Volume Two 2004PwC dge e

Knowing Your Value*Resurging M&A in Asia

,s Financial Services –

Caveat Emptor!

To Buy or Not to Buy

Goodwill = Goodbuy or Goodbye?

Valuation of Intangibles

Benefits-in-kind Reaps Benefits in Tax

Managing EditorKyle LeeEditorJacqueline GohContributorsKaren LoonPeter LowKeoy Soo EarnLucy GweeJenny GohDesign & LayoutYvonne Yan

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This publication aims to provideclients with an updateon business trends. No liabilitycan be accepted for anyaction taken as a result of readingthe notes withoutprior consultation with regardto all relevant factors.

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Copyright© December 2004PricewaterhouseCoopers Singapore.All rights reserved.

Mergers and acquisitions (M&A) are on the rise again,according to statistics provided by Karen Loon. Few willdisagree that M&A deals make sense when they reinforcea company

,s existing competitive position or when they help

a company make a shift as the industry‘s competitive basechanges. Regardless of whether the deal is a merger or anacquisition, these transactions are fraught with risks andare potentially costly beyond the money paid. Yet decisionson M&A are often made without due consideration for thekey risks. Karen highlights the often overlooked risksassociated with a financial services industry M&Atransaction. These include regulatory, governance, riskmanagement framework and control environment.

How will FRS 103 affect acquisitions? asked Peter Low inhis article To Buy or Not to Buy. Peter identified 4 factorsfor management

,s consideration in the context of FRS 103:

1.How do the acquired intangible assets and contingentliabilities affect the post acquisition financial position?

2.What is the financial effect of any excess of the acquirer,s

interest in the net fair value of acquiree,s identifiable

assets and liabilities over cost (negative goodwill)?

3.How good a fit is the target?

Editor’s Note

4.How would restructuring costs impact post acquisitionresults?

Keoy Soo Earn explains the key concepts underpinningFRS 103 in the article Goodwill = Goodbuy or Goodbye?He also identifies examples of intangible assets to berecognised and valued separately from goodwill and thevaluation methodologies which will satisfy the rigourimposed by the standard.

Lucy Gwee takes us on a journey of discovery onintangible asset valuation. Starting with the basic – costapproach – and ending with the esoteric – probabilisticdiscounted cash flow. So, can an intangible asset bereliably measured? ...Read on.

Human capital, arguably the greatest source ofcompetitive advantage, is not recognised as a separateintangible asset but subsumed in the general goodwillacquired in an M&A deal. Jenny Goh explores the taxadvantages of Benefits-in-kind in keeping human capitalintact without increasing operating costs. Too good to betrue? Jenny argues her case in Benefits-in-kind ReapsBenefits in Tax.

Kyle LeeManaging Editor

Commentary 3 - 9

Resurging M&A in Asia’s Financial Services – Caveat Emptor!A rise in business confidence has seen an increase in the level of restructuring activityin the financial services industry over the past twelve months in a number of AsiaPacific countries, including China, Indonesia and Japan. The increasing importance ofother stakeholders, and their expectations, means that financial institutions can nolonger focus solely on obtaining acceptable shareholder returns when entering intotransactions...

Corporate Watch 10 - 14

To Buy or Not to BuyIn July 2004, the Council on Corporate Disclosure and Governance (CCDG) issuedFRS 103 Business Combinations, which is effective for annual periods beginning on orafter 1 July 2004.

FRS 103 has been the cause of much debate in the Singapore business communityand has made the accounting for business combinations a boardroom issue...

Features 15 - 26

Goodwill = Goodbuy or Goodbye?Following the recent introduction of Financial Reporting Standards (FRS) 103 BusinessCombinations coupled with the revised FRS 36 (2004) Impairment of Assets andFRS 38 (2004) Intangible Assets, companies are required to comply with theserequirements when accounting for business combinations for annual periodscommencing on or after 1st July 2004...

