Identifiable Intangible Assets in Business Combinations
– A Quantitative Study of US Companies –
Hanna Hedin Hilda Havert
BACHELOR THESIS IN ACCOUNTING
AT THE DEPARTMENT OF BUSINESS ADMINISTRATION GOTHENBURG UNIVERSITY
AUTUMN 2014
SUPERVISED BY JAN MARTON AND SAVVAS PAPADOPOULOS
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ABSTRACT
This thesis is a quantitative study of how U.S. companies allocate purchase prices paid in acquisitions to identified intangible assets in relation to goodwill. It seeks to identify how the percentage of identified intangible assets in business combinations varies with acquirer firm characteristics. Since SFAS 141 and SFAS 142 are the two principle-based standards that regulate how U.S. companies account for acquired intangible assets, the study seeks to indicate whether these seem to work efficiently, providing the users of financial statements with relevant information that reflect the economic values of the intangible assets correctly.
The economy seems to have become increasingly knowledge-driven and technology based during the last couple of decades. This has resulted in intangible assets representing a larger proportion of balance sheet totals and subsequently the proportion of acquired assets in business combinations. Problems related to the accounting for intangible assets led to FASB’s issuance of standards SFAS 141 and SFAS 142 that have brought changes in the way to account for intangibles. Since few studies have focused on how acquired intangible assets are identified in business combinations post the issuance of SFAS 141 and 142, it has been of this study’s objective to provide additional knowledge and increased insight about this. Current knowledge and previous research literature has guided and supported this study throughout the hypothesis development, methodology and analysis. A similar methodology as Rehnberg (2012) used in her thesis studying identification of intangible assets in business combinations, has been applied but this thesis studies U.S. companies instead of Swedish companies, it studies acquisitions made between 2010-2014 (the large majority of the observations can be found between 2011-2013) and it has a significantly greater sample. This was facilitated through the usage and data collection from database Compustat. Two multiple regression models are used to draw conclusions about five hypothesis regarding acquirer firm characteristics relationship to the level of identified intangible assets. The findings of this paper is that the size and profitability of the acquirer, with a 95% confidence, has a negative correlation with the percentage of purchase price allocated to identified intangible assets in U.S. business combinations. The authors do not find that the debt to equity ratio and book to market ratio of the acquirer can explain this level. The percentage of identified acquired intangible assets varies between industries and profitability and size affect the percentage of identified intangible assets differently in different industries. The Energy, Materials, Industrials, Consumer Discretionary, Information Technology, Telecommunication Services, and Utilities industries identified significantly less intangible assets in business combinations than the Consumer Staples industry (43% versus 56,7%). The mean percentage of identified intangible assets across industries was found to be 47%.
Most findings are not in line with the ones in previous research and the thesis does not attempt to explain why. One reason could however be that the years of study for this paper is a typical post-crisis period characterized with impairment of goodwill and other assets whilst the one of Rehnberg was characterized by significant growth. The study cannot draw a conclusion
whether the levels of identified intangible assets in business combinations observed in this research indicate efficient principle-based standards but the finding that the level of identified intangible assets varies between industries is a sign that they do.
KEYWORDS
FASB, SFAS 142, SFAS 141, US GAAP, purchase price allocation, goodwill, intangible assets, identification of intangible assets, business combinations, incentives in accounting choices, acquirer firm characteristics.
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ACKNOWLEDGMENTS
We would like to express our gratitude to supervisors Jan Marton and Savvas Papadopoulos for taking their time and knowledge to provide us with valuable input and guidance throughout this research. Furthermore we would like to thank our group discussants for giving us their helpful opinions of improvement and letting us take part in interesting discussions.
Gothenburg, January 4 2015
Hanna Hedin Hilda Havert
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ABBREVIATIONS, SYMBOLS AND DEFINITIONS ABBREVIATIONS
BTM Book to Market Ratio of Common Equity
DE Debt to Equity Ratio
EBIT Earnings Before Interest and Taxes
ESMA European Securities and Markets Authority
FAS Financial Accounting Standards
FDI Foreign Direct Investments
FASB Financial Accounting Standards Board
GICS Global Industry Classification Standards
IAS International Accounting Standards
IASB International Accounting Standards Board IFRS International Financial Reporting Standards
PPA Purchase Price Allocation
SFAS Statements of Financial Accounting Standards
US GAAP Generally Accepted Accounting Principles in the United States
SYMBOLS
N Sample size
sig Significance
R2 Coefficient of determination
β Unstandardized coefficient (beta)
σ Standard deviation
a Regression intercept
ɛ Error
DEFINITIONS
Fair Market Value The price a willing buyer would pay, and a willing seller would receive, through an arm’s length transaction in a market with perfect information.
Company Market Value The sum of all issue-level market values (trading and non-trading issues). For single-issue companies this is common shares outstanding multiplied by the month-end price that corresponds to the period end date.
Control Group The group in a study that does not receive treatment and is then used as a benchmark to measure how the other tested subjects do.
