New Accounting Standards - Implications for Marketers - FM 2005

By Roger Sinclair

Goodwill is not what it used to be. Once it was the accounting profession’s seventh cavalry: always on hand to save the day when immeasurable intangibles created costs that were not covered by Generally Accepted Accounting Principles (GAAP). As such it has served a useful purpose for much of the past one hundred years. It arose because business owners have a habit of negotiating a price for a business they want to buy that exceeds the value placed on the company’s equity by the auditors.

In recent years this arithmetical difference between the net assets as recorded by the accountants and the price paid in the acquisition has been recognised as an asset. After all it conforms pretty well to the definition of an asset: it is under the control of the enterprise, it apparently generates future economic benefits (why else would the acquirer have paid a price for it?) and has been reliably measured by the arithmetic.

But goodwill is a vague and uncertain thing. As a word sitting in the balance sheet it says nothing about why it is there. How did the participants in the original deal arrive at the price? Why were they willing to pay more than the company appeared to be worth?

The academic theorists have an answer to that. They explain it away under the blanket of Efficient Markets. Apparently the owners of the invisible hands that set prices on the world’s markets, have access to a stream of information. At any time they all know what there is to know about a company. Anything else could fall foul of insider trading rules and information that is new is just that. It will be taken account of as soon as it is known at which time it is no longer new.

Merger and acquisition experts use the market price compared with the company’s earnings to set their purchase offers; the famous price to earnings ratio.

I was once involved in the sale of a company that I ran and watched this in action. Our lawyer and their lawyer turned to the share price listings in the latest copy of the Financial Mail; found a few comparable listed firms and agreed on the price according to the p;e ratios of similar companies (I have since looked at that price and judged by the way companies are valued today, we were robbed!). The difference between what they agreed over a whisky or two and the net asset value as calculated by the firm’s auditors was goodwill which was dealt with in the books according to the convention of the time.

Thanks to the late Nobel Prize winning economist professor James Tobin we know now that goodwill comprises resources of an intangibles nature (Tobin’s “q” measures the tangible/intangible ratio captured in the share price of a listed company). We also know that these include assets such as customer lists; customer loyalty; patents and trademarks; business systems; distribution and established brands.

But, with the advent this year of global accounting standard IFRS 3 Business Combinations, goodwill will fall from favour.

In short, when the auditors prepare the accounts for the enlarged company they will have some new calculations to conduct. Goodwill will still be the residue after the net assets have been subtracted from the purchase consideration. What will change is the composition of the net assets. In future these will include any and all intangibles that can be separated from goodwill because they comply with laid down recognition criteria and which can be reliably measured.

What is stunning in this new standard is the unambiguous view of the standard writer (The International Accounting Standards Board - IASB) that very few intangibles will fail the test. Thus brands, which are not recognised in the books of companies that developed them, will suddenly acquire full asset status once they, or the company that owns them, are sold.

This new development has some interesting implications. For example:

· Since intangibles such as brands will only be on the balance sheet after a company has been bought, how will analysts evaluate the performance of companies where brands are important, but are not recorded because they have not been sold? Tiger Brands is a case in point.

· If intangibles now join tangibles as measured assets, what impact will this have on ratios such as Return on Assets and Equity?

· Although its market rating has improved over the last year, the value of Distell’s portfolio of brands exceeds the market premium placed on it by the investment community. If there were a bid for the company, how would or should analysts take this into account when determining the company’s worth?

· Will companies that will soon have their brand assets on the balance sheet be called on by the investment community to report more fully on how they protect and build these assets than companies that are not subject to this accounting reporting requirement?

There are other implications too such as the facility this change provides for marketers to employ financial tools such as Net Present Value to motivate and support their budget requests. But first the financial community must fully come to grips with what these new requirements mean. It will also be interesting to see how the IASB responds to the anomaly that will arise when companies either include intangible as assets because of some historic event or do not because the intangibles were internally generated.

One thing is certain. An unintended consequence of this new accounting standards is that it will bring the finance and marketing functions closer together. Once brands are on the balance sheet, management will show elevated interest in what the marketing people are doing to enhance and accelerate the income that these assets generate.

Financial Mail, South Africa - May 2005