[IMGCAP(1)]Auditors face numerous challenges when it comes to helping clients understand financial reporting issues related to accounting for intangible assets acquired in a business combination.

Some challenges are a function of management’s attempts to prepare the purchase price allocation with insufficient expertise, according to Rachel Flaskey, vice president at Chartwell, a national financial advisory and valuation services firm.

Other challenges are tied to a misunderstanding of recent guidance that allows private companies to forego recognizing and measuring certain customer-related intangible assets (those incapable of being sold or licensed independently from other assets of the business) and those intangible assets attributable to non-compete agreements, and instead include those amounts as part of goodwill.

Some clients assume the recent guidance will automatically result in less costly purchase price allocation engagements. That may not be the case, Flaskey says.

“Some people were initially reading the guidance and saying, ‘Everything can just go to goodwill,’” she said. Certain intangibles can, but everything else needs to be considered, Flaskey noted. “Most companies operate under a trade name or have Internet domain names or have something of value that allows them to continue to function or develop market share or recognition. That type of asset still has to be valued and broken out separately in order to be properly reporting everything on your financial statement.”

In other words, companies must “walk through” a list of various types of intangible assets and determine whether each must be recognized in their particular case.

Indeed, this is one of the common errors in calculations prepared by management: The assumption that no intangibles need to be valued, and the entire “excess” purchase price above the fair value of tangible assets can be allocated directly to goodwill.

A second common error that can crop up in business-combination calculations prepared by clients’ management is the assumption that the fair value of inventory and fixed assets should be equal to the book value. Companies that fail to prepare a separate analysis or hire an equipment appraiser may record too much or too little in the way of intangible assets and goodwill. This can make a difference in taxable income (due to difference in allowed depreciation or amortization) or, for financial reporting purposes, result in a misstatement of the opening balance sheet after the combination.

“Say you paid $1 million for the business and you strictly use the book value of the receivables, inventory and fixed assets—buildings or equipment,” Flaskey said.

If the book value of those items was $500,000, it would appear you have $500,000 to allocate to goodwill and intangibles on the buyer’s balance sheet. “If you had an appraisal done on your equipment or inventory, it could be that the value was really $750,000, which reduced intangibles and goodwill to $250,000, so it can make a difference on the amount of intangibles and goodwill,” said Flaskey.

A third common error Flaskey finds when reviewing calculations prepared by client management occurs when preparers don’t understand the vast array of intangible assets that need to be considered. Intangible assets fall into five different buckets: marketing, customer, artistic, contract and technology. These can include Internet domain names, contracted order backlog, pictures and photographs, franchise agreements, patents, developed software or databases, and other trade secrets (business know-how).

Flaskey said the new guidance does provide real cost savings to clients in some cases. The savings are tied to testing for goodwill impairment of the identified intangible assets and goodwill. The guidance provides a simplified, trigger-based model of assessing impairment at either the entity-wide level or the reporting-unit level as opposed to a required, annual impairment test at the reporting-unit level. The guidance also provides a one-step approach for measuring goodwill impairment instead of the traditional two-step approach.

Mary Ellen Biery is a research specialist at the financial information company Sageworks, which is hosting a webinar on May 18, “The Four C’s: How Intangible Assets Significantly Drive or Kill Business Value.”

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