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TABLE OF CONTENTS
1. INTRODUCTION ... 5
1.1 BACKGROUND AND PROBLEM DISCUSSION ... 5
1.2 PURPOSE ... 6
1.3 RESEARCH QUESTION ... 6
1.4 LIMITATION ... 6
2. EMPIRICAL CONTEXT ... 7
2.1 THE REGULATORY ENVIRONMENT FOR BUSINESS COMBINATIONS IN THE U.S... 7
2.2 IMPORTANT ASPECTS OF ACCOUNTING FOR INTANGIBLE ASSETS IN BUSINESS COMBINATIONS ... 10
3. HYPOTHESIS DEVELOPMENT ... 15
3.1 EARNINGS MANAGEMENT INCENTIVE ... 15
3.2 CAPITAL MANAGEMENT INCENTIVE ... 15
3.3 DIFFERENCES BETWEEN INDUSTRIES ... 16
3.4 BOOK TO MARKET RATIO ... 17
4. RESEARCH METHODOLOGY ... 18
4.1 RESEARCH DESIGN ... 18
4.2 DEPENDENT VARIABLE ... 18
4.3 INDEPENDENT VARIABLES ... 18
4.4 HYPOTHESIS TEST ... 20
4.5 MODELS ... 20
4.6 DATA COLLECTION ... 22
4.7 DATA TREATMENT AND APPLIED TESTS... 22
4.8 CRITICAL REVIEW... 23
5. EMPIRICAL FINDINGS ... 25
5.1 DESCRIPTIVE STATISTICS ... 25
5.2 RESULTS AND ANALYSIS ... 27
6. SUMMARY ... 42
6.1 CONCLUSIONS ... 42
6.2 CONTRIBUTION AND SUGGESTED FURTHER RESEARCH ... 43
7. SOURCE OF REFERENCE ... 45
APPENDIX 1 ... 47
Industry classification ... 47
APPENDIX 2 ... 48
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1. INTRODUCTION
The first section of this thesis is an introduction that will provide the reader with a general understanding of the area of study. It initiates with a background of the issue and topic at hand and ends with a purpose and research question that will lay ground for the rest of the disposition of the thesis.
1.1 BACKGROUND AND PROBLEM DISCUSSION
The world economy seems to have become successively more knowledge-driven and technology-based during the last couple of decades (Rehnberg, 2012). As a result one has been able to see intangible assets as an increasingly larger proportion of companies’ balance sheet totals and the importance of well-functioning regulations and guidelines in how to account for intangibles is therefore crucial. The relevance of financial reports is increasingly dependent on the quality of the accounting for intangibles.
Researchers and regulators within accounting and financial reporting have long debated the accounting for intangible assets. The debate centers on the relevance and reliability of how acquirers account for intangible assets acquired in business combinations. FASB, the American board that establishes and communicates financial accounting standards and reporting standards in the U.S. (US GAAP), was the first international standard setter who answered to this need of redefined regulations and guidelines.
SFAS 141 Business Combinations and SFAS 142 Goodwill and Other Intangible Assets are two standards that were introduced by FASB in 2001 as a direct effort to improve the way U.S. companies valuated and accounted for intangible assets in business combinations. SFAS 142 is considered an important step towards fair-value-based accounting.
U.S. firms have experienced an increased requirement for identification of intangible assets in business combinations since the introduction of SFAS 141 and SFAS 142. The standards have been intensely debated in research as well as in practice. The large majority of the research has however focused on the impairment of goodwill but there has hardly been any studies done on the increased requirement for identification of intangible assets. Motivated by the debate regarding accounting for intangible assets and that on SFAS 142, this study will be an empirical study investigating this area further. Not only by explaining how U.S. companies, covered by SFAS 141 and 142, identify intangible assets in business combinations but also by researching whether there are any firm characteristics that explain this.
The U.S. is a large economy and consequently U.S. firms may impact the global financial stability to a larger extent than most other countries’ business operations can. The U.S. has also been the number one destination for FDI net inflows for over a decade and although the U.S. slice of global FDI has eroded as competitor nations work to make their economies more hospitable to global investors, the U.S. share still accounted for 17 percent of the world’s inward FDI stock in 2012 (OFII, 2014)
The need of stable and well-functioning regulations and standards that can assure accounting quality of U.S. companies is undeniable. Financial statement users must be able to understand their investments made in assets and the subsequent performance of those investments. This requires that financial statements provide relevance, transparency and comparability to the user. SFAS 141 and 142 are primarily principle-based rules and there are indications within research that companies' accounting choices are influenced by management incentives related to financial consequences. The components that make up goodwill have subjective values and there is a risk that acquiring companies could overvalue goodwill in the business combinations if the valuation process is not done properly (Rehnberg, 2012). If an acquiring
6 company overvalues goodwill, it would have a negative effect on shareholders since they are likely see a drop in their share values when the company is required to perform goodwill impairment. In fact, this happened when AOL merged with Time Warner in 2001 (Wallstreet Journal 2003). When the accountant’s subjective judgment comes into play in the process of identifying intangible assets, it also becomes more difficult for the users of the financial statements to verify the information provided and the relevance of the financial statements is decreased (Watts 2003). Subjective interpretations also result in lower comparability between firm’s financial statements from a user’s perspective (Rehnberg, 2012). This could have a negative effect on international trade and investments.
A challenge that companies face when accounting for intangible assets is to make sure that it corresponds with faithful representation. This can be a tough challenge because intangible assets often lack active markets for proper valuation and it can be difficult to determine whether the company meets the requirement of control for an intangible asset or not. One of the main purposes with the introduction of SFAS 141 and 142 (see section 2.1) was to achieve relevant and faithfully represented financial information but the question is whether this has been achieved? Does US GAAP and principle-based standards work efficiently?
