knav intangible assets - knav accounting firm

INTRODUCTION

2

What are intangible assets?

• ICAI Valuation Standard 302 define intangible assets as “an identifiable non-monetary asset without physical substance.”

• Lacks physical properties and represents legal rights developed or acquired by an owner;

• An entity for the purpose of recognition of an item as an intangible asset requires to demonstrate that theintangible

• Meets definition of intangible asset AND

• Meets the Recognition criteriao Probability of future economic benefitso The cost of the asset can be measured reliably.

INTRODUCTION

3

When to value intangible assets?

• Purchase price allocation• Fair valuation of intangible assets acquired in course of an acquisition• Impairment testing

Financial reporting

• Transfer of intangible asset to related party (Transfer pricing)• Estate or gift planning

Taxation support

• For the purpose of providing the asset as collateralFinancing support

• Determination of fair value for purpose of sale or purchase of such asset• Determining the licensing terms with respect to such asset

Transaction support

• Infringement• Bankruptcy/ Insolvency and Bankruptcy code• Martial and family dissolution

Dispute resolution

IDENTIFYING INTANGIBLES ACQUIRED

SeparableContractual OR

Capable of being

• separated or divided• transferred• licensed• rented• exchanged

Arises from

• contractual or other legal rights

Transferability or separability not relevant to establish if an contractual assets is an intangible asset

Intangible assets that do not qualify for the separability criterion or the contractual-legal criterion are subsumed into goodwill.

Some of the intangibles merged with goodwill are assembled workforce, buyer specific synergies, distribution channels, technical knowledge,customer base, training and recruitment programs, customer service capability, product or service support, effective advertising programs etc.

How do we identify intangible assets


5

How do we identify intangible assets

No

No

Is there a restrictionon the transfer

or sale of the asset?

Recognise separateintangible asset

at fair value

Yes

NoYes

Yes

Identify intangibleassets that may qualify

for separate recognition

Does the intangibleasset meet the

contractual-legalcriterion?

Does the intangibleasset meet the

Separability criterion?

Do not recognisea separate

intangible assetCustomer list with a confidentiality term

prohibiting information exchange


Intangible assetContractual- legal

criterion Separability criterionMarketing related:- Trademarks, trade names ✓

- Service marks, collective marks, certification marks ✓

- Trade dress (unique colour, shape, or package design) ✓

- Newspaper mastheads ✓

- Internet domain names ✓

- Noncompetition agreements ✓

Customer related:- Customer lists ✓

- Order or production backlog ✓

- Customer contracts and related customer relationships ✓

- Noncontractual customer relationships ✓

Artistic-related:- Plays, operas, ballets ✓

- Books, magazines, newspapers, other literary works ✓

- Musical works, such as compositions, song lyrics, advertising jingles ✓

- Pictures, photographs ✓

- Video and audio-visual material, including motion pictures, music videos, television programmes

✓


Intangible assetContractual- legal

criterion Separability criterionContract based:- Licensing, royalty, standstillagreements ✓

- Advertising, construction, management,service or supply contracts ✓

- Lease agreements ✓

- Construction permits ✓

- Franchise agreements ✓

- Operating and broadcast rights ✓

- Use rights, such as drilling, water,air, mineral, timber cutting, and route authorities ✓

- Servicing contracts (e.g., mortgage servicing contracts) ✓

- Employment contracts ✓

Technology based:- Patented technology ✓

- Research and development ✓

- Computer software and mask works ✓

- Unpatented technology ✓

- Databases ✓

- Trade secrets, such as secret formulas, processes, recipes ✓


No

No

Identify intangibleassets that may qualify for separate

recognition

Does the intangibleasset meet the contractual-legal

criterion?

Does the intangibleasset meet the separability

criterion?

