Mergers and Acquisitions fever is back again. The value of deals in 1998 has broken all box office records. The last time we saw this degree of activity was in the late 1980s when the vogue for financing transactions with high-yield ‘junk’ bonds led to a wave of hostile takeovers.
In those days, cash was king. In the 1990s, M&A activity has been characterised by corporate marriages where the parties seem only too happy to commit.
The difference this time is that where cash was once king, today equity rules.
In the late 1980s, we saw, for the first time, a recognition of the value of intangible assets in a business. Ranks Hovis McDougall (RHM) successfully defended a hostile bid from Goodman Fielder Wattie by demonstrating that the offer had significantly undervalued RHM’s brands.
The level of goodwill in deals at that time was testimony to the fact that the substance of transactions was to acquire the brands rather than the plant and equipment of target companies.
When Nestle bought Rowntree, the goodwill as a percentage of the price paid was 83% and, when Grand Metropolitan purchased Pillsbury, the figure was 86%. However, accounting for these acquisitions created balance sheets whose net assets were often diminished to the point where there were net liabilities.
After ten years of hard debating, the Accounting Standards Board last year issued the long-awaited results of its discussions and deliberations. FRS 10 ‘Accounting for Goodwill and Intangible Assets’ and 11 ‘Impairment of Fixed Assets and Goodwill’ came into effect for years ending on or after 23 December 1998. The ASB has recognised that it can no longer ignore the issue by subsuming brands and other intangibles within the all-consuming goodwill number.
Companies can now capitalise separately identifiable components of goodwill including brands. Furthermore, the ASB has done away with the inconsistency of having optional accounting treatments. Previously, companies were allowed to either write off goodwill straight to reserves or to capitalise and amortise. FRS 10 prescribes the latter treatment.
There is a rebuttable presumption that the life of the goodwill or the brand is no more than 20 years, and that the period over which the values are amortised should reflect this.
If however, it can be demonstrated that the economic life of the asset is not finite, then there is no requirement to amortise. Instead, an annual impairment review would need to be conducted and the amount of any permanent impairment written off through the p&l.
FRS 11 describes the means by which impairment tests should be conducted.
While the ASB should be applauded for concluding that historic cost or relief from royalty methods are inappropriate, the standards do not address the real issues surrounding brands on balance sheets.
The wave of M&A activity has highlighted some of these issues, which can be categorised separately into accounting and commercial issues.
Problems of comparability still exist across companies and territories.
Differences of commercial substance and accounting form arise over merger and acquisition accounting, and real value of invested capital is not properly recognised. On comparability, while there is consistency in prohibiting the capitalisation of internally generated brands between UK GAAP, US GAAP and International Accounting Standards, the respective accounting bodies of Australia, New Zealand and France have not made the distinction between acquired and internally generated brands. However, the definition of useful economic life varies widely.
The UK, France, Australia and New Zealand allow a brand to have an indefinite life, the IAS allows the flexibility to exceed 20 years but excludes terms which are infinite, while the US limits the useful economic life to a maximum of 40 years. One of the arguments against applying an indefinite life for goodwill or a brand is that the effect of maintenance and continued support of such assets is to replace the original purchased goodwill or brand value with internally generated value which is specifically prohibited from recognition in the UK. The argument being that the benefits of purchased goodwill or brand value at the time of acquisition are always consumed over a relatively short period; the continuing or enhanced premium over net asset value is eventually transformed into internally generated goodwill.
Michael Perry, the former chairman of Unilever, is quoted as saying: ‘Buildings age and become dilapidated. Machines wear out. People die. But what live on are the brands.’
A recent study by Interbrand proved the point. The study revealed that nearly 60% of the world’s top brands are pre-war and that more than a quarter were launched in the 19th century. It is clear that brands can have extremely long lives and can be sufficiently robust to survive the test of time.
The rules governing whether companies can acquisition account or merger account are set out in FRS 6. Merger accounting has often been cited as the more popular, as it avoids fair-value adjustments, the issue of goodwill and usually results in lower amortisation charges. Many finance directors will not engage in deals which are earnings dilutive as a result of amortisation charges and may therefore try to meet the FRS 6 requirements for merger accounting.
However, it is rarely the case that, when two companies combine, there is a meeting of equals.
This is especially the case where one is deemed to have either a stronger portfolio of brands or a stronger corporate brand.
It appears that, despite the aggregated efforts of consulting firms to push economic value added and free cash flow metrics, the City is reluctant to give up benchmarks such as earnings per share.
The problem is exacerbated by the fact that many analysts calculate eps in their own in-house ways despite the fact that the IIMR (Institute for Investment Management and Research) has issued a recommendation on adding back amortisation in calculating eps, return on equity and capital employed figures.
For brands there are two issues. First, with merger accounting, there are no fair value adjustments and hence goodwill does not arise and therefore no possibility of capitalising the value of brands. Despite the best efforts of FRS 6, some acquisitions are disguised as mergers, not in a previous fashion such as vendor placing, but more subtly through the control of brands.
For example, the merger between the Halifax (now a bank) and the Leeds Building Society quickly saw the removal of the Leeds brand in favour of the stronger Halifax name.
Second, with acquisition accounting, the target’s assets are restated at their fair values; although this does not apply to any purchased goodwill carried on the target’s balance sheet. The existing goodwill on the target’s balance sheet must be written off in the fair value calculation only to be absorbed into the new amount of goodwill on acquisition. The new amount of goodwill can be separated out into its constituent components one of which could be the brand.