1.2 PURPOSE
This is a quantitative study that aims to provide additional knowledge of how U.S. companies under effect of SFAS 141 and SFAS 142 identify and report intangible assets in conjunction with their accounting for business combinations and whether there are any firm characteristics that correlate with a certain level of identified intangible assets.
The purpose is also to investigate whether the same conclusions can be drawn and result produced as Rehnberg (2012) when applying a similar test and methodology but with a larger sample of specifically U.S. companies under US GAAP instead of IFRS.
1.3 RESEARCH QUESTION
How do U.S. companies identify and report intangible assets in business combinations and are there any specific firm characteristics that explain this?
1.4 LIMITATION
This study specifically studies U.S. companies compliant with US GAAP between years 2010-2014 (the sample does not contain all acquisition made during 2010 and 2014 since data was limited in 2010 and not yet reported in 2014). Due to the limited amount of time, this thesis will only study a couple firm characteristics of U.S. acquirers: size, profitability, DE, BTM and industry. The Financials industry (e.g. banks, insurance companies) is excluded since the regulations and business environment that they operate under is significantly different from all the other industries.
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2. EMPIRICAL CONTEXT
The following chapter describes the empirical context to facilitate the reader’s understanding of the study. It initiates by describing the regulatory environment in the U.S. and the process of purchase price allocation and identification of intangible assets. It continues by presenting the current knowledge and prior studies related to accountancy of intangible assets in business combinations. The literatures presented have been identified as useful providers of beneficial information for this study. The hypotheses presented in chapter 4 are motivated by the findings in the earlier studies presented below.
2.1 THE REGULATORY ENVIRONMENT FOR BUSINESS COMBINATIONS IN THE U.S.
2.1.1 THE PURCHASE PRICE ALLOCATION AND IDENTIFICATION OF ACQUIRED INTANGIBLE ASSETS
This section initiates the empirical context with a shorter description of the identification of intangible assets and the process of allocating purchase prices paid in business combinations.
The idea is that a basic knowledge of the process will facilitate the reader’s ability to follow discussions further into the paper when reflecting about how different factors could affect levels identified intangible assets.
Purchase price allocation (PPA) is a process required of the acquiring company in business combinations. In the United States, this process is generally conducted in accordance with the purchase method of SFAS 141 and 142. A PPA categorizes the purchase price into the various assets and liabilities acquired. The process requires the conduction of acquisition appraisal, fair market valuation of acquired assets and liabilities, recalculation of the net identifiable assets from the old balance sheet price to the fair market value and that the level of unidentifiable intangible assets be determined and reported as goodwill in the transaction. The fair market value is to be determined per the date of acquisition.
Since the acquiree’s total assets and liabilities are recalculated from book value to their current market value, the PPA corresponds to a complete balance sheet produced to the real value of the assets and liabilities per the day of acquisition (Rehnberg, 2012). This can be seen as the acquirer’s way of expanding the acquiree’s balance sheet based on the book values to also entail those assets/values, risks and obligations assumed outside of the accountancy (Johansson 2003). The hidden values are based on what an acquirer think can promote and generate future cash flows, growth and profitability. The hidden values that an acquirer might consider and recognize are for example customer and supplier relationships, client registers, brand name, trademarks, organizational structures, information systems and human resources (i.e. employee knowledge and skills).
In the PPA process, acquired intangible assets can either be identified or not. If not identified, they are to be reported as goodwill. For illustrative purposes, assume a business combination where the acquirer acquirers the acquiree for the purchase price of $30B. The value of the acquiree’s balance sheet value corresponds to its net identifiable assets (the balance sheet total subtracted by the acquiree’s existing goodwill and liabilities). Assume that this is appraised to the value of $8B. Next, the fair market valuation concludes that the net identifiable assets’ fair market values are worth three times the value reported on the original balance sheet, thus
$16B in write-ups are accounted for. Finally, the difference between the purchase price paid ($30B) and $24B (balance sheet value $8B and fair market value write up $16B) is the
8 residual $6B, which is to be reported as goodwill acquired. The acquirer then adds both the value of the written-up assets ($24B) as well as the goodwill ($6B) onto the balance sheet, for a total of $30B in new assets on the balance sheet.
2.1.2 FASB AND US GAAP
Most companies in the U.S. are subject to the same set of accounting standards, which is the US GAAP issued by FASB. Public companies are required under SEC rules to prepare audited, GAAP-compliant financial statements. Private companies are generally not legally obligated to follow GAAP, but they may need to do so to satisfy lenders, sureties, venture capitalists, or other stakeholders. All companies listed on the U.S. stock exchange must however follow US GAAP. This means that a substantial part of U.S. companies follow SFAS 141R and SFAS 142. Since these firms are very different from each other in terms of how they are financed and which industry they operate within, it becomes interesting to compare them and to investigate if there are any patterns of characteristics in combination with a certain level of identified intangible assets. The comparison gives us a deeper understanding of how firm characteristics and other variables affect the accounting quality of acquired intangible assets.