Do not recognisea separate intangible asset

Individual employees may haveemployment agreements with theacquiree, the entire assembledworkforce does not have such acontract

An assembled workforce is notconsidered separable, because itcannot be sold or transferredwithout causing disruption to theacquiree’s business

Valuation of assembled workforce


Customer Or

TechnologyTechnology

Customers Goodwill

Tech

no

logy

CustomersExisting

New

Exis

tin

g

New

What would be your primary intangible asset?The following table helps identify where value resides for a firm with both technology and customer relationships that generate cash flow.

• Discussion with the management, • understand the business,• Look at due diligence reports, • look at public filings of similar

companies

VALUATION PRINCIPLES

Definition of fair value under Ind AS 113

“Price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between MARKET PARTICIPANTS at the measurement date”

Description Comments

Sell an asset Exit price

Orderly transaction It is not a forced or a distressed sale

Between market participants It is a market-based measurement and not entity specific


Market participant assumption

What is market participant?

• Group of a 4 – 5 comparable companies operating in the same industry or offering similar products and services

Example 1: Debt to capital ratio

Example 2– Company A is acquired and has a trade name that was used previously. Buyer intends to discontinue the name in the near future. Further analyses suggests that other strategic buyers may no to discontinue the use of trade name. In this case, the valuation of the trade name without an assumption of discontinued use would seem appropriate.

• Synergies to be excluded. Form a part of GOODWILL


Highest and best use assumption

• A market participant’s use that maximizes the value• By using the asset on a stand-alone basis• By using it with a group of assets• By using it in a business, or • By selling it to another market participant who would use it in the highest and best manner

• Use must be physically possible, legally permissible and financially feasible.• Current use is presumed to be highest and best unless evidence to the contrary.

Illustration

• Excess office space, used as exhibition centre for discontinued products• No economic benefits• Leased out to generate income• Valued assuming leased out – Highest and best use

VALUATION METHODS

Approach

Hierarchy

Cost approachIncome approachMarket approach

Methods

Price/ Valuation multiples/ Capitalization rates

Multi period excess earning method

Reproduction cost method

Relief from royalty method

With or without method

Replacement cost method

Distributor or greenfield method

Not commonly used Preferred approach

No connection to future financial benefits

Guideline pricing method

VALUATION METHODS

Factors to be considered

Sufficient data is available

Appropriateness

Number and subjectivity of adjustments to

inputs

Multiple valuation

techniques

VALUATION METHODS

INTANGIBLE ASSET COMMONLY USED METHODS COMMENTS

Customer relationships/ Customer contractsANDSoftware/ Intellectual property/ Technology

Income approach: MPEEM Most commonly identified intangible asset. Assumption affecting value: Attrition rate; Cost savings on SGA, Value of other intangible assets

Tradename/ Technology Income/ Market approach: Relief from royalty

Royalty rate, Probability of discontinuing use

Non compete agreements Income approach: With or without approach

Probability of leaving and competing

Technology/ Customer list Cost approach Time spent, obscelesence factor

Assembled workforce Cost approach Time spent

VALUATION METHODS – VALUE DRIVERS

Discount rate

Attrition rate

Expectation of cash flows for

the asset being valued


Value of other

intangible assets


- Royalty rate

- Discount rate

- Probability of continuing/Discontinuing the

use of the tradename


Revenues lost due to

competition

Probability of

employee leaving and competing


Time and cost of

development

CONSIDERATION FOR VALUING INTANGIBLE ASSETS

Defensive assets

An intangible asset acquired in a business combination that an entity does not intend to actively use. However, prevents others from using it

Unlikely to be classified as an indefinite lived intangible asset

That is likely to increase the value of other assets owned by the entity


Valuation of assembled workforce

Company A acquires Company B along with its workforce.

