Speech by SEC Staff:
2003 Thirty-First AICPA National Conference on Current SEC Developments
Chad A. Kokenge
Professional Accounting Fellow, Office of the Chief Accountant
U.S. Securities and Exchange Commission
December 11, 2003
As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
I would like to share with you some views on a number of technical issues including those on: (1) contingent consideration arrangements that may be compensatory, (2) issues related to customer related intangible assets, and more broadly, (3) amortization methods for finite-lived intangible assets.
Contingent consideration arrangements that may be compensatory
When an entity acquires a business, the purchase price is allocated to the assets acquired and the liabilities assumed based on their estimated fair values at the date of acquisition. However, the fact that a business is acquired doesn't obviate the need to evaluate whether portions of the arrangement need to be accounted for separately.
I'll discuss an example that highlights this issue: contingent consideration that may be compensatory.
Determining whether contingent consideration in a business combination is additional purchase price or a period expense is judgmental. Generally, from a conceptual standpoint, contingency arrangements should be treated as additional purchase price when they serve to resolve differences in view between the buyer and the seller about the value of the business. However, when a selling shareholder becomes a continuing employee of the post-combination enterprise, it is often difficult to determine whether the contingency is truly a resolution of a business value disagreement, or simply compensation for post-acquisition services. EITF Issue 95-81 is helpful in this assessment as it provides guidance on factors to consider.
Issue 95-8 indicates that a contingent consideration arrangement in which the payments are subject to forfeiture if employment terminates is a strong indicator that the arrangement is compensation for post-combination services. Accordingly, when this indicator is present, we believe over-coming the compensation conclusion is very difficult.
With that said, this is not a bright line test, and we have, in rare situations, agreed with registrants who have suggested that a contingency arrangement that is tied to employment should, nonetheless, be treated as purchase price. I thought it would be useful to explain our thinking about some of the more pertinent considerations:
- If there are other selling shareholders who are subject to the exact same contingency formula on a per share basis but who do not continue or become employees, it would appear that the contingency is not solely based on employment. We would, however, want to understand why the continuing employees are asked to be subject to an employment contingency, in addition to the formula based on post-acquisition results;
- If the employees receive a level of compensation, including the contingent payments, that is significantly in excess of the amount that could conceivably be expected to be earned via employment, this would be an indicator that supports purchase price. However, the usefulness of this factor is often limited by the fact that many times the continuing employees perform services that are not comparable to the other employees of the merged entity, and the fact that executive management compensation often exceeds the compensation of other employees by a significant amount;
- If the contingent consideration formula is consistent with how the business valuation was established then this would also point toward purchase price. For example, by setting the fixed portion of the purchase price at the low end of a valuation range, with the contingency moving the price towards the high-end of the valuation range, based upon appropriate post-acquisition measures, the formula would at least be consistent with the business valuation. However, in these cases, we would, again, want to understand why an employment contingency was also added; and
- Lastly, understanding the basis of why the contingent consideration is included in the arrangement in the first place is important to the assessment. For example, if the contingency is only employment related, it is not clear to us how a case can really be made for purchase price.
We believe such evaluations are very fact specific. Accordingly, I recommend you carefully consider the factors relative to your particular arrangement.
Issues related to customer related intangible assets
Since the FASB issued Statements 1412 and 1423, many issues have arisen with respect to intangible assets, and in particular, customer related intangible assets. The EITF addressed certain customer related intangible issues in Issue 02-174; however, other questions still remain. Given that, I'd like to discuss some issues regarding customer related intangibles assets and how we have thought about them. Specifically these issues relate to 1) recognition, 2) life, and 3) valuation.
In Issue 02-17 the EITF addressed certain recognition matters; specifically reaching the conclusion that the guidance in paragraph A20 of Statement 141 regarding contractual rights applies if an entity has a practice of establishing contracts with its customers, regardless of whether a contract is in existence at the date of acquisition. Conceptually, this indicates that customer related intangible assets exist in a wide variety of situations, even if such assets are not considered separable from the acquired entity or if no contracts exist at the date of acquisition. Accordingly, one should not have a narrow focus when analyzing what is acquired. For example, consider the acquisition of income producing real estate. Does a customer related intangible exist or is the consideration paid solely related to fixed assets and perhaps the underlying leases?
We believe that there may very well be a customer related intangible that requires recognition as there is a contractual relationship established between the entity and the tenants. The customer related intangible may be related to the synergistic effect of having the customer (for example, the entity has the ability to lease the customer additional space), referral capability, or perhaps the probability of the tenants signing new leases when their current leases expire. The evaluation of such transactions is fact specific; however, when customers are present, consideration should be given to the recognition of related intangible assets.