Valuation of IntangiblesFRS 38 defines an ‘intangible asset’ as ‘an identifiable non-monetary asset withoutphysical substance’. Intangible assets include intellectual property such as patents,trademarks, copyrights, trade secrets and industrial know-how as well as customerlists, software license, franchise agreements, trained workforce, networks, etc. Theseassets are rapidly becoming a core source of wealth creation in many sectors of theeconomy...

Tax Angle 28 - 32

Benefits-in-kind Reap Benefits in TaxTax is often one of the key considerations when companies evaluate the value of startingan operation in a new country. Yet, one of the crucial components of tax planning mayinadvertently be overlooked in the rush to expand. And this tends to form a large chunkof expenses, especially for the professional or consultative services industry...

ContentsPWC EDGE VOLUME TWO 2004

3PWC EDGE

Resurging M&A in Asia’s financialservices industry – Caveat Emptor!A rise in business confidence has seen an increase in the level of restructuringactivity in the financial services industry over the past twelve months in anumber of Asia Pacific countries, including China, Indonesia and Japan. Theincreasing importance of other stakeholders, and their expectations, means thatfinancial institutions can no longer focus solely on obtaining acceptableshareholder returns when entering into transactions. Prior to determiningwhether they should enter into a transaction, financial institutions need toensure that appropriate consideration is given to the needs and expectations ofshareholders and other stakeholders and build in appropriate commercial duediligence procedures into the deal process to take into account theseexpectations.

BY KAREN LOON Banking and Capital Markets Industry Group

PWC EDGE4

Almost four out of five financial servicesrespondents to an online survey conducted inSeptember and October 2003 byPricewaterhouseCoopers and the EconomicIntelligence Unit (EIU) expect their firms to berestructured significantly within the next fiveyears. 92% believed that restructuring will be‘important, very important or integral’ to helpcomplete their strategies. 64% and 53% ofsurvey respondents cited regulatory capital andreporting requirements as the most likely issuesto impact on their firms’ strategy for restructuring.

Much of this activity, which will be designed tosharpen focus, improve efficiency and takeincremental steps forward, is being drivenprincipally by external drivers including increasingcompetition and customer demands, as well asregulator restrictions (refer to Figure 2).

A new wave of restructuring in financialservices

2004 has seen an increase in the level of mergerand acquisition (M&A) activity in the Asia Pacificregion as a whole, especially in the financialservices industry, including countries like China,Korea, Indonesia and Japan.

Announced Value Number(US$ million) of Deals

2000 168,099 544

2001 270,096 605

2002 91,765 478

2003 101,822 497

2004 172,261 375(up to Q3 2004)

Figure 1: Annual volumes of cross-border banking M&Atransactions

Source: Bloomberg

However, this wave of restructuring activity willbe different from the blockbuster transactions inthe 1990s as:

• Regulators are exercising greater influence

• Competition is intensifying

• Awareness of the challenges and pitfalls ofundertaking mergers and acquisitions is high

• The seeds of economic recovery remainfragile

• Institutions are more wary than ever ofreputational and others forms of risk

Figure 2: Drivers of restructuring activitySource: PricewaterhouseCoopers/Economic Intelligence Unit survey, September - October 2003

The next wave of restructuring is likely to becharacterised by:

Innovation• Straightforward M&As may not be the way

ahead

• Alternatives in alliances, joint ventures andoutsourcing

Focus• Billion dollar deals, but...

• Blockbuster mergers of big institutions lesslikely

• Restructuring is likely to be realistic ratherthan radical

What will be the main external drivers of your organisation’s restructuring activity over the next five years?Please choose up to three answers.