2.1.3 SFAS 142 GOODWILL AND OTHER INTANGIBLE ASSETS
SFAS 142 is a standard issued by FASB that replaced SFAS 121 and became effective in July 2001. It addresses how US GAAP compliant entities should report for acquired goodwill and other intangible assets. Acquiring companies must account for acquired intangible assets in financial statements upon acquisition and account for goodwill and other intangible assets after they have been initially recognized in the financial statements.
The introduction of SFAS 142 meant that firms would no longer perform goodwill amortization but instead do annual impairment tests to see whether the carrying value of goodwill could be considered to exceed the fair value, and if so perform goodwill impairment.
The introduction of SFAS 142 also meant more specific guidance in how to determine and measure goodwill. SFAS 142 also differs from SFAS 121 in the way that acquirers now need to allocate the purchase price paid in a business combination to acquired identifiable intangible assets based on their fair values. The remainder of the purchase price is to be recognized as goodwill. The acquirer is to allocate the recorded goodwill to its reporting units based on the expected benefits, or synergies, each reporting unit obtains from the acquisition.
This is estimated by measuring the fair values of the reporting units before and after the acquisition (FASB, 2014).
Similar to acquired goodwill, identifiable intangible assets that can be considered to have an indefinite life, such as a trademark, is not amortized. Identifiable intangible with indefinite life are to be subject for the same annual impairment test as goodwill. According to FASB, the majority of the identified intangible assets are considered having finite lives and are therefore to be amortized over its useful life.
FASBs Reasons for Issuing the 142 Statement and How Its Changes are Supposed to Improve Financial Reporting
It was noted by both producers (company management) and users of financial statements that intangible assets are becoming an increasingly important economic resource for many entities.
They also seem to make up a successively larger proportion of the assets acquired in many business combinations. FASB recognized that there was a need for better information about intangibles.
9 Financial statements are supposed to be improved by SFAS 142 by better reflecting the underlying economics of the acquired intangible assets. This will help potential and existing stakeholders such as investors and lenders to make successful and efficient business and investment decisions.
The increased requirement for disclosures about acquired goodwill and other intangible assets will provide users with a better understanding what changes in those assets that can be expected over time. The changes in SFAS 142 are therefore supposed to make it easier to asses future profitability and cash flows in companies and their different entities.
2.1.4 SFAS 141R BUSINESS COMBINATIONS
SFAS 141R is a revised version of SFAS 141 (2001) and issued by FASB in 2007. The standard is an establishment of principles and requirements for how a publicly traded U.S.
company (or other companies under the effect of US GAAP) as an acquirer is to recognize and measure acquired identifiable assets, liabilities and other non-controlling interest in its financial statements. SFAS 141R sets standards and requirements for how a US GAAP compliant company is supposed to recognize and measure goodwill acquired or gained from business combinations and what information regarding the business combination that must be disclosed in the company’s financial statements to provide relevant information from a user’s perspective. SFAS 141R recognizes that users of the financial statements must be able to determine the nature and financial effects of business combination and force transparency in the acquirer’s financial reports.
SFAS 141R sets principles and requirements for how the acquirer:
Recognizes and measures identified assets acquired, goodwill acquired and liabilities assumed in its financial reports.
Disclose information about the purpose and financial effects of the business combination
When SFAS 141 was originally issued in 2001 it promulgated changes in the accounting practice that were a direct effort to improve financial reporting in the U.S. SFAS 141R is not substantially different from the original SFAS 141 but there are some significant changes. The scope of SFAS 141R is broader than the one of SFAS 141 since it applies to business combinations in which control has not been obtained through transferring consideration.
SFAS 141R requires that the acquirer and the acquiree are identified and that the acquisition date is recognized so that the fair value of the assets and assumed liabilities acquired can be calculated correctly as of that date. The SFAS 141R Statement also requires that intangible assets be recognized apart from goodwill if they meet either the contractual-legal criterion or the separability criterion. Intangible assets lack physical substance and are therefore unlike tangible assets often hard to recognize and in need of a structured identification process.
One of the major changes that came with the revised version of SFAS 141 (SFAS 141R) was the requirement that all business combinations be accounted for by the purchase method. The purchase method recognizes all intangible assets acquired in a business combination while the previously allowed pooling method in SFAS 141 only recognized those previously recorded by the acquiree. This was to facilitate comparability and it allowed the investment made in an acquired entity to be better reflected in the acquirers’ financial statements. The explanation to this is that the purchase method in contrast to the pooling method account for an acquisition based on the values exchanged which provides users with information about the total purchase price paid.
10 FASBs Reasons for Issuing the 141R Statement and How Its Changes are Supposed to Improve Financial Reporting
The reason behind the issuance of SFAS 141R is very similar to that of SFAS 142: “to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects” (FASB 2007).
SFAS 141R also forced that better information regarding intangible assets was provided to the users of financial reports. Acquiring companies now have to disclose the primary reasons for a business combination, the allocation of the purchase price paid and other more specific information about those assets.
The issuance of SFAS 141R together with IFRS 3 Business Combinations issued by IASB in 2005 (revised in 2007) has had a convergence effect for international reporting standards. It was an effort by FASB and IASB to foster a better comparability between European and American companies’, to boost international accounting efficiency and to make it easier for international investors to do business. SFAS 141R and IFRS 3 are therefore very similar but not identical.
