Marketing and Accounting Converge - A BrandMetrics White Paper

The Final Barrier: Marketing and Accounting Converge at the Corporate Finance Interface.

By Professor Roger Sinclair PhD.

Abstract: In the context of a momentous start to the new century a sea change in the world of accounting will probably not make Time Magazine’s league table of the most notable events. For marketers it might well become the most significant event of the decade. The move is the long awaited change from historic cost to fair value. Instead of accounting for assets according to what they cost and depreciating that cost over a pre-determined period, acquired assets are now valued at their fair value. That is the price they might achieve in the open market. Thus certain assets will now be valued at the present value of their future cash flows; in the identical way to which brands are measured. Coupled with revised accounting standards that recognize, for the first time, acquired brands as assets, the marketing Holy Grail is now within reach: brands on the balance sheet representing a single number by which their return might be measured. This essay examines the phenomenon.

Five hundred years in the making

Goodwill is much ado about nothing. It has tested the patience and resolve of the accountants for many generations. It conflicts with the neat and tidy way they like to deal with the financial affairs of companies. And for many years they have not known how to treat it.

Business people have a tendency to value companies in a different way to the accountants. They recognize that a business is more than the tangible assets that the firm owns and which are recorded in the audited financial statements. Businesses succeed or fail because its managers have built up networks of relationships with suppliers, distributors and customers. They have innovated systems and new products; employed and trained supportive staff; and they have ways of managing their margins that optimize profitability.

It is these types of resources within a business that attract buyers. Businesses would like to own an efficient and profitable competitor and are willing to pay a price that incorporates these resources. They might negotiate a settlement that is well above the value of the target firm as estimated by the accountants whose focus is what the assets cost less the liabilities (what the company owes). Goodwill is the difference between the two: the price paid and the net accounting value of the assets.

It is an arithmetic difference. It has no substance. But it has caused much heartache among the accountants who have to grapple with this difference when they reconcile the books at the year-end following such a deal.

The problem stretches back 500 years to an Italian mathematician called Luca Pacioli who, in 1494, introduced double entry bookkeeping . If money goes out of the company it is recorded in the debit column. It must be matched with an entry coming in on the credit side. The sum of each column must balance with the other. If a company pays over and above the net asset value to buy the business the accountants have no difficulty in identifying and entering the out flowing cash. The problem lies with the matching column because nothing that is tangible and which they can readily identify has flowed in. Confused by this void, they coined the catchall title of goodwill.

Awkward entrepreneurs

The issue reached a head in the late 1980s. The previous few years had seen some massive takeovers, some of which are mentioned in Chapter 10 of this book. Companies had paid prices that exceeded the net asset value of the target company by many multiples. They did it to gain control of brands that they coveted. For example, in the US, Kraft was bought for a staggering 600% more than its book value . In Europe, several companies such as Nestlé, Reckitt & Coleman and Grand Metropolitan (now renamed Diageo), were involved in deals that included vast amounts paid for goodwill.

Significantly, these companies recognized the brands they had bought as assets; had them valued and began to place them on the balance sheet. This boosted the worth of the company and also solved the problem of what to do with a large potion of the premium they had paid: or goodwill to the accountants. The view of the business people who did the deals was that this is no different from a company spending shareholder funds on, say, a new building. Cash goes out and a tangible asset comes in. But, the accountants were less than sanguine about this treatment of intangible assets and, in the United Kingdom where this approach had become endemic, they instructed their members to “cease and desist ” the practice while they investigated the correctness of it. That investigation lasted more than ten years.

Less haste, no speed

To understand why it took so long requires an appreciation of how accounting is organized.

Accountants prepare annual financial statements in a structured manner so that:

· one year can be compared with the previous; and,

· one company’s results can be compared with another.

The basis for this comparability is generally accepted accounting practice (GAAP), which has its roots in a series of accounting standards. Globalization and cross border trade has brought about a need for this comparability to span country borders and consequently there has been a move in recent years to harmonize GAAP internationally.

