4.1) (4.0) (3.9) (3.8) (3.6) (3.4) (3.2) (3.0)
Less: Fair return on fixed assets (183) (151) (124) (106) (92) (81) (71) (64) (57)
Less: Fair return of fixed assets (128) (61) (64) (66) (60) (55) (51) (47) (44)
Less: Fair return on assembled workforce (113) (113) (111) (110) (108) (104) (99) (94) (88)
Total contributory charges (429) (329) (303) (285) (263) (243) (225) (208) (192)
Cash flow after contributory charges 1,072 1,325 1,456 1,492 1,517 1,248 1,174 1,092 1,015
Partial period adjustment 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Revised cash flow 359 1,281 1,456 1,492 1,517 1,248 1,174 1,092 1,015
Discounting period- mid year 0.31 1.13 2.13 3.13 4.13 5.13 6.13 7.13 8.13
Present value factor @ 14.78% 0.96 0.86 0.75 0.65 0.57 0.49 0.43 0.37 0.33
Present value of cash flows 344 1,097 1,086 970 859 616 505 409 331
Sum of present value of cash flows 6,217
Tax amortization benefit 1.20
Fair value of customer relationships 7,480
VALUATION METHODS – ILLUSTRATION
VALUATION METHODS – ILLUSTRATION
Management projections for the year ending December 31,
Extended projections
Description 2020 2021 2022 2023 2024 2025 2026 2027 2028
Total revenue 110,738 12,976 15,569 17,986 20,207 22,497 24,637 26,550 28,392
% Growth 20.8% 20.0% 15.5% 12.3% 11.3% 9.5% 7.8% 6.9%
Probability of discontinuing trade name in respective year 0% 0% 0% 0% 0% 0% 0% 0% 0%
Probability of continuing trade name in respective year 100% 100% 100% 100% 100% 100% 100% 100% 100%Probability of not having previously discontinued trade name N.A. 100% 100% 100% 100% 100% 100% 100% 100%
Cumulative probability of continuing to use the trade name 100% 100% 100% 100% 100% 100% 100% 100% 100%
Pre-tax royalty relieved, adjusted for probability @ 3% 322 389 467 540 606 675 739 797 852
Less: Income taxes @ 40% (129) (156) (187) (216) (242) (270) (296) (319) (341)
After-tax royalty relieved 193 234 280 324 364 405 443 478 511
Partial year adjustment 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
After-tax royalty relieved, adjusted 121 234 280 324 364 405 443 478 511
Discounting period- mid year 0.31 1.13 2.13 3.13 4.13 5.13 6.13 7.13 8.13
Present value factor @ 15.78% 0.96 0.85 0.73 0.63 0.55 0.47 0.41 0.35 0.30
Present value of after-tax royalty relieved 115 198 205 205 199 191 181 168 155
Terminal value 1,227Sum of the present value of after-tax royalty relieved (including terminal value) 2,845
Tax amortization benefit 1.19
Fair value of trade name 3,393
VALUATION METHODS – ILLUSTRATION
Employee classificationHead
countsAvg.
salaryGross salary
Fringe benefits @
20.2%
Total salary
(a)
Avg. advertising
and recruitment
costs (b)
Avg. relocation costs (c)
Hiring cost (d)
(b+c)
Direct training
costs(e)
No. of months until full
productivity (f)
Lost productivi
ty (g)(a/12*f)
Training cost (h)
(e+g)
Total replaceme
nt cost (d+h)
Analyst 4 30 120 24 144 2 0 2 1 2 24 25 27
R&D 5 55 275 56 331 6 2 8 1 3 83 84 92
Admin 8 31 248 50 298 1 0 1 0 1 25 25 26
Executive 8 125 1000 202 1202 30 7 37 3 3 301 304 341
Research 32 35 1120 226 1346 5 0 5 2 2 224 226 231
Sales - Membership Director11 25 275 56 331 1 0 1 0 1 28 28 29
Marketing promotion 3 20 60 12 72 2 0 2 1 1 6 7 9
Client Relationship Managers18 36 648 131 779 1 0 1 1 2 130 131 132
Fair value of assembled workforce (Total) 886
TAX IMPLICATIONS - OVERVIEW OF THE ACT
Section 32(1) of the Income Tax Act, 1961 (‘the Act’) provides for deduction on account of depreciation on block of assetsat prescribed percentage on the written down value.
Explanation 3 thereto explains intangible assets include know how, patents or commercial rights of similar nature. TheExplanation does not specifically contain goodwill as an asset, however, due to presence of the words ‘commercial rights ofsimilar nature’, it has been a commercial practice to consider goodwill as an intangible and hence a depreciable asset.
The Hon’ble Supreme Court in the case of CIT vs. SMIFS Securities Ltd. [2012] 348 ITR 302 (SC) upheld that goodwill is also adepreciable asset since section 32 of the Act covers “any other business or commercial rights of similar nature”.
Impact on M&A transactions
Businesses taking corporate reorganization actions have relied on the Supreme Court decision and treated the excessamount paid over the fair value as goodwill and claimed depreciation thereon.
Any goodwill arising on account of corporate actions undertaken through merger or acquisition or demerger through shareswap also relied on the Supreme Court’s decision.
TAX IMPLICATIONS - UNION BUDGET PROPOSAL
The Union Budget 2021 has proposed to amend the definition of “block of assets” under section 2(11) and the “assets” asper Explanation 1 to Section 32(1) of the Act to specifically exclude goodwill of a business or profession from the scope ofdepreciable assets.
It is proposed to insert a proviso to section 50 of the Act to provide the manner of determination of the Written DownValue (‘WDV’) of the block of asset as well as the short-term capital gains where the block of asset for FY (2019-20) AY2020-21 which includes goodwill.
Section 55(2)(a) of the Act deals with cost of acquisition of goodwill wherein a proviso shall be inserted to reduce the costof acquired goodwill with the value of depreciation already claimed thereon.
The changes are proposed to be applicable from April 01, 2020 i.e. Assessment Year 2020-21.
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