In conclusion U.S. companies have experienced an increased requirement for identification of intangible assets since the introduction of SFAS 141 Business Combinations and SFAS 142 Goodwill and Other Intangible Assets as a consequence of FASBs strive to solve the earlier experienced problems associated with accounting for business combinations. Increased requirement and a more detailed guidance in how identification of intangible assets is to be done should reduce US firms’ goodwill at initial recognition. If identification of intangible assets in business combinations were done properly, goodwill would be relatively small, and therefore not represent such a material issue. It has been questioned whether this is reality.
There is a need of additional research of how U.S. firms identify intangible assets in their annual reports since the introduction of SFAS 141 and 142.
2.2 IMPORTANT ASPECTS OF ACCOUNTING FOR INTANGIBLE ASSETS IN BUSINESS COMBINATIONS
Accountancy is a process performed by employees within a company and it is ultimately put together to financial reports issued by the management or board of the company. During this process, accounting areas covered by principle-based standards such as SFAS 141 and 142, are sometimes in need of accounting choices partially based on subjective interpretations (Rehnberg, 2012). The main accounting choice discussed in this paper is the one where acquired intangible assets are identified or not. When the acquirer performs the PPA, it will determine the amount of identified intangible assets in a business combination. This will affect the acquirer’s future cost, balance sheet and therefore also result and profitability since intangible assets with definite economic life is subject to amortization while goodwill is not.
The debate of SFAS 142 and 141 mainly focuses on those effects that accounting choices bring to the financial reports and through this indirectly to the users. Earlier studies indicate that the accounting choices determining the amount of identified acquired intangible assets seem to be correlated with management incentives and a various set of acquirer firm characteristics.
2.2.1 ACCOUNTING QUALITY AND ACCOUNTING CHOICES FOR BUSINESS COMBINATIONS
One of the main purposes of financial statements is to provide the user with information that
11 enables him or her to make decisions about investment opportunities or other business oriented opportunities such as partnerships. Barth (2008) explains how accounting quality has a significant affect on the efficiency of capital markets. Poor accounting quality is likely to result in capital costs, how effectively capital is allocated and on international capital mobility (Young & Guenther 2002). Accounting quality is a fundamental condition for investments. If poor or not regulated investor perceived higher risk and will only be inclined to invest when the expected return on investment compensate. The same applies on creditors who are more unlikely to issue loans to companies that cannot ensure accounting quality.
There are different measures to describe accounting quality within firms. IASBs Conceptual Framework lists the qualitative characteristics of financial information that are required for quality financial statements from a user’s perspective. The financial information must provide relevance, faithful representation (completeness, neutrality, freedom from material error), comparability, timeliness, verifiability and understandability. In line with IASB, Barth (2008) partially defines accounting quality as the financial reports’ relevance to the user and its ability to make efficient decision based on it. The Conceptual Framework specifies that the financial information needs to provide predictive value and confirming value to be relevant (IASB, 2009).
Prior research has indicated that intangible assets provide valuable information to the users of the financial reports and thus contributes to their relevance (Rehnberg, 2012). For the information about intangible assets to be relevant it requires that it is in line with faithful representation. It has been discussed whether a higher or lower level of identified intangible assets provide the most relevance and accounting quality the financial statements. One discussion is of the opinion that comparability between companies’ financial statements is reduced when a lower proportion of intangible assets are identified since the user will not have access to the acquired assets character and will therefore not be able to make his or her own conclusion about the assets value, prospects and future contribution to the profitability of the company. When reporting goodwill, the user of the financial reports are forced to guess what type of assets have been acquired and how long their economic lives are, i.e. less identified intangible assets affect the relevance and comparability of the financial statements negatively. Rehnberg (2012) defined financial reports as more relevant and of higher quality when a larger proportion of acquired intangible assets were identified. This opens up for interesting areas of research. If the quality and relevance of financial statements can be considered higher when a larger proportion of acquired intangible assets are identified, then the level of identified intangible assets in business combinations could indicate whether the principle-based standards especially SFAS 142 work efficiently to provide relevance and accounting quality to the financial statements.
2.2.2 COMPANIES’ COMPLIANCE WITH REQUIREMENTS FOR BUSINESS COMBINATIONS IN FINANCIAL STATEMENTS
The European Securities and Markets Authority (ESMA) published a report in June 2014, discussing the importance of accounting quality for intangible assets and transparency during business combinations. The report studies how EU companies apply IFRS Requirements for Business Combinations in Financial Statements and whether this is compliant with IFRS or not. Although the report discuss perceived issues that occur when European companies apply IFRS 3, the basic problem at hand can be directly related to U.S. companies applying SFAS 142, but most importantly SFAS 141R Business Combinations. The report by ESMA concludes that EU companies overall provide sufficient and relevant information of their business combinations in line with IFRS 3 but it also identifies certain areas that are in need
12 of improvement. This paper refers to the report issued by ESMA to highlight the importance of studying how companies identify and account for intangible assets in business combinations. The report serves as an argument that it is practically motivated to research the area further to investigate whether SFAS 141 and 142 seem to work efficiently.
2.2.3 ACCOUNTING FOR ACQUIRED INTANGIBLE ASSETS IN BUSINESS COMBINATIONS IN COMPLIANCE WITH IFRS 3
Rehnberg published a thesis in 2012 discussing how the introduction of IFRS 3 by IASB has affected the way EU companies account for intangible assets in business combinations. Her discussion focused on relevance and how the financial statements were affected by accounting choices. Rehnberg’s thesis serves as an argument that it is theoretically motivated to research how companies identify acquired intangible assets. It is an area where there has hardly been any research done and it is a topic of current matter.