Increasing competition (e.g. price cuts, threats to market share)

Increasing customer demands (e.g. open-architecture products)

Regulatory restrictions (e.g. compliance burden, capital requirements, competition issues)

Regulatory liberalisation (e.g. convergence opportunities, new competitors)

Sluggish state of economy (e.g. need to cut costs, cheap aquisition prices)

Increasing shareholder demands (e.g. demand for transparent reporting and risk profile)

Rebounding economy (e.g. better access to capital, more risk-taking)

Development of outsourcing market (e.g. lower outsourcing costs, better technologies)

Increased access to funding (e.g. lower risk premiums)

Increasing IT costs (e.g. IT integration, security costs)

Higher fixed costs (e.g. property costs)

Higher cost of capital (e.g. regulatory capital requirements)

Other

0 10 20 30 40 50 60 70 80

73%45%

29%26%

21%18%

17%17%

13%

7%6%7%

8%

5PWC EDGE

The briefing also revealed that many financialinstitutions will no longer seek to be in everysegment and territory in which they operate.Instead, they will look to expand regionallyinstead of expanding globally or focussing onniche products and services, especially ininsurance, asset management and alternativeinvestments. Asia will be increasingly on theradar screen of many institutions – one third ofNorth American respondents and 40% of WesternEuropean respondents have set sights on Asia asan important target for acquisition activity.

It is also interesting to note that outsourcing is nolonger regarded as a way to cut costs but as alogical result of the need by financial servicesfirms to stick to what they do best. One of thedrivers of changes and innovative thinking –especially in Asia – has been the costsassociated with implementing various regulatoryand reporting changes. This has encouragedbanks to look to new ways to do things. In Asia,there are many examples of banks moving in thisdirection, such as HSBC’s decision to transfer afurther 4,000 jobs from Britain to the bank’sexisting processing centres in India, China andMalaysia. Others have been increasingly lookingto use outsource specialists, in particularspecialists from India as they have now raisedtheir game: presently, they do everything fromwriting programs to installing enterprise softwareand monitoring computer systems from afar, aswell as performing voice and text messagingservices, producing investment banking ‘pitch’documents, and other higher value-addedservices.

Caveat emptor – Buyer beware!

Financial institutions often enter into transactionsbased primarily on strategic fit, and select targetsthat score high on both competitive strength andcompatibility with the acquirer. Due diligenceexercises for many M&As, joint ventures, allianceand outsourcing transactions are often focussedon whether the expected shareholder returnsfrom the transaction will be acceptable. Thedeadline-driven pressures of completing atransaction often means non-financial issues areoverlooked or given inadequate attention at thepre-deal stage.

Financial services transactions are also gettingmore complicated; whilst there have been anumber of large in-market financial servicestransactions in the last two years, the proportion

of cross-border financial services deals has beenincreasing. In-market transactions tend to be lowerrisk, as the primary drivers are costs and revenuesynergies, which can be more easily estimated inadvance. Flawless execution is still critical,although admittedly there are less risks in relationto the deal valuation. On the other hand, in spite ofthe higher execution risk faced, financialinstitutions need to continually look to cross-bordertransactions to develop new market places anddiversify risk. On the valuation side, it is moredifficult to produce synergies from collaborativeefforts of international operations. As such, anypremium paid over and above the fair value of thebusiness on a standalone basis must be justifiedby something extra which the acquirer brings to thetable – whether it is better management, clearerstrategy, access to new products or better systems– which often tends to be hard to value accurately.Due to the added complication of managing bothcorporate and ethnic cultural differences, thismakes it more challenging for an organisation toexecute and integrate a cross-border operationand subsequently realise the expected synergies.

As such, transactions are facing more scrutinytoday than they were a few years ago. Severalstudies covering M&A activity in the past 75 yearshave concluded that well over half of mergers andacquisitions failed to create their expected value.Ironically, in many cases, value was destroyed andthe company’s performance after the deal wassignificantly below what it had been before thedeal. Often, this may have been due to theacquirers paying more than the acquisition wasworth to them1. With the knowledge gleaned fromsuch experiences, financial institutions are underpressure to execute transactions more effectivelyin order to further their strategic objectives. In thisenvironment, a thorough target screening processis essential.