Paragraph 11 of Statement 142 addresses how to determine the useful life of an intangible asset. In general, we believe an indefinite life conclusion for a customer related intangible asset would be extremely rare. Among the factors that cause me to say this are the following:
- The asset being inherently related to relationships with "people", where people in organizations are subject to turnover;
- More broadly, the customer churn rate. Generally, an established customer turnover rate and likewise, a forecasted customer turnover rate, would directly affect the life estimate;
- The relative cost or penalty to the customer for terminating the relationship. Generally, a customer is not "controlled" by an entity such that the customer can't transfer its business elsewhere without undue cost or penalty; and
- Economic effects such as competition and demand. Economic effects will vary depending on each situation; however, higher demand elasticity and switching availability would typically correspond to a shorter life estimate.
Lastly, I wanted to discuss one aspect of "fair value" as it relates to a customer related intangible asset. Irrespective of the valuation method employed in assessing fair value, the assessment must take into account the view of a marketplace participant. Therefore, entity specific assumptions may not be appropriate as they may not represent how a marketplace participant would assess the value.
For example, consider the previous income producing real estate illustration and assume the entity uses a cost approach to value a customer related intangible asset by calculating the cost of an employee's time necessary for the entity to "sign-up" the tenant. In this simple example, the approach only focuses on the entity's specific costs that are necessary to "establish" the relationship. Such an approach would not be sensitive to the volume of business that might be generated by the customer, other relationship aspects, such as referral capability, or other factors that may be important to how a marketplace participant might assess the asset. If these factors are significant, we believe the use of such an approach would generally be inconsistent with the Statement 142 definition of fair value.
Amortization methods for finite-lived intangible assets
The last topical area I will discuss is broadly applicable to all finite-lived intangible assets. Having recognized an intangible asset, if it has a finite life, it must be amortized over the expected life.
Paragraph 12 of Statement 142 states, in part, that "the method of amortization shall reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. If that pattern cannot be reliably determined, a straight-line amortization method shall be used."
Some have begun to focus on the degree to which that paragraph has or should change existing practice. In fact, the EITF has formed a working group for Issue 03-95 to in part address this issue. I'd like to present some of the SEC staff thinking, specifically in regard to 1) the pattern of consumption, 2) phased-in amortization, and 3) reliability of the pattern.
The FASB noted in the basis for conclusions of Statement 142 that a method other than straight-line may be appropriate, "such as in the case of a license that entitles the holder to produce a finite quantity of product." Accordingly, we have often focused our attention on production, or output, when evaluating patterns of consumption. As production of a finite quantity may be suggestive of an other than straight-line method, on the flip side of the coin, if an intangible asset is available for unconstrained output over a finite life, it begs the question as to why the asset's wasting pattern is not consistent with this availability. Said another way, why is the pattern of consumption not reflective of time? This is not to suggest that this thinking is the only way to consider the pattern of consumption; however, it is one way that we believe could have merit given the appropriate facts and circumstances.
When should amortization begin? In certain cases, an intangible asset may be in service, yet, the ability to realize the full value of that asset may be related to certain tangible assets that are to be constructed over time. Some have suggested that it might be appropriate to analogize to Statement 516 and to phase-in an intangible asset's amortization expense as a related tangible asset is constructed and capacity is increased. However, we have focused on the concept as illustrated in EITF Topic D-217 with regard to physical tangible assets.
Topic D-21 sets forth an example where two electric generating plants on a common site share certain facilities, such as coal handling equipment. One plant (Unit 1) is completed at the beginning of the year and the other plant (Unit 2) is completed at the end of the year. The coal handling equipment is completed at the beginning of the year and is used by Unit 1 during the year. Topic D-21 indicates that "depreciation for the common facilities should begin [at the beginning of the year]." In other words, even though the common facilities are not being utilized at full capacity, the company is nonetheless deriving the benefits available from the facilities as a result of having an asset placed into service.
Lastly, I also want to emphasize that Statement 142 states that to follow a method of consumption other than straight-line, that method must be reliably determinable. Accordingly, the pattern should be based on supportable assumptions. We recognize that this determination is naturally subject to judgment.
In general, we believe the analysis of a pattern of consumption for a finite-lived intangible asset is not significantly different from that of a physical, tangible asset. With that said, we look forward to the EITF's continued deliberations and realize that the EITF will most likely discuss other viewpoints and variations on today's discussion. We are hopeful that the guidance put forward will provide clarity to the issue once a consensus, if any, is reached by the EITF.
Although a lot has changed in our office over the past year, many things remain the same. In that regard, we would like to continue to encourage registrants to consult with the Office of the Chief Accountant on complex or unusual accounting, financial reporting, and auditing issues. We appreciate those of you who have been willing to discuss your issues or concerns with us during the past year.
If you plan on taking advantage of the pre-clearance process this year, I would like to remind you of the benefits of following the protocol procedures outlined on our web site8. We realize that following the protocol procedures suggests some up-front effort; however, taking the time to provide a comprehensive pre-clearance submission certainly goes a long way in maximizing the efficiency and effectiveness of the process. The result is usually fewer conference calls and follow-ups that can delay the process.
I would like to add an additional thought. When it is not otherwise evident, it would be helpful if registrants include in the submission a summary of the business purpose of the transaction. We plan to add this suggestion to the protocol procedures in the near future.