An important event in accounting for an acquisition in a Business Combination has become the recognition and measurement of intangible assets, other than goodwill.
In the past the difference between the consideration transferred (transaction, purchase or acquisition price) and the fair value of net assets acquired was simply goodwill in many countries.
With increasing transaction prices for acquiring – not so increased – values of net assets, goodwill as a percentage of the transaction price went sky high. Especially during the internet bubble in the late nineteen-nineties goodwill allocations went through the roof.
In the US long time accounting standards in respect of intangible assets (other than goodwill) exist from the early 1970-ies (see History of intangible assets) to recognise many intangible assets in Business Combinations, IFRSs followed largely in the 1990-ies.
It is a bit of a chicken and egg dilemma, where transaction prices rising and IFRS followed with increased possibilities to recognise intangible assets acquired in a Business Combination or did IFRS allow an increased recognition of intangible assets and transaction prices increased, always good to remember but that is history.
An important input in calculating the fair value on acquisition of intangible assets in a Business Combination is the discount rate.
First a short introduction of the relation between risk (captured in the discount rate in fair value calculations) and the tangible nature of the intangible assets.
There is a relation between the ‘tangibility’ of intangible assets and the risks (and as a result discount rate) associated to these intangible assets in fair value calculations. The more tangible, concrete, vested in legal concepts or operational unavoidable necessity an intangible item is, the lower the risk (and discount rate) should be:
So basically the discount rate is build up from a risk-free discount rate/risk-free interest rate to the discount rate to be used for this specific slice of intangible assets (taking into account differences in taxation of interest on debt/equity).
Here you have a methodology to build up the expected rate of return of a company,
The discount rate to be used for intangible assets fair value calculations needs an adjustment to convert the rate of return of a company to the specific slice of intangible assets (and related cash flows), as follows:
Rit = Re + or -/- Rint
Rit = Expected return of the specific intangible asset
Re = Expected rate of return of the acquiring company
Rint = Expected rate of return adjustment to the specific slice/tangible nature of the intangible asset.
The expected rate of return of the acquiring company (Re) can also very well be represented by the WACC, as a specifically determined rate to the company.
The WACC represents the average expected return from the business (that is, all assets and liabilities used collectively in generating cash flows of the entire business) for a market participant investor, and includes an element to compensate for the average risk associated with potential realisation of these cash flows. The internal rate of return (IRR) represents the implied return from the transaction that may include acquirer-specific elements.
The WACC applicable for the acquiree should be the starting point for developing the appropriate discount rate for the specific intangible asset. The WACC and the IIR should be equal when the projected financial information (PFI) is market participant expected cash flows and the consideration transferred equals the fair value of the acquiree. However, circumstances arise in practice when the WACC and the IRR are not equal, creating the need for further analysis to determine the appropriate starting point for an intangible asset discount rate.
If a difference exists between the IRR and the WACC and it is driven by the cash flows (that is, optimistic or conservative bias rather than expected cash flows, while consideration transferred is the fair value of the acquiree); best practice would be to use expected cash flows. If this is not possible, it may be necessary to consider the IRR as a starting point when considering adjustments to discount rates for intangible assets. However, in this situation it is important to assess whether cash flows allocated to the individual intangible assets have been adjusted to eliminate the optimistic or conservative bias reflected in the overall business cash flows.
If the IRR in a technology acquisition is higher than the WACC because the business cash flows include optimistic assumptions about revenue growth from selling products to future customers, adjustments must be made to the discount rate used to value the technology in the products that would be sold to both existing and future customers. However, if the revenue growth rate for the existing customer relationships does not reflect a similar level of growth or risk, then the discount rate for existing customer relationships should generally be based on the WACC without such adjustments.
If the difference between the IRR and the WACC is driven by the consideration transferred (that is, the transaction is a bargain purchase or includes entity specific synergies), then the WACC may be more applicable to use as the basis of the intangible assets’ required returns. The relationship between the WACC and the IRR in certain circumstances impacts the selection of discounts rates and is illustrated in the example below.
Example, which discount rate to use Discount rates for intangible assets
The projected financial information (PFI) represent market participant cash flows and consideration represents fair value. Discount rates for intangible assets
WACC = IRR
Alternatively: Discount rates for intangible assets
The PFI is optimistic, therefore, WACC ≠ IRR
Consideration is a bargain purchase
PFI includes synergies not paid for
Consideration is not fair value, because it includes entity specific synergies
Adjust cash flows so WACC and IRR are the same
The WACC is generally the starting point for determining the discount applicable to an individual intangible asset. However, as discussed above, in certain circumstances the WACC may need to be adjusted if the cash flows do not represent market participant assumptions, for example because the information needed to adjust cash flows is not available. Premiums and discounts are applied to the entity’s WACC and IRR to reflect the relative risk associated with the particular tangible and intangible asset categories that comprise the group of assets expected to generate the projected cash flows. Discount rates for intangible assets
The range of discount rates assigned to the various tangible and intangible assets should reconcile, in a fair-value-weighted basis, to the entity’s overall WACC. For example, working capital and fixed assets are generally assigned a lower required rate of return relative to a company’s overall discount rate, whereas intangible assets and goodwill are assigned a higher discount rate. This is because achieving the lower levels of cash flow necessary to provide a ‘fair’ return on investment (ROI) on tangible assets is more certain than achieving the higher levels of cash flows necessary to provide a ‘fair’ ROI on intangible assets. Discount rates for intangible assets
Application of the concept is subjective and requires significant judgment. It is and remains a many inputs estimation process. See also ‘Estimating fair value‘.
Weighted average return analysis Discount rates for intangible assets
The WACC is a tool to assess the reasonableness of the selected discount rates by reconciling the discount rates assigned to the various tangible and intangible assets on a fair-value-weighted basis to the entity’s overall WACC. Discount rates for intangible assets
This is calculated by aggregating each asset’s rate of return multiplied by the percentage of each asset’s value relative to the total acquired asset value.
The value of the WARA typically needs to be close to the WACC and IRR values in order for the analysis to be deemed reasonable.