Financial services cross-border transactions arebecoming increasingly more complex as regulatoryand other stakeholder expectations change, andregulations become more complex. As financialinstitutions look toward opportunities in newmarkets and products, due diligence proceduresneed to increasingly focus on non-financial areaswhich could impact the ability of a financialinstitution to minimise its closing and integrationrisk. Commercial due diligence areas whichrequire focus include regulatory risk, humanresources, governance, risk management andcontrol environment, and differences in accountingstandards. Inadequate consideration of these

1 Eccles, R.G., Lanes, K.L., and Wilson, T.C., ‘Are You Paying Too Much For That Acquisition?’, Harvard Business Review, July/August 1999, Vol.77, Issue 4. Kersyen L.Lanes is a partner of PricewaterhouseCoopers in New York.

PWC EDGE6

areas may inevitably result in delays inimplementation and sometimes the full potentialof the transaction may not be achieved. Thiscould expose the institution to greaterreputational risk and potential brand erosion.

Are regulatory risks fully understood?

Not only do financial institutions need to managetheir shareholders, they also need to manageother critical and important stakeholders,including employees, customers, regulators,rating agencies and the government (refer toFigure 3).

Our PricewaterhouseCoopers/EIU FinancialServices briefing Governance: From complianceto strategic advantage, issued in April 2004,noted that over 50% of Asian respondentsindicated that boards, regulators andmanagement have gained influence over thestrategic decision-making of financial institutionsas a result of greater focus on governance.

Compliance with government and exchange-mandated rules is often seen to be less importantfor avoiding reputational risk than internal codesof practice, according to a

PricewaterhouseCoopers/EIUFinancial Services briefing issuedin June 2003 on Compliance: A gapat the heart of risk management.Adherence to the law is necessary,but by no means sufficient, toprotect against reputational risk.What’s more, due to theimportance and complexity ofproducts, the burden on financialservices institutions to ensure thatall reasonable steps are taken toprotect consumer rights is muchmore onerous than in otherindustries. Due diligenceprocedures should includeconsideration of both the target’scompliance with mandated rules,as well as the strength of itscompliance framework, policiesand internal codes of practice.

Managing regulatory risk will beone of the key drivers for successof financial institutions over thecoming years in determiningeverything from capital to reportingprocesses. Winners will seek tounderstand the current and futureregulatory environment andundertake to embed a culture ofcompliance throughout theirorganisation. They will also buildclose relationships with theregulators.

Figure 3: Key stakeholdersSource: PricewaterhouseCoopers/Economic Intelligence Unit survey, October 2004

Please note that totals do not always add up to 100 because of rounding, or because respondents could choose more then one answer.

Which of the following groups do you see as being stakeholders in your business?Please rate between 1 and 3, 1 being a critical stakeholder, 2 an importantstakeholder and 3 not a stakeholder.

Employees

Customers

Shareholders

Regulators

Ratings agencies

Government

Suppliers

Media

Citizens/civil societyorganisations

Auditors

Business partners

0 100

AsiaEurope

North America

Not a Critical Important stakeholder

59% 41%

56% 39% 5%

62% 33% 5%

72% 19% 9%

86% 12% 2%

96% 21% 8%

75% 21% 4%

81% 14% 5%

69% 10% 21%

33% 49% 17%

33% 56% 11%

38% 36% 26%

18% 43% 39%

16% 44% 40%

15% 36% 49%

18% 45% 37%

14% 49% 35%

10% 51% 38%

4% 45% 41%

14% 44% 42%

5% 44% 51%

4% 35% 51%

5% 49% 46%

3% 28% 69%

4% 43% 43%

12% 46% 42%

5% 38% 56%

19% 50% 23%

21% 54% 25%

28% 44% 28%

29% 61% 10%

37% 56% 7%

36% 44% 21%

PWC EDGE 7

Regulatory risks to watch out for:

• What is the relationship between the targetand its key regulator?

• Have you had dealings with the target’sregulators?