To arrive at the fair value of the primary intangible (which is valued using MPEEM where the charges on and of the other intangibles are reduced), we

need to value the AWF using “replacement cost method”

The contributory asset charges on AWF are reduced from the cash flows to arrive at the cash flow attributable to the customer relationship

Particulars 20XX 20XX 20XXAssembled workforce adjusted average balance XX XX XX Assembled workforce required return XX XX XX Allocation to customer relationship XX XX XX

Illustration Calculation of contributory charge on assembled workforce:


Prospective financial information

MARKET PARTICIPANT

Synergies

Deal model


Discount rate

The calculation of the appropriate discount rate to estimate an intangible asset’s fair value requires some additionalconsiderations as follows:

The discount rate should be determined considering the market-participant assumption

Both the IRR and the WACC are to be considered when selecting discount rates used to measure the fair value of tangible and intangible assets

The discount rate should reflect the risks commensurate with the intangible asset’s individual cash flows

Patents, Backlogcontracts

Trademarks, Publishing rights, Brands

Copyrightsinformation database, Software

Trade-secrets, Developed technology

Know-how, Customer relationship, IPR&D

Goodwill

Spectrum of risk:

Least MostRisk


Economic life

The useful life of an intangible asset is the period over which the asset is expected to contribute directly or indirectly to thefuture cash flows of the entity.

Factors determining useful life

• Entities' historical experience• Expected use of asset• Legal, contractual or regulatory provision limiting life• Expected useful life of related asset• Effects of obsolescence, demand, competition, and other economic factors

Useful life is an important determinant in allocation of value between identified intangibles and goodwill.


Illustration: Here the useful life of the customer - related asset is concluded to be 7 years

Particulars 1 2 3 4 5 6 7Present value of cash flows 1,496 1,283 1,098 854 587 326 234 Sum of present value of cash flows 5,644 5,878 Tax Savings of amortization 1.2 1.2

Fair value of customer relationship 6,773 7,054 PV as a % of fair value 5% 3%

Management discussions

Weighted average

contribution of PV of cash

flows

Attrition rate

Benchmarking (Lives

reported by other

companies)

Economic Life vs Accounting Life


Tax amortization benefit is the amount that represents the present value of income tax shield benefits from theamortization of the value of the intangible assets. The tax jurisdiction of the country the asset is domiciled in should drivethe tax amortization benefit calculation.

Amortization benefit is applied when using the income approach and not applied when using the market approach.

Market-based data used in the market approach is assumed to include the potential tax benefits resulting from obtaining anew tax basis.

TAB factor using adjusted WACCAdjusted WACC 17.34% PV Mid-pointTax life 8.00 Year 1 4.62 0.5Value of asset 100.00 Year 2 3.93 1.5Amortization/year 12.50 Year 3 3.35 2.5Tax rate 40% Year 4 2.86 3.5Amortization benefit/year 5 Year 5 2.44 4.5Sum of present values 22.55 Year 6 2.08 5.5Asset value pre amortization benefit 77.45 Year 7 1.77 6.5Tax amortization premium 29% Year 8 1.51 7.5TAB factor 1.29 Annuity 22.55

For example:

Tax amortization benefit

VALUATION METHODS – ILLUSTRATION

DescriptionManagement projections for the years ending December 31, Extended projections

2020 2021 2022 2023 2024 2025 2026 2027 2028Total revenue (from existing customers) 10,738 12,976 15,569 17,986 20,207 22,497 24,637 26,550 28,392Surviving revenue from existing customers 7,730 7,583 7,429 7,241 6,988 6,702 6,358 5,972 5,565Ratio of surviving revenue to total revenue 0.72 0.58 0.48 0.40 0.35 0.30 0.26 0.22 0.20Cost of services for surviving customers (3.93) (4.11) (4.00) (3.86) (3.71) (3.56) (3.37) (3.17) (2.95)Gross profit 7,726 7,579 7,425 7,237 6,984 6,699 6,355 5,968 5,562

