News Update - June 2005

NEWS UPDATE

We keep very closely in touch with developments in the accounting world because of the rapid convergence between brand equity and brands as assets. This year saw the introduction of the new IFRS (International Financial Reporting Standard) 3 Business Combinations that has already changed the way brands are viewed by accountants when they are part of a merger or takeover. The Americans have had a similar approach since 2001(SFAS 141) and the IFRS 3 introduction was partially driven by the goal of achieving global harmonisation of GAAP.

The Barclays, Absa illustration

We have stated recently in the media and at several conferences and talks that this has produced a vital anomaly best illustrated by the Barclays take over of Absa.

In terms of IFRS 3 when the 2006 annual financial statements are published for Barclays Plc the Absa brand will be shown in the balance sheet as an acquired asset. In other words the auditors will have recognised that one of the assets comprising the purchase price was the brand; assuming, that is, that the auditors are satisfied that the asset can be measured reliably. The standard writers themselves and those who have analysed the text of the standard are convinced that brands are capable of meeting the recognition criteria and that they, and other classes of intangibles, can be reliably measured.

While Absa will appear in the balance sheet acknowledging that brands generate future economic benefits, the Barclays brand will not be there. This is because Barclays is what is known as an internally generated brand and, at this stage, there is no requirement for this class of asset to be recognised as an asset.

But this is set to change.

A solution in the offing

A standard already exists that deals with intangible assets. In its new guise it is called IFRS 38 Intangible Assets. It is, though, still part of the old order. It expressly states that brands, among other potential intangibles, will not achieve asset recognition. In the light of IFRS 3 there is now a conflict.


Page 2

One IFRS says brands will be recognised; the other says they cannot. What is important is that the standard setters have understood the economic power of intangibles and state quite clearly that they are under pressure from the users of financials statements to ensure standards are changed to take account of this potent force.

Consequently the world’s two main accounting bodies, The International Accounting Standards Board (IASB), which issues standards for the world outside the United States, and the Federal Accounting Standards Board (FASB) which is the North American body, are working together to achieve this.

FASB was a long way down the line when they halted work on revisions to their SFAS 142 Intangible Assets in January 2004. We are told by our local body, The South African Institute of Chartered Accountants (SAICA), that the IASB has an active programme of research and discussion in hand, led by the Australians, and new or modified versions of IAS 38 Intangible Assets are probably a couple of years away. The important thing is that the issue is being seriously examined.

What kept them so long?

What we have just learned from our sources in the United States is why the FASB research into the modification of SFAS 142 was suspended last year.

The recognition of intangible assets has brought to the fore the shift in accounting philosophy from historic cost to fair value measurement. This is a vital shift because it changes the focus of accounting practice from its traditional backward looking stance to one that fully recognises the wording of the accounting definition of an asset being a resource which generates future economic benefits.

From this time on accountants will, when guided by the standard, be required to measure assets at fair value and not historic cost. Presumably the incidence of this will initially be low but will increase over time. But, currently, no statement exists that sets out how fair value should be measured. The problem, FASB emphases, is not what should be measured but how fair value should be measured.

This then is why FSAB stopped work on SFAS 142. They reason that until such time as they are able to guide users of the standard in how fair value should be measured, they should not insist on this requirement. Of course they are fully aware of the IASB research and since the relationship between the two bodies is close. FASB will doubtless use the outcome of what IASB develops.



Page 3

FASB has undertaken to issue the statement on fair value measurement before the end of this year (2005).

To bring this about FASB set up in 2003 a body called the Valuation Resource Group (VRG) to act as what it describe as a standing resource on fair value measurement. Already this has resulted in a discussion paper and a well-attended round table meeting. They also draw on the work of the UK based International Valuation Standards Committee (IVS), which published a guidance note on, among other assets, intangibles (Note Number 4 revised 2005).

So what can we expect? How will fair value be measured?

How will fair value be measured?

If you have followed the development of brand equity measurement you will have a clue as to what the standard will say. When we started work on BrandMetrics in the early 1990s, we drew heavily on the growing stream of literature arising from the initiative by the Marketing Science Institute (MSI) in Boston, USA which made brand equity what they call a capital topic. It was for six years a research priority. Although we were criticised at the time we decided that the only viable approach to brand valuation was the income model, which is the capitalised present value of future income flows.

Our detractors thought that this was too subjective. We argued that with sound judgement this is the only way to value brands. We reasoned that a brand is little more than the present value of the lifetime value of its customers – an idea that subsequently is having its day. Judgement is a quality that is commended to accountants in all textbooks on the topic.

Early signs are that there will be a choice of approaches: market; cost and income.

Market requires the valuer to find a comparable value from assets that are exchanged in an open market. The asset is not exchanged under duress or distress. It is an open deal at arms length between willing buyers and sellers.

Cost assumes that the cost expended in establishing the asset can be evaluated. It is what it would cost to replace the asset.

It is generally agreed that neither of these two are suitable for brands. There is no active market in brands and it is almost impossible to establish the cost of launching a new brand. What makes the latter especially hard is the probability that as many as three in four new brand launches fail.


Page 4

The fair value of the brand asset will almost definitely use the income approach for measurement.

If the approach suggested in International Valuation Guidance Note no. 4 issued by the IVSC in 2005 is anything to go by the recommended model will be discounted cash flow or the present value of anticipated benefits.

Basic conditions

A number of requirements are specified that are fundamental to a credible valuation using this approach:

· Discount rate. The standard explains that the discount rate used correlate with the Weighted Average Cost of Capital (WACC) used for the business. By implication the discount rate should be the WACC possibly modified to
take account of the special risk inherent in the brand being valued. Best practice would be to calculate the WACC using the Capital Asset Pricing Model. Thus the manner in which the capital employed in the brand is funded is taken into account.

· Economic life. The model should incorporate some way by which the period of time over which the intangible asset can be expected to give the owner an economic return, can be evaluated.

· Extraneous forces. Factors that might influence the asset such as inflation, economic outlook, exchange rate, government policy, industry specific conditions such as availability of raw materials, competition must be taken into account.

It is no coincidence that BrandMetrics conforms to these very principles because the methodology was founded on the basis that it must use basic corporate finance tools and be acceptable in a world where the brand asset has balance sheet status. In establishing those principles we were a decade ahead of the game

BrandMetrics (Pty) Limited. 2005 ©

Please feel free to distribute this briefing to anyone you wish. Should you want to use extracts of it in your own work you may do as long as the source is fully cited.