• What is the relationship between your homeregulator and the target’s regulator?

• Does the target have a ‘compliance culture’?What is the quality of the compliancedepartment’s staff? Is compliance givenappropriate prominence in the organisation?How is compliance risk managed – is itproactive or reactive?

• Code of Conduct and management’s ethics –Does the organisation have a code ofconduct, and how does it enforcecompliance? Have we considered the ethicsof management?

• What is the quality of the target’s regulatoryreporting to the regulator? How robust aretheir reporting processes, and are theyreconciled to the financial statements? Willthey be able to report sufficiently accurate andtimely data to the acquiring entity to facilitatereporting to your home regulator?

• How robust are the target’s capitalcomputation processes? Will the target berequired to comply with Basel II requirementslocally, and when?

Do we fully understand the ‘peopleissues’?

As financial institutions continue to extend theirreach into overseas markets, their human capitalstrategies should increasingly focus on humanresource (HR) due diligence and post-mergerintegration issues. Focussed up-front research,combined with careful planning is essential toensure a quick and effective transition once thetransaction has been completed.

Financial institutions should undertake a carefulassessment of people issues during the duediligence process. Looming deadline pressuresoften means that critical people issues areskipped or skimmed over at the pre-deal stage.Many M&A transactions fail to deliver anticipatedincreases in shareholder value, because ‘peopleissues’ are not addressed effectively or quicklyenough.

People issues to watch out for:

• Governance

Consider early in the process whether to runthe target as an independent unit or part of anexisting business

• Determine the people you want

Retention programmes should be linked tointegration goals, and should consider relativecriticality, period of retention, the target’s changein control payments, award size, funding ofpackages, time-base of payments and back-loading of payments

• Find and consider resolution of culturaldifferencesCultural fit should be assessed early in thedue diligence process, and includeorganisational form (centralised vs.decentralised), business horizon (long term vs.short term), and leadership style (autocratic vs.decentralised). The cultures of the target andacquiring entity should be mapped to identifydifferences in operating styles, cultural driversand HR policies

Is the governance, risk managementframework and control environmentappropriate?

Whilst the impact of new legislation like theSarbanes-Oxley Act in the United States and theBasel Committee guidelines is resulting in someconvergence of views on governance, riskmanagement and control of financial institutionsglobally, the strength of the governance and controlenvironments of financial institutions in manyjurisdictions do differ significantly, often as areflection of the sophistication of the financialmarkets, as well as the regulatory and culturalinfluences in that jurisdiction. An acquirer shouldpay close attention to the quality of thegovernance, risk management and controlenvironment of the target, including unique localbusiness practices that the acquirer may not wishto permit after acquisition. In some cases, changesin the policies in relation to acceptable businesspractices could impact the future profitability of theacquired entity.

As part of the due diligence process, an acquirershould also consider how it intends to oversee andintegrate the operations of the acquiree. Recentlarge losses due to lapses in control environmentsin subsidiary banks and overseas branches have

required to upgrade the support unit systems,people and processes to an appropriatestandard? If we are likely to process or booktransactions in another country, have wethought through the regulatory (includingclient confidentiality and taxation) issues?

Have we understood differences inaccounting standards?

Whilst accounting standards globally continue toconverge, and will continue to change rapidly,nevertheless differences in standards and theirapplication do exist. Some countries in AsiaPacific will be moving towards full compliancewith IFRS in 2005; other countries will movetowards full compliance at a slower speed. Incross-border due diligences, one needs tocarefully review differences in accountingstandards and their local application ascompared to those applied by the acquirer. Thisis important as it could have significantimplications on the reported group consolidatednumbers, as well as the appropriate consolidatedcapital treatment.

As part of the due diligence process, an acquirershould also consider how it intends toconsolidate the results of the target, including theability of the target’s finance team to meet theacquirer’s reporting deadlines andresponsibilities in accordance with the acquirer’sgenerally accepted accounting policies.