Compensation for selling and marketing (498) (506) (508) (491) (459) (446) (424) (398) (371)Compensation for operations and shared services (3,107) (3,335) (3,092) (2,921) (2,725) (2,750) (2,608) (2,450) (2,283)Administrative (552) (426) (369) (330) (299) (356) (338) (317) (296)Shared services (826) (274) (254) (237) (222) (324) (307) (289) (269)Membership offering (410) (372) (348) (327) (307) (319) (303) (284) (265)Total operating expenses (5,394) (4,912) (4,569) (4,305) (4,013) (4,195) (3,980) (3,737) (3,483)EBITDA 2,332 2,667 2,856 2,932 2,972 2,504 2,375 2,231 2,079Less: Depreciation (128) (61) (64) (66) (60) (55) (51) (47) (44)Less: Amortization-AWF (43) (35) (28) (24) (20) (18) (15) (13) (12)Earnings before interest and taxes 2,162 2,571 2,764 2,842 2,891 2,431 2,309 2,170 2,024

Plus/(Minus): Favourable/(Unfavourable) lease terms 20 28 24 21 19 17 7 - -

Minus: Hypothetical charge for use of trade name @ 3% (232) (227) (223) (217) (210) (201) (191) (179) (167)Earnings before interest and taxes – Adjusted 1,949 2,372 2,565 2,646 2,700 2,247 2,125 1,991 1,857Less: Income taxes @ 40% (780) (949) (1,026) (1,058) (1,080) (899) (850) (796) (743)After-tax earnings 1,170 1,423 1,539 1,588 1,620 1,348 1,275 1,195 1,114Add : Depreciation 128 61 64 66 60 55 51 47 44Add : Amortization-AWF 43 35 28 24 20 18 15 13 12Cash flow 1,501 1,654 1,759 1,778 1,780 1,491 1,398 1,300 1,207

Descriptions

Management projections for the years ending December 31, Extended projections

2020 2021 2022 2023 2024 2025 2026 2027 2028

Cash flow 1,501 1,654 1,759 1,778 1,780 1,491 1,398 1,300 1,207

Contributory charges to customer relationships

Less: Fair return on working capital (4.1) (4.1) (4.0) (3.9) (3.8) (3.6) (3.4) (3.2) (3.0)

Less: Fair return on fixed assets (183) (151) (124) (106) (92) (81) (71) (64) (57)

Less: Fair return of fixed assets (128) (61) (64) (66) (60) (55) (51) (47) (44)

Less: Fair return on assembled workforce (113) (113) (111) (110) (108) (104) (99) (94) (88)

Total contributory charges (429) (329) (303) (285) (263) (243) (225) (208) (192)

Cash flow after contributory charges 1,072 1,325 1,456 1,492 1,517 1,248 1,174 1,092 1,015

Partial period adjustment 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00

Revised cash flow 359 1,281 1,456 1,492 1,517 1,248 1,174 1,092 1,015

Discounting period- mid year 0.31 1.13 2.13 3.13 4.13 5.13 6.13 7.13 8.13

Present value factor @ 14.78% 0.96 0.86 0.75 0.65 0.57 0.49 0.43 0.37 0.33

Present value of cash flows 344 1,097 1,086 970 859 616 505 409 331

Sum of present value of cash flows 6,217

Tax amortization benefit 1.20

Fair value of customer relationships 7,480



Management projections for the year ending December 31,

Extended projections

Description 2020 2021 2022 2023 2024 2025 2026 2027 2028

Total revenue 110,738 12,976 15,569 17,986 20,207 22,497 24,637 26,550 28,392

% Growth 20.8% 20.0% 15.5% 12.3% 11.3% 9.5% 7.8% 6.9%

Probability of discontinuing trade name in respective year 0% 0% 0% 0% 0% 0% 0% 0% 0%

Probability of continuing trade name in respective year 100% 100% 100% 100% 100% 100% 100% 100% 100%Probability of not having previously discontinued trade name N.A. 100% 100% 100% 100% 100% 100% 100% 100%

Cumulative probability of continuing to use the trade name 100% 100% 100% 100% 100% 100% 100% 100% 100%

Pre-tax royalty relieved, adjusted for probability @ 3% 322 389 467 540 606 675 739 797 852