As a result, there is potential to reflect the increased value of the brand as a measure of the target’s good stewardship. Yet, once the acquisition has been made, there is the anomalous situation that the acquiring company cannot reflect its own good management of the brand since post-acquisition upward revaluation is prohibited by FRS 10.
Under hostile takeovers, the fair value of assets must be recognised and goodwill (and possibly brands) capitalised. As such, the real value of the invested capital in the target company is reflected. Merger accounting on the other hand, requires the merged entity to bring book values into the consolidated balance sheet. There is no opportunity to reflect on the balance sheet the real reason why many companies merge, which is to gain the benefits of enhanced brand portfolios or to leverage the corporate brands to produce market or revenue synergies. For example, the Lloyds TSB merger was really about the strength of the brands in their respective heartlands.
Lloyds has a strong presence in the South while TSB is a much stronger brand in the North of England and Scotland. But the reality of what is adding value in these deals, the strength of the brands, remains conspicuously absent.
The ASB’s accounting guidelines still propagate the nonsense that home-grown brands do not have a value while acquired brands do.
It is this law which allowed Grand Metropolitan to put Haagen-Dazs on the balance sheet because it was acquired as part of the brand portfolio of the Pillsbury acquisition, yet could not capitalise Baileys which has grown organically.
Merger accounting leaves Diageo, the newly-formed holding company of the Guinness/Grand Metropolitan merger, in much the same position.
While the deal was brand driven, the financial statements failed to demonstrate this business ethic. The absurdity of the law is made quite apparent when considering that, as a condition of the merger approval, Diageo was compelled to sell two of its spirits brands, Dewar’s (whisky) and Bombay Sapphire (gin). The cash realised on the sale was over #1bn, now sitting on the balance sheet as part of the capital employed.
The ASB’s failure to deal with the issue of home-grown brands and the capitalisation of brands under merger accounting perpetuates the problem of comparative rates of return across companies and industries.
Accounting rates of return have always been used by the City and investment analysts as a means to measure and compare company performance.
The single most important measure has been the eps figure. The arguments about the suitability and manipulation of this figure are well documented. Notwithstanding that, share valuation techniques often use the growth in eps as the premise for stock valuations. The higher the eps growth rate, the higher the price/earnings ratio.
The higher the price/earnings ratio the higher the value of the stock (since a higher multiple of earnings is applied). However, growth is measured from a base which is calculated through rates of return such as return on capital or return on equity.
Clearly, if the capital base does not reflect the genuine value of the assets employed in the business, then these rates of return will be overstated.
Even when considering the speed with which new metrics such as economic value added have gained acceptance similar problems arise. EVA is not the holy grail as it depends to a large degree on the charge for capital.
If the charge is made against invested capital which excludes the value of home-grown brands, then, once again, there will be an overstatement of the EVA.
This is a worrying phenomenon. Pressure to perform on EVA yardsticks means that a positive EVA can be achieved at the expense of the brand value added.
Since the increase in brand value contributes to the increase in shareholder value, reducing the investment in the brand for short-term, EVA success will ultimately destroy shareholder value.
Shareholders forewarned is forearmed – positive EVA headlines could be masking the under-investment in the real drivers of growth in the business, the brands.
The publication of FRS 10 and 11 now gives users of financial statements more information about brands which are often companies’ most important assets.
The users of financial statements increasingly include all stakeholders from investors to employees and customers.
However, these users can only determine which acquired brands have been poorly managed (through the impairment review process) but not those that have been well managed.
The rationale for the purchase of any brand is value creation, not just value maintenance. The Green Giant acquisition by Grand Metropolitan (now part of Diageo) has not performed well, yet its performance cannot be distinguished from Haagen-Dazs, which has exceeded all expectations.
In addition, no judgement can be made about home-grown brands.
Both Smirnoff, the leading vodka brand, and Baileys liqueur may have done well, but only Smirnoff is capitalised and hence no comparison can be made.
The UK has always been the pre-eminent standard setter. Where the UK leads, others are sure to follow. As investment grows in the developing world, there will be a greater focus on financial statements as a means to measure not just performance but, more importantly, accountability.
The financial statements should provide a degree of comfort about the assets and operations of a company. Increasingly, there is a demand for the financial statements to include more information which is relevant and useful to the user.
The ASB has the opportunity to lead the world in reporting for value.
In today’s world, much of that value is in the intangible assets and, in particular, in the brands of a business. Unfortunately, in its attempt to resolve the brand accounting debate, the ASB has failed to secure accountability for brand stewardship.
EXAMPLE OF PERFORMANCE METRICS WITH REAL INVESTED CAPITAL CAPITALISATION OF INTERNALLY #m NON-RECOGNITION OF INTERNALLY #m GENERATED BRANDS GENERATED BRANDS Net operating profit after tax 300 Net operating profit after tax 300 Invested capital 1000 Invested capital 1000 Internally generated brands 1000 Capital employed 2000 Capital employed 1000 Net operating profit after tax 300 Net operating profit after tax 300 Capital charge @ 10% cost of (200) Capital charge @ 10% cost of (100) capital (2000x10%) capital (1000x10%) EVA 100 EVA 200 Return on capital employed 15% Return on capital employed 30% (300/2000) (300/1000)
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