Accounting Standards to watch out for:

• Special purpose entities, securitisationtransactions, leasing arrangements, equityinvestments

• Differences in loan grading and provisioningregulatory standards between the target andthe acquiring entity

• Classification of securities into trading, held-to-maturity and available-for-sale portfolios,and the application of appropriate valuationpolicies

• Purchase price accounting, treatment of dealcosts and goodwill

• Classification of financing instruments as debtor equity

• Employee compensation benefits

• Possible implications of Sarbanes-Oxley Actrequirements, such as Section 404

PWC EDGE8

continued to highlight the importance of ensuringthat an appropriate governance risk frameworkgoverning overseas operations is in place. Homeregulators expect an appropriate governance, riskmanagement and control framework to beexercised over all operations of a regulated group,and may have an expectation that the acquiree’scontrol environment will operate at a levelacceptable to the home regulator soon afteracquisition.

Governance, risk management andcontrols to watch out for:

• Key Performance Indicators and MISAre these sufficiently robust and accurate toallow monitoring of key performance indicatorsof the organisation? Are they available on atimely basis?

• Escalation procedures

Are control exceptions and other issuesescalated to senior management on a timelybasis, and are procedures for escalationdefined?

• Control Self Assessment (CSA)

Does the organisation use CSA or other tools?Are the results of the CSA objective?

• Internal audit

Who does the Head of Internal Audit report to?What are the qualifications of the internalauditors and do they following the COSOframework or equivalent? Is their approach andare their report gradings sufficiently risk-focussed? Do they review all areas of thefinancial institution, and does the timing of theirvisits appropriately reflect the risk of thebusiness area? Are control exceptionsescalated to the Audit Committee/seniormanagement on a timely basis, and appropriatefollow-up actions taken on a timely basis?

• Financial controls

Does the institution have in place a GeneralLedger Reconciliation process, or even acertification process over its financial numbersand is it robust? Are controls overintercompany, inter-entity, inter-unit, suspense,clearing accounts tight and reconciled on atimely basis?

• Support unitsIs appropriate investment given to supportunits to allow them to support businessesappropriately? What investment will be

Taking the next steps

Successful restructurings over the next five yearswill rely on five key principles:

(1) Defining a clear strategy

(2) Effective communication, both within and outside the organisation

(3) Managing regulatory risk

(4) Differentiation

(5) Innovation

Before entering into a transaction, a financialinstitution should ensure that its deal process,including its due diligence coverage, is sufficientfor it to undertake a robust initial evaluation of thetarget before determining whether it should incurthe ‘heavy expenditure’, and to minimise closingand integration risk. In addition to financial duediligence, commercial due diligence areas whichshould be appropriately covered includeregulatory risk, human resources, governance,risk management and internal controls, andaccounting standard differences.

Take time to apply these five principles inassessing the true value of M&A targets.... beforethe next wave of M&A activity sweeps you offyour feet!

Karen Loon can be contacted attel • (65) 6236 3021e-mail • karen.loon@sg.pwc.com

Take time to apply these five

principles in assessing the

true value of M&A targets....

before the next wave of

M&A activity sweeps you off

your feet!

10 PWC EDGE

In July 2004, the Council on Corporate Disclosure and Governance (CCDG)issued FRS 103 Business Combinations, which is effective for annual periodsbeginning on or after 1 July 2004.

FRS 103 has been the cause of much debate in the Singapore businesscommunity and has made the accounting for business combinations aboardroom issue. FRS 103 requires all business combinations that fall withinits scope to be accounted for using the purchase method of accounting. Thepooling of interest method is now prohibited. It should be noted that thepooling of interest method is also prohibited in Australia, Canada and theUnited States. This alignment would result in increased comparability offinancial information that will provide the market players greater insight inrelation to the acquired entity. Senior management, therefore, mustunderstand the implications of FRS 103 and be prepared to explain preciselywhat has been acquired and how the acquisition was transacted.