Rehnberg found that large companies and companies with a higher percentage of external financing accounted for a larger proportion identified intangible assets. Rehnberg reasoned that larger companies tend to be more conservative in their accounting practices and would therefore choose to continue to amortize and depreciate assets by identify a larger percentage intangible assets like done prior to the introduction of SFAS 141 and 142. The theory was that highly indebted companies would find it extra important to communicate the picture of a stable financial position to stakeholders, as well as disclosing the type of assets owned by identifying a larger proportion of acquired intangible assets.
2.2.4 ACCOUNTING DISCRETION IN PURCHASE PRICE ALLOCATION
Zhang and Zhang published a study in 2007 investigating how companies allocated purchase prices paid in acquisition between goodwill and identifiable intangible assets. The prediction of the study was that the issuance of SFAS 142 had created a management incentive to allocate a greater proportion to goodwill to reduce amortization expenses. The result of their study was that acquirers that reported small positive earnings were more likely to be concerned with amortization expenses depressing already small earnings. They were consequently also more inclined to allocate a larger proportion of the purchase price paid in acquisitions to goodwill. The authors concluded that there was a strong correlation between the profitability ranking of a company and the percentage of goodwill allocated to that unit.
The authors reasoned that the incentive to avoid amortization expenses was connected to management bonus systems based on annual results. An additional motive for earnings management incentives according to Rehnberg (2012) is the need or desire to meet existing listing requirement with stock exchanges that demands that a certain level of pre-tax earnings.
The study of Zhang and Zhang also found that there was a positive correlation between the level of reported goodwill and the acquirer’s anticipated discretion in future goodwill assessment to avoid reporting impairment. The anticipated discretion was higher if the acquirer was far from undervalued (low BTM) thus a positive relationship between BTM and the percentage of identified acquired intangible assets.
PwC published a study in 2009 that found undervalued companies (BTM ratio larger than 1) more likely to have to perform goodwill impairment. Prior research suggests that an undervalued company with a higher BTM seem to be more likely to identify a larger proportion of acquired intangible assets since they are exposed to higher risk of goodwill impairment (Smith and Watts, 1992). An acquirer with more discretion in future goodwill assessment (a lower BTM) was found to record more goodwill (Zhang, Zhang, 2007).
13 The myopic behavior of reporting more goodwill to avoid amortization mentioned earlier in section 2.3 can be bad or even dangerous for both the company and its stakeholders since it increases the risk for larger future impairment of goodwill. A larger impairment of goodwill than expected by the shareholders (or other stakeholders) can hurt them badly financially and it can also jeopardize the survival of the company. There have been several scandals involving firms that have artificially inflated their balance sheets by reported excessive goodwill value and that later had to perform massive goodwill impairment (Rehnberg, 2012).
The figure 2.2.4 below illustrates PwC’s findings that the BTM of U.S. publically traded companies has a positive correlation with the need of future goodwill impairment. The study refers to their observation in the financial crisis of 2008. As stock prices fell, there was a significant drop in many U.S. companies’ BTM. Between the third quarters of 2008 up until the end of the first quarter of 2009, Fortune 500 companies had announced $230 billion of goodwill impairment, which was more than twice the amount recorded the three earlier years, combined.
Figure 2.2.4 Breakdown of Trading and Impairments
Additionally, there have been other theories about why there seems to be a positive correlation between BTM and the amount of identified intangible assets in a business combination. Authors Zhang and Zhang (2007) wrote in their thesis that acquirers with lower BTM (overvalued) can be good quality firms are more able to carry out better acquisitions that generate more synergies. As a result, they would record more goodwill.
2.2.5 BUSINESS COMBINATIONS IN DIFFERENT INDUSTRIES
In 2009 KPMG released a study providing insight to how the percentage of purchase price paid in acquisition varied between industries. The study found that the percentage of purchase price allocated to goodwill correlated with industry classification. Thus, the finding was that there exist industry-specific patterns for the identification of intangible assets.
KPMG’s analysis and conclusion behind why patterns differed between industries was that some industries could meet the contractual-legal criterion and the separability criterion more easily due to the business environment they operated within and therefore also recognize a
Trading Below Book
and Impairment
Not Taken Since 6/2008;
21%
Trading Below Book
and Impairment Taken Since 6/2008; 23%
Trading Above Book
and Impairment
Not Taken Since 6/2008 ;
44%
Trading Above Book
and Impairment Taken Since 6/2008; 12%
14 larger percentage of the acquired intangible assets apart from goodwill in line with SFAS 141R.
KPMG’s research also found that industry specific value drivers and competitive environment were vital for the valuation of intangible assets. The forecasted and expected synergies and long-term growth expectations for business combinations are according to KPMG dependent on industry specific structures, regulations and value drivers. The operational environment came in to play in the PPA process when identifying intangible assets.
Most industries were found to identify more than 50% of acquired intangible assets in business combinations, reporting less than 50% of goodwill. Across all industries, the Building & Construction industry attributed the lowest value to intangible assets, allocating an average of just 6.0 % of the purchase price. The industries with the highest percentage of identified intangible assets were the Consumer Products & Services (57.0%) and Life Science
& Health Care Industry (45.1%).