Two private sector, independent, not-for-profit bodies dominate this movement. In the United States it is the Financial Accounting Standards Board (FASB) www.fasb.org and for much of the rest of the world it is the London based International Accounting Standards Board www.iasb.org.

FASB and IASB have a close working arrangement and much of what they do and produce is in conjunction. Increasingly FASB and IASB standards are similar. Over ninety countries use the IASB standards and those that do not (Japan, Hong Kong, Canada and Australia for example, which have their own standard setting bodies), work closely with the IASB to ensure that their financial reporting is not out of step.

Producing accounting standards or even modifying existing ones is a slow process. Suggestions are received from a variety of sources and once they are on the agenda as a project, are subject to open forum discussions and research by FASB and IASB staff. Each series of changes or development has to be published in exposure drafts (ED), discussion papers and working drafts. Comments are received, assessed and accommodated until the final standard is deemed ready for issue.

The final standard is issued by FASB under the title Statement of Financial Accounting Standards (SFAS); and by IASB as International Financial Reporting Standards (IFRS).

That’s what we’ve been saying for years!

Intangible assets have been a focus of attention by both bodies since the events of the 1980s, described above. But as the term intangible asset implies this is far broader than brands. In fact brands were hardly mentioned in earlier versions of the standards released (SFAS 142 and IFRS 38). An intangible asset in the standards is conceptualized as:

“an identifiable non-monetary asset without physical substance held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.”

The list of what this covers excludes brands but includes computer software, patents, copyrights, motion picture films, customer lists, franchises, customer or supplier relationships, customer loyalty, market share and marketing rights. The standard specifically states that internally generated brands, newspaper mastheads, publishing titles and others should not be recognized as intangible assets.

The reason given is that these resources cannot be separated from the rest of the business; the same reason given in the late 1980s for issuing the “cease and desist” instruction to stop treating brands as assets. Even when a brand was bought as part of a takeover or merger, the intangible aspect was considered to be goodwill, which was treated as an asset. This was contentious because, as has been pointed out earlier, goodwill is an arithmetic difference that captures the future economic benefit capacity of a collection of intangible assets. It does not itself generate income.

Events of the first five years of the new century signalled substantial change.

Both FASB and IASB have had standards relating to intangibles and goodwill for some years. SFAS 141 Business Combinations and SFAS 142 Intangible Assets are the FASB standards; IASB has IFRS 3 and IFRS 38 with the same titles.

This extract from a FASB document explains why both bodies have changed their stance regarding brands (and other intangibles) in the past few years.

“(Investors need) better information about intangible assets because those assets are an increasingly important economic resource for many entities and are an increasing proportion of the assets acquired in many business combinations.”

FASB issued the revised SFAS 141 in June 2001, IASB followed suit with very similar amendments to IFRS 3 in January 2005. The most important aspect of these modified standards from the brand management point of view is the complete turnaround with regards to brands.

So, what is this thing called goodwill?

The amorphous goodwill has now given way to something more substantial. When company A buys company B the difference between the purchase price and net asset value (if it exists) may no longer be ascribed solely to goodwill. The new standards require the accountants to account for the costs of the intangibles that make up the goodwill portion. In other words they have to work out why the premium over net asset value was paid. What was bought for that price?

The strange thing is that the people who did the deal might not have quantified these components. They knew the company had established distribution; brands that command premium prices; an active research and development program; and a portfolio of successful brands. The task of the accountants, after the event, is to identify and value as many of these intangibles as the standard will permit them to recognize.

The standard provides detailed guidance as to which intangibles will and are likely to meet the recognition criteria. For example:

· Trademarks, trade names, service marks, collective marks and certification marks. The standard expands this by stating that the terms “brand” and “brand name” are used by marketers when they refer to trademarks. Trademarks of course are the basis of brand value because they provide the brand with legal protection and permit identification. This means that the legal rights of the brand are contractually based and could be transferred from one owner to another. It is loyal customers (or brand equity) that give the trademark its value.