To Buy or Not to Buy?– How will FRS 103 affect acquisitions?

BY Peter Low Professional Standards Group

PWC EDGE 11

How will FRS 103 affect an entity’s acquisitionstrategies? This article highlights some of thekey issues that management should consider atthe four stages of the acquisition process namely,planning, assessing, execution and post-acquisition.1

Planning for acquisitions

FRS 22 Business Combinations (superseded byFRS 103 with effect from financial periodcommencing 1 July 2004), para 13, recognisedsituations whereby it may not be possible toidentify an acquirer and consequently allowed thepooling of interest method to account for themerger under certain strict conditions. However,FRS 103 prohibits the pooling of interest methodand prescribes the purchase method ofaccounting for all business combinations (para14). It is now critical at the planning stage toidentify the acquirer for the implementation of thepurchase method. Where a new company iscreated to acquire two or more pre-existingcompanies, one of the pre-existing companiesmust be designated as the acquirer. Thedetermination of the accounting acquirer is basedon the facts and circumstances of the deal and willhave a significant impact on the post-acquisitionbalance sheet. However, this may not always beclear especially in a complex transaction.

Under the pooling of interest method, the financialstatement items are combined at cost, while thepurchase method mandates fair valuing offinancial statements items of the acquiree. Assuch, management should also evaluate thecomposition of the opening balance sheet as wellas impact of the new rules on key ratios.

Given the financial impact of the acquisition andthe additional disclosures resulting from FRS 103,it is important to plan early communication tostakeholders and ascertain adequate resourcesare available to ensure compliance with FRS 103.In particular, specialist resources may be requiredto identify and fair value intangible assets andcontingent liabilities which were previously notrequired under the pooling of interest method.

Assessing the acquisitions

FRS 103 prohibits the amortisation of goodwillacquired in a business combination and insteadrequires the goodwill to be tested for impairmentannually, or more frequently if events or changesin circumstances indicate that the asset might be

impaired, in accordance with FRS 36 Impairment ofAssets [FRS 103, IN 7(g)].

Goodwill arises when the cost of the combinationexceeds the net fair value of identifiable assets,liabilities and contingent liabilities. Under suchcircumstances, FRS 103 first requires goodwill tobe recognised as an asset (FRS 103.51).

On the other hand, when the fair value ofidentifiable assets, liabilities and contingentliabilities exceeds the cost of the combination(previously known as negative goodwill andreferred to as ‘excess of fair value over cost ofbusiness combination’ for the purpose of thisarticle), FRS 103 requires the acquirer to reassessthe identification and measurement of theacquiree’s identifiable assets, liabilities andcontingent liabilities; and the measurement of thecost of the business combination. Subsequent tothe reassessment, any ‘excess of the fair valueover the cost of the combination’ must berecognised in the post-acquisition incomestatement by the acquirer.

Given the above process to account for anydifference between the fair value and cost ofbusiness combination, it is necessary to consider:

• How acquired intangible assets and contingentliabilities affect post-acquisition financialposition;

• The financial effect of any excess of the fairvalue of identifiable assets, liabilities andcontingent liabilities; and

• How the target fits into the organisation.

Furthermore, restructuring costs are nowspecifically excluded in FRS 103 and its impactshould also be taken into careful consideration.The four factors for management’s considerationare:

Factor 1:Consider how acquired intangible assets andcontingent liabilities affect the post-acquisitionfinancial position

A fair valuation process encompasses a detailedevaluation of the potential assets and liabilities(including all intangible assets and contingentliabilities), which is required to determine theimpact on the post-acquisition group balance sheetas well as income statement. This complex andrigorous valuation may require specialist

1 This article is based on the PricewaterhouseCoopers, April 2004, publication Acquisitions: Accounting and Transparency under IFRS 3.

12 PWC EDGE

involvement, which will inadvertently increase thecost of acquisition.

