The Impact on Brands of IRFS 3 -Accounting SA 2004

When International Financial Reporting Standard (IFRS) 3 takes over from AC 131 next January a new era will have begun. The new standard might appear innocuous, but to some observers and users of financial statements it carries with it substantial ramifications.

For a start it is one of the first raft of standards to be introduced under this acronym. SAICA will adopt the IFRS series as they are issued because it has been involved in the working groups that developed them. More importantly IFRS 3 breaks with tradition as it contains provisions that allow certain classes of intangible assets to be recognised that previously were disallowed. It goes as far as suggesting that these might include brands and brand names.

In future it will be insufficient to measure goodwill arising from a business combination. Intangibles that are acquired in the process and which meet the recognition criteria must be recognised and accounted for. Goodwill will be the residue and has its own treatment. There are basically three requirements for the recognition of an intangible: that it is identifiable, is separable from the rest of the business and that it can be reliably measured.

Since most brands are based on trademarks that are registered, there should be no problem with the identity issue. The brand is based on legal rights that are identifiable and separable. The difficulty arises from the measurement requirement. Can brands be measured and is the process used reliable?

Brand valuation has matured over the past few years. Brand owning companies commission brand valuations for a variety of reasons ranging from sale and purchase of brands; establishing the base cost of a brand asset for Capital Gains Tax; determining the value of a brand asset that is subject to some form of litigation; and for marketing purposes.

All credible brand valuation methodologies use Discounted Cash Flow (DCF) to calculate the value. This is consistent with the present value method of measurement described in 100 (d) of AC 000. This approach to brand valuation is also referred to approvingly in clause .30 of AC 129 Intangible Assets.

Where a leap of faith is required on the part of accountants is the source of the future economic benefits and the number of years used in the DCF model.

Brands depend on consumers for their revenues. Service firms, which are brands, such as accounting practices are very sensitive to competitive pressures and the need to provide a quality service in order to retain existing clients and attract new ones. If the name of the practice is not known in the market, the firm cannot be invited to propose for new work. But awareness of the name is not enough. In order for a client who wishes to change accountants to include any firm on the short list, he must associate the name with the attributes that are important to him. These might include an ability to handle his type of work; a reputation for efficiency and delivering work on time. Or, in these times, he might look for a firm that has a sound reputation for working within the strictures of Corporate Governance.

These are perceptions and firms succeed or decline based on market perceptions. Just think of Arthur Andersen where an entire global practice disintegrated when its reputation was destroyed by the alleged (at the time) actions that took place in one of its many offices.

The strength of these associations relative to competitors is what keeps clients and attracts new ones. These are the drivers of future economic benefits. The closer the relationship between a brand and its consumers, the greater will be the stream of revenue that those consumers will generate into the future. In some cases when clients have a strong attachment to the firm they are using, they are even willing to pay a premium price to have that firm work for them. At the very least, the firm can rely on repeat fees each year from clients who are happy with the relationship.

This is the basis of brand valuation theory. The value of the brand is the capitalised present value of customer generated future economic benefits. Now that accountants are dealing with intangibles as they are in AC 129, AC 131 and soon IFRS 3, historic cost, current cost and realisable value are concepts that tend not to apply. It is almost impossible to trace the costs of an internally generated brand especially one that has existed for decades, as is so often the case. There are few if any active markets in brands so it is hard to determine what the current cost would be and equally difficult to know what price would be achieved if the brand were to be sold. Even when a brand is acquired in a business combination, the brands are rarely split out from the purchase price. Companies are still bought on the basis of multiples and price to earnings ratios. The brands come within the price and the only thing known is the difference between the Net Asset Value (NAV) and the purchase price: goodwill.

Valuation methodologies have two key tasks: to isolate the brand portion of profit and to determine the number of years in the DCF projection. Each of these has its roots in the strength of the brand/consumer relationship. The greater the influence of the end user the larger the profit slice attributable to the brand and the more years in the DCF projection.

There are several ways of measuring this influence but market research is the most effective and useful. Surveys that measure consumer awareness and strength of perceived brand performance relative to the competition are the most commonly used. If a reputable survey company, utilising scientifically developed questionnaires and randomly drawn samples, conducts the research the results will be reliable and consistent over time. Trademark protection legislation introduced in the United States in the mid 1990s has by all accounts elevated the use of survey data to demonstrate the extent of alleged trademark dilution. Judges are asking for market research to be used as evidence.

Accounting standards that deal with intangible assets and goodwill were developed due to a conflict that arose in the 1980s. Company executives were buying other companies to gain control of their famous brands. They were paying large premiums over Net Asset Value and often at a premium to market value.

The resulting goodwill caused a serious accounting problem which used to be dealt with by applying the acquired goodwill to shareholder funds. This became impracticable when the goodwill quantum represented a substantial portion of shareholder funds. The conflict arose when certain companies treated the acquired brands (some doing the same with internally generated brands) as assets and placed them on the balance sheet. This did not sit well with the accountants who banned the practice and initiated the work that resulted in these new standards.

IFRS 3 takes the recognition of intangibles further than was the case with AC 131. Trademarks only have value when they become brands and consumers are willing to spend money to own or use them. Consumers create the future economic benefits that are the foundation of asset recognition. The sticking point is the difficulties accountants have in recognising the intangible and (to some extent) judgemental nature of brand value.

This has to change. Brands are traded more frequently now then ever before. They are assets in the eyes of the Receiver of Revenue for Capital Gains Tax purposes and values are needed when brands are contested in court. Methodologies have been developed to measure them.

As the call for Non-Financial Indicators increases in the interests of more transparent disclosure, accountants have to broaden their vision. The Sarbanes-Oxley Act in the United States and the pending Operating and Financial Review (OFR) due for introduction in the United Kingdom later this year, are powerful signs of how demands on company reporting are changing. Small changes to GAAP may be insufficient. New circumstances and demands by investors might propel the accounting profession into areas that are uncomfortable. They should not resist the pressure.

Dr Roger Sinclair is professor of marketing in the School of Economic and Business Sciences at Wits University and MD of brand valuation company, BrandMetrics.