Rehnberg (2012) tested whether technology intense industries reported a higher percentage of identified intangible assets but did not find a significant difference. There have however been other studies indicating existing differences between industry classifications and the level of identified intangible assets (Godfrey & Jones 1999).
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3. HYPOTHESIS DEVELOPMENT
This chapter develops hypothesizes of the relationship between identified intangible assets in business combinations and the firm characteristics of the acquirer. The development is based on the empirical context presented in chapter 2.
3.1 EARNINGS MANAGEMENT INCENTIVE
The introduction of SFAS 141 and SFAS 142 in 2001, meant that U.S. companies under the effect of US GAAP no longer were to perform amortization on goodwill or other intangible assets with indefinite life (section 2.1.3). This meant that acquiring companies could avoid amortization expenses by not identifying intangible assets during business combinations and thus account for larger proportion goodwill. Another way of avoiding the amortization expense was by assessing the identified intangible assets economic life as indefinite. There are obviously well defined guidance in when and how acquiring companies should recognize an acquired asset as identified or not and how to asses its useful life. Rehnberg (2012) did however emphasize that standards are not strict rules and that IFRS 3, very similar to SFAS 141R and 142 contain a lower proportion of detailed rules. Zhang and Zhang (2007) meant that this creates a leeway for myopic actions in line with management incentives, especially if management bonuses are tied to the annual financial performance. The incentive is to identify less intangible assets in business combinations to avoid amortization expenses and thus report better annual profit. The first hypothesis is based on Zhang and Zhang (2007) findings in section 2.3 that acquirers reporting small positive earnings are more likely to be concerned with amortization expenses and will therefore allocate a larger proportion of the purchase price paid in acquisitions to goodwill. The hypothesis of this study is developed as follows:
H1: U.S. acquiring companies that report low profitability will identify a smaller proportion of identified intangible assets in business combinations than those with a higher profitability ranking.
The expectation based on the earlier studies is in other words that there is a positive correlation between the profitability ranking of U.S. acquiring companies and the proportion of intangible assets that they identify in business combinations.
3.2 CAPITAL MANAGEMENT INCENTIVE
Intangible amortization does not only decrease the annual result but it also reduces net assets on a regular basis. As mentioned in chapter 2, Rehnberg (2012) found that large companies account for more intangible assets separated from goodwill than what small companies do.
There were several theories in her thesis that were believed to explain this correlation. Just like the management bonus incentive, some companies tie their bonus compensation systems to different key performance indicators where the balance sheet total might be included (such as in Return on Capital Employed and other profitability measures). It is also not uncommon that banks, venture capitalist and other lenders have certain requirements on how big a loan taker is or how internally financed it is (e.g. a minimum level of debt to equity ratio). The motive for companies identifying a smaller proportion of acquired intangible assets separated from goodwill might therefore be that they desire grow their balance sheet totals (since goodwill is not to be amortized).
The size of a company is often measured as the balance sheet total (either total assets or equity and liabilities) or measured in the level of annual revenue. If larger companies seem to identify more intangible assets and therefore more relevant financial statements with better accounting quality (Rehnberg, 2012 see section 2.2.3), it might be because of their ability,
16 being large, and not because of management incentives. Large acquirers might have a more developed and advanced accounting division and procedures that can ensure accounting quality by identifying a larger proportion of acquired intangible assets. From the empirical context, the second hypothesis is defined as follows:
H2: U.S. acquiring companies with a larger balance sheet total account for a larger proportion of identified intangible assets in business combinations than what smaller companies do.
In section 2.2.3, Rehnberg (2012) observed that highly externally financed companies reported more a higher level of identified intangible assets when acquiring entities. Based on this the third hypothesis is defined as follows:
H3: U.S. acquiring companies with a higher debt to equity ratio will identify a larger proportion of identified intangible assets in business combinations than those with a lower ratio.
The third hypothesis is that there is a positive correlation between debt to equity ratio (DE) in U.S. companies and the proportion of intangible assets that they identify in business combinations.
3.3 DIFFERENCES BETWEEN INDUSTRIES
If some companies identify a higher proportion of intangible assets in business combinations it does not necessarily need to be because of management incentives or its size. The underlying economics in industries can affect the level of recorded goodwill in business combination (KPMG, 2009, section 2.2.5). If the acquiree is a service company for example, there will be a significantly larger proportion goodwill recorded than if the acquiree where to be a producing company. The reason behind this is that the underlying economics is of a more intangible character in the service industry than in production where the value driven activities often are based on the quality of machines and other tangible assets and these make up a large proportion of the balance sheet. In service companies the most valuable assets tend to be for example trademark, intellectual property and customer lists (KPMG, 2009).
In section 2.2.3 it was mentioned that Rehnberg (2012) found that relevance in acquiring companies’ financial reports increased when they reported intangible assets separated from goodwill. There was an indication in earlier studies that this relevance varied between industries. Motivated by the indication that the underlying economics in industries seem to create a variance between the level of intangibles identified in acquisitions, this study will research whether a various set of industries in the U.S. seem to do this to a larger extent. The fourth hypothesis is developed as follows:
H4a) There is a correlation between the level of identified intangible assets in business combinations and which industry the acquirer operates within.