Less: Income taxes @ 40% (129) (156) (187) (216) (242) (270) (296) (319) (341)

After-tax royalty relieved 193 234 280 324 364 405 443 478 511

Partial year adjustment 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00

After-tax royalty relieved, adjusted 121 234 280 324 364 405 443 478 511

Discounting period- mid year 0.31 1.13 2.13 3.13 4.13 5.13 6.13 7.13 8.13

Present value factor @ 15.78% 0.96 0.85 0.73 0.63 0.55 0.47 0.41 0.35 0.30

Present value of after-tax royalty relieved 115 198 205 205 199 191 181 168 155

Terminal value 1,227Sum of the present value of after-tax royalty relieved (including terminal value) 2,845

Tax amortization benefit 1.19

Fair value of trade name 3,393


Employee classificationHead

countsAvg.

salaryGross salary

Fringe benefits @

20.2%

Total salary

(a)

Avg. advertising

and recruitment

costs (b)

Avg. relocation costs (c)

Hiring cost (d)

(b+c)

Direct training

costs(e)

No. of months until full

productivity (f)

Lost productivi

ty (g)(a/12*f)

Training cost (h)

(e+g)

Total replaceme

nt cost (d+h)

Analyst 4 30 120 24 144 2 0 2 1 2 24 25 27

R&D 5 55 275 56 331 6 2 8 1 3 83 84 92

Admin 8 31 248 50 298 1 0 1 0 1 25 25 26

Executive 8 125 1000 202 1202 30 7 37 3 3 301 304 341

Research 32 35 1120 226 1346 5 0 5 2 2 224 226 231

Sales - Membership Director11 25 275 56 331 1 0 1 0 1 28 28 29

Marketing promotion 3 20 60 12 72 2 0 2 1 1 6 7 9

Client Relationship Managers18 36 648 131 779 1 0 1 1 2 130 131 132

Fair value of assembled workforce (Total) 886

TAX IMPLICATIONS - OVERVIEW OF THE ACT

Section 32(1) of the Income Tax Act, 1961 (‘the Act’) provides for deduction on account of depreciation on block of assetsat prescribed percentage on the written down value.

Explanation 3 thereto explains intangible assets include know how, patents or commercial rights of similar nature. TheExplanation does not specifically contain goodwill as an asset, however, due to presence of the words ‘commercial rights ofsimilar nature’, it has been a commercial practice to consider goodwill as an intangible and hence a depreciable asset.

The Hon’ble Supreme Court in the case of CIT vs. SMIFS Securities Ltd. [2012] 348 ITR 302 (SC) upheld that goodwill is also adepreciable asset since section 32 of the Act covers “any other business or commercial rights of similar nature”.

Impact on M&A transactions

Businesses taking corporate reorganization actions have relied on the Supreme Court decision and treated the excessamount paid over the fair value as goodwill and claimed depreciation thereon.

Any goodwill arising on account of corporate actions undertaken through merger or acquisition or demerger through shareswap also relied on the Supreme Court’s decision.

TAX IMPLICATIONS - UNION BUDGET PROPOSAL

The Union Budget 2021 has proposed to amend the definition of “block of assets” under section 2(11) and the “assets” asper Explanation 1 to Section 32(1) of the Act to specifically exclude goodwill of a business or profession from the scope ofdepreciable assets.

It is proposed to insert a proviso to section 50 of the Act to provide the manner of determination of the Written DownValue (‘WDV’) of the block of asset as well as the short-term capital gains where the block of asset for FY (2019-20) AY2020-21 which includes goodwill.

Section 55(2)(a) of the Act deals with cost of acquisition of goodwill wherein a proviso shall be inserted to reduce the costof acquired goodwill with the value of depreciation already claimed thereon.

The changes are proposed to be applicable from April 01, 2020 i.e. Assessment Year 2020-21.

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knav intangible assets - knav accounting firm

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