New accounting rule could significantly change IP valuations

A new statement issued by the Financial Accounting Standards Board (FASB) could significantly impact how assets, including intangible assets, are valued, and will require companies to significantly overhaul their current valuation procedures.
The policy – known as Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) – goes into effect for fiscal years starting after Nov. 15.
SFAS 157 provides a single definition of fair value and proscribes a consistent framework for establishing the fair value of acquired assets.
Despite the coming changes, a recent Deloitte survey shows that only 6 percent of companies have assessed how SFAS 157 will impact the valuation of their assets and liabilities. (See Deloitte Financial Advisory Services Online Poll Shows Few Companies Ready for New Rules in Fair Value Measurement (May 16, 2007), available at http://www.iasplus.com/usa/0705fairvaluepoll.pdf.)
Under current practice, companies have wide latitude in assigning value to individual IP assets based on their value to the acquirer. In contrast, SFAS 157 moves away from the traditional historical-cost model toward a unified definition of “fair value.”
Specifically, SFAS 157 defines fair value as “the 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.” (SFAS 157, par. 5)
The statement also establishes a framework for measuring fair value, and expands required disclosures as to what inputs were used by the company to determine fair value.
SFAS 157 focuses on the “highest and best use” of an asset as the basis for establishing fair value and, in combination with SFAS 141, requires acquiring companies to assign value to all acquired IP and other intangible assets based on what the acquiring company could expect to receive for them from prospective purchasers in the marketplace. The acquiring company will then have to amortize those assets over their useful lifetime, such as the period of enforceability of the patent.
This shift to basing value on the “highest and best use” of assets, particularly non-financial assets like intangibles, “could have a significant effect on the fair value measurement.” (See, e.g., SFAS 157, Appendix A, par. A6.) This is because there is often a broad range of potential uses for intangible assets depending on how a company plans to use the asset.
Before SFAS 157, a company could simply value the asset based on its worth in the specific context of that company. Now, an asset’s value is not entity-specific, but instead is based on “the price that maximizes the amount that would be received for the asset” in “the most advantageous market” for that asset. (SFAS 157, par. 8.)
Thus, under the new rules, even if a company has an asset not being actively used in the reporting entity’s business, but is instead being retained for defensive purposes, the company still must assign a value to it – and test annually for impairment – based on its highest and best use in light of what market participants would do with the patent.
Appendix A to SFAS 157 highlights some of the unique difficulties the new statement creates when applied to intangible assets like intellectual property.
Paragraph A12 describes a situation in which a company acquires an in-process R&D project (IPR&D) in a business combination that the reporting entity does not intend to complete. Instead, the company intends to hold (lock up) the IPR&D project to prevent its competitors from obtaining access to the technology.
The “highest and best use” by “market participants” of an asset under SFAS 157 may be “in-use” if the asset’s maximum value comes from use in combination with other assets, or “in-exchange” if maximum value comes from the asset on a stand-alone basis. (SFAS 157, par. 13.)
Possible scenarios
Paragraph A12 applies the new statement to this hypothetical piece of IP and suggests three possible scenarios for how the highest and best use of the IPR&D might be calculated.
In the first scenario, it’s assumed that market participants do not have similar technology, and would want to purchase the IPR&D, complete the development, and commercialize the resulting product. The highest and best use of the IPR&D project in that case would be “in-use” by market participants to maximize the value of the group of assets in which the IPR&D project would be used. Fair value would then be based on what such an entity would pay for the asset.
In the second scenario, it’s assumed that market participants have technology in a more advanced stage of development that would compete with the IPR&D project (if completed), and the IPR&D project would be expected to provide defensive value (if locked up). The highest and best use of the IPR&D project also would be “in-use” if, for these competitive reasons, market participants would lock up the IPR&D project and that locking-up would maximize the value of the group of assets in which the IPR&D project would be used. The fair value of the IPR&D project in the second scenario would be the price received in a current transaction to sell the IPR&D project to be locked up with its complementary assets as a group.
In the third scenario, the assumption is that the IPR&D project is not expected to provide a market rate of return (if completed) and would not otherwise provide defensive value (if locked up). The highest and best use of the IPR&D project would be “in-exchange” if market participants would discontinue the development of the IPR&D project. The fair value of the IPR&D project, measured using an in-exchange valuation premise, would be determined based on the price that would be received in a current transaction to sell the IPR&D project as a stand-alone (which might be zero).
In other words, depending on what a company believes its competitors might do with an intangible asset like an R&D project or a trade name, the asset’s value might range from very high to absolutely nothing. This is the case even the day after the company acquires the asset in a larger transaction, since SFAS 157 makes clear that the price paid for the asset (the “entry price”) is not the same as the “exit price” the asset might sell for on the market. The statement indicates that “conceptually, entry prices and exit prices are different. Entities do not necessarily sell assets at the prices paid to acquire them.” (SFAS 157, par. 16.)

Noteworthy ramifications
The ramifications of the new definition of fair value for intellectual property and other intangible assets are noteworthy for several reasons. SFAS 157 requires a company to understand not only what its own intentions are for the IP, but how its competitors would use the IP. If the asset would be more valuable to a competitor, SFAS 157 suggests that it must be booked at that higher fair value. Conversely, if it is determined that the market participants might shelve the IP (such as discontinuing the project as posited by paragraph A12), then its fair value may in fact be zero. This would require writing off any pre-acquisition book value attributed to that asset. Companies will need to identify both the observable and unobservable inputs used to establish the fair value. Observable inputs include market prices or data for identical or similar assets. Unobservable inputs include the company’s own assumptions about how the market would establish prices. Because the valuation of intangible assets is not solely based on observable market values, it is imperative that companies take the time to design a comprehensive methodology for gathering and analyzing the unobservable and more subjective inputs.
Before a company will be in any condition to ascertain what its competitors might do with its intangible assets, the company must ascertain exactly what those assets are, what the company believes is the best allocation of those resources, and what the value of those assets are in that context.
Such an assessment will not happen without the kind of systematic approach to understanding and valuing intellectual property and other intangible assets that comes from establishing an IP valuation committee, including both accountants and IP counsel, and conducting a thorough IP audit and routine impairment analyses.
In light of the major implications that SFAS 157 may have with respect to accounting for intangible assets, companies should prepare themselves now for these new standards by taking a long, hard look at their IP, as well as the overall market in which the company competes.
Unless such steps are taken now, the company may face major problems down the line that could arise from a perceived failure to properly book and report such assets – failures that could lead, for example, to significant liability under Sarbanes-Oxley.
Joshua M. Dalton is a partner in the intellectual property litigation and patent prosecution group at Bingham McCutchen LLP, resident in the firm’s Boston office. He may be reached at [email protected]. Lawrence T. Stanley Jr. is an associate in the intellectual property litigation and patent prosecution group at Bingham McCutchen LLP, resident in the firm’s Boston office. He may be reached at [email protected].