H4b) The acquirer firm characteristics profitability, size, DE and BTM explain the level of identified intangible assets in business combinations differently in different industries.
The fourth hypothesis defined above is that there is a correlation between which industry an acquirer operates within and the level of identified intangible assets it reports in business combinations (H4a). It is also predicted, based on the study of KPMG that firm characteristics might explain the level of identified intangible assets differently between industries due to
17 their underlying economics and industry specific business environment (H4b) (see section 2.5).
3.4 BOOK TO MARKET RATIO
The Book to Market ratio (BTM) is a ratio used to measure the value of a company. BTM attempts to identify undervalued or overvalued securities by taking the book value and dividing it by market value (market capitalization). A ratio larger than 1 indicates that stock is undervalued and thus overvalued if the ratio falls below 1.
In section 2.4 it was presented that a study pursued by PwC had found that positive correlation existed between BTM and goodwill impairment. Zhang and Zhang’s found that there was a positive correlation between the level of reported goodwill and the acquirer’s anticipated discretion in future goodwill assessment to avoid reporting impairment. It is therefore expected that undervalued acquiring companies (BTM larger than 1) will report less goodwill and therefore identify a higher percentage of intangible assets in business combinations.
Since BTM has been found to be an important factor of goodwill recognition in earlier studies this research finds it motivated to investigate whether U.S. acquiring companies with a higher book to market ratio on common equity will identify a larger proportion of identified intangible assets in business combinations than those with a lower ratio. The fifth hypothesis is developed as follows:
H5: U.S. acquiring companies with a higher BTM on common equity will identify a larger proportion of identified intangible assets in business combinations than those with a lower ratio.
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4. RESEARCH METHODOLOGY
This chapter aims to describe the research methodology and the data collection process applied in this thesis. The chapter presents which models are used to test the hypotheses developed in chapter 3 and the way which data has been processed. It ends with a critical review of the thesis’ validity and reliability.
4.1 RESEARCH DESIGN
This paper seeks to empirically investigate and draw conclusions about how U.S. companies identify intangible assets in business combinations and whether there are any firm characteristics that explain this. The paper will draw conclusions about the research question and the developed hypothesis by applying a quantitative method based on a multiple regression analysis similar to Rehnberg (2012). Secondary data is used, which has been retrieved from database Compustat. The quantitative character of the methodology and the way which data is presented in Compustat facilitates the use of a big sample size (N =1948).
4.2 DEPENDENT VARIABLE
Compustat does not provide a list of all acquisitions made per year but provides data of companies’ annual financials where acquired intangible assets (identified) and acquired goodwill can be seen as miscellaneous items. We do not know how many acquisitions that have been made each year, only the number of acquirers.
Table 4.2.1 Definition of Dependent Variable Variable
abbreviation
Variable name Definition
Y The ratio of identified intangible assets
Identified intangible assets acquired divided by the sum of acquired goodwill and identified intangible assets
4.3 INDEPENDENT VARIABLES
All variables are related directly to the acquirer and the data is from the same year as the acquisition was made.
Table 4.3.1 Definition of Independent Variables Variable
Abbreviatio n
Variable Name
Definition Variable Equation
BTM Book to
Market Ratio
The book to market ratio of the acquirer’s common equity the year of the acquisition.
BTM Book Value of Common Equity Market Value of Common Equity
DE Debt to
Equity Ratio
Debt to equity ratio measures how externally financed a company is.
DE Liabilities Stockholders Equity
BTM = b o o k v alu e o f co mmo n eq u ity mark et v alu e o f co mmo n eq u ity
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I Industry A dummy for each
industry in our sample classified accordance to GICS from Compustat.
PROF Profitabilit y
A continuous variable that measures how profitable a company is.
PROF EBIT
Total Assets SIZE Size The acquirer’s balance
sheet total defined as total assets. A continuous variable calculated as its logarithm to obtain normal distribution and a more exact result.
SIZElog(Total Assets)
The industries are studied in regard to which two-digit GICS code they belong to. The two- digit GICS code is the lowest, most grouped level of the Global Industry Classification Standards (GICS). GICS is a way of classifying which industry publically traded companies belong to and it is among others used in Compustat. The GICS index was developed by Morgan Stanley Capital International and Standard & Poors. The GICS index was used in Rehnberg’s thesis to classify industries as well, which makes it easier to compare the results of this study to hers. The nine industry sectors that will be studied are listed and described in Table 4.3.2 below.
Table 4.3.2 Industry Definitions and Description GICS Code Industry Name Description
10
15
20
25
30
35
45
50
55
Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Information Technology
Telecommunication Services
Utilities
Oil, gas, coal and consumable fuels.
Chemicals, construction materials e.g. sand, wood, paper, metals.
Aviation, defense, construction, machines, trucks, ships, related services.
Consumer services and cars, kitchen appliances, furniture, clothes, media,
Consumer beauty supplies, food, beverages, other everyday commodities.
Health care equipment and services, biotechnology, pharmaceuticals.
Computers, software, hardware and related services.
Telephone network operators and network operators.
Electricity, gas, water utilities and other power producers.
*Please observe that the Financials Sector (GICS 40) is excluded, therefore only 9 out of the 10 GICS sectors are studied in this paper.