Thus in the context of a business combination brands are now recognized as intangible assets. Further they must be valued, not as was the case according to their historic cost, but at their Fair Value at the time of the purchase.

Pacioli re-invented

Fair value is a relatively new concept for accountants because it forces them to look into the future and not the past. It is defined as:

“the price that would be received for an asset … in a current transaction between marketplace participants in the reference market …”

Fair value is the market value of the asset, not its book value. Because the concept of fair value is new, FASB has drafted a standard that guides accountants on how it should be measured. This becomes effective in December 2006. IASB will issue its own standard on fair value measurement in the first quarter of 2006.

The statement is long and complex and only the key aspects are reviewed here. Perhaps the most important elements are that the measurement of fair value reflects the market estimate of the future discounted inflows associated with the asset. Secondly most intangible assets will be based on a premise that the asset is valued “in-use”. That means that the buyer of the asset would continue to use it as it had previously been used and will operate it in conjunction with other assets in the business. This could for example be the use of the same production line, distribution network, or IT system.

The statement limits the valuer’s choice to three main valuation types: market, cost and income.

· Market. The valuer examines the reference market to establish what prices are being achieved for similar assets. This works well in property where prices are published, but there are no clear markets for most intangible assets, specially brands.

· Cost. The basis of the approach is an estimate of what it would cost to replace the asset. Since the statement makes reference to obsolescence, it is most appropriate for tangible assets such as machines. Whereas you can construct a machine you cannot simply construct a brand and instantly create a similar level of customer acceptance and distribution.

· Income. This is the approach that is consistent with the nature of intangibles in that it converts future cash flows or earnings into a single discounted present value.

It is evident that the reliable measurement of intangible assets at their fair value will utilize variations around discounted cash flows. The statement recommends that the valuer maximize the use of inputs from the market rather from the entity itself. This reduces the extent to which the company’s own, probably subjective views are incorporated. The standard also suggests that risk be accommodated through the use of a discount rate in which a risk premium is added to the risk free rate. This is preferable to applying risk to the future cash flows.

Famous old brands are next

Progressive as all these developments have been, they have left a glaring anomaly.

British based Barclays is one of the world’s largest banks. During 2005 it concluded a deal in which it bought control of Absa, one of South Africa’s leading banks for £2,6 billion. In terms of IFRS 3 described above, the Absa brand will be valued and will appear in the Barclay’s 2006 balance sheet as an acquired intangible asset. In other words the brand will be listed as an asset. The anomaly is that the parent brand, Barclays is not recognized as an asset. It will not be listed in the balance sheet as an asset because it is internally generated and the accounting standards do not accommodate internally generated brands.

This will change. In fact FASB had a project designed to deal with this. The project was:

“to establish standards that will improve disclosure of information about intangible assets that are not recognized in financial statement.”

This project was aborted in 2004, but there is little doubt that this uneven state of affairs will be addressed in the near future.

The minds meet at last

Brands as assets mean a single number on the balance sheet. This already applies to brands that are bought as part of a business combination. It will not be long before brands that are home grown will be recognized as well. FASB has looked at it and the anomaly that exists without it cannot be left unattended.

When brands are valued for accounting purposes they will be at their fair value, not historic cost. Present value valuation is the way brands are valued and is how they will be measured for the balance sheet. The brand value is the asset value.

Since valuation methodologies exist that merge marketing metrics with financial data to produce the value, marketers and shareholders are given a sensitive link between brand marketing and accounting for brands.

As with any other asset, this not only permits but also demands the application of standard finance tools. Net present value (NPV) for assessing marketing investment requests; return on investment (ROI) to test the appropriateness of the marketing budget; and changes in asset value to measure the success or otherwise of the marketing programme.