Many of those intangible assets that wouldpreviously be subsumed within goodwill mustnow be separately identified and valued. Bydefinition, an asset is identifiable when it eitherarises from contractual or other legal rights, or isseparable. An asset is separable if it could besold on its own or with other assets. This willcapture more intangible assets than what hadtypically been previously recognised.

While goodwill amortisation is prohibited,amortisation charges may still increase as aresult of the recognition of these identifiableintangible assets because most of such assetsare likely to have a much shorter useful life thanthe 20 year period commonly used for goodwill.

On the flip side, companies will need to considerthe impact of contingent liabilities in anyacquisition transaction. Contingent liabilities ofthe acquired entity will be more visible as theymust be recognised in the balance sheet at fairvalue. The existence of contingent liabilities hadhistorically been implicitly reflected in a lowerstock trading price, a reflection of the risk thatsuch liabilities could crystallise.

Factor 2:Consider the financial effect of any excess ofacquirer’s interest in the net fair value ofacquiree’s identifiable assets and liabilities overcost (previously known as negative goodwill)

An excess of the net fair value over the cost ofbusiness combination could imply:

(i) errors in measuring the fair value of the costof the combination or the acquiree’s identifiedassets, liabilities or contingent liabilities [FRS103.57(a)];

(ii) identifiable net assets not measured at fairvalue [FRS103.57(b)]; or

(iii) a bargain purchase [FRS103.57(c)].

Previously, in FRS 22, negative goodwill wasgenerally carried on the balance sheet andrecognised as income on a systematic basis,whereas, FRS 103 is sceptical that bargainsexist. The prescribed accounting treatment inFRS 103 strips out the earnings cushioning-effect, thus increasing the risk of later impairmentif the acquisition does not turn out to be a bar-gain after all.

The requirement to recognise the excessimmediately as a profit or loss may have animpact on the post-acquisition results if futurelosses and expenses arise. However, this excessshould rarely remain if the valuations inherent inthe accounting for a business combination areproperly performed, identified and recognised.Therefore, when such an excess exists, theacquirer should perform rigorous reassessment ofthe identification and measurement of theacquiree’s identifiable assets, liabilities andcontingent liabilities as well as the measurementof the cost of the business combination toascertain that such a gain truly exists.

Factor 3:Consider how the target fits into the organisation

A cash generating unit (CGU) comprisesidentifiable assets, liabilities and goodwill.Goodwill impairment is assessed within the CGU.Management should consider how the target fitsinto the organisation. This exercise also enablesmanagement to identify CGUs within the potentialcombined organisation.

This increases the risk of there being animpairment charge against goodwill – as poorlyperforming units can no longer be ‘supported’ bythose that are performing well. Therefore, it iscrucial that the structure of CGUs must becarefully planned to reduce the risk of impairmentbecause poor definitions of CGUs might result inan impairment charge. It is noteworthy that theopportunities to minimise risks of futureimpairment are only available at the time of thetransaction.

Factor 4:Consider the impact of restructuring cost on post-acquisition results

Previously, companies tend to includerestructuring provisions in the allocated cost of anacquisition and this helps to shelter some of thecost impact of absorbing the acquired entity.Frequently, the most visible income statementeffect has been positive when provisions turn outto be overstated and the excess is released to theincome statement.

Restructuring provisions are now excluded fromacquisition accounting under FRS 103 unless thetarget was already committed to the plan prior tothe acquisition. All restructuring costs will be acharge in the post-acquisition income statement,making it harder to demonstrate that any

13PWC EDGE

acquisition serves to immediately enhanceearnings.

Execution process of acquisitiontransaction

The previous sections outline the requirementsto:

(i) identify an acquirer at the planning stage; and

(ii) consider the financial impact of the potentialacquisition at the assessment stage.

Once these factors have been deliberated, anappropriate structure should be planned forconsideration to execute the acquisitiontransaction. The purchase accountingimplications of involving the variable share pricesin non-cash deals which arise should also betaken into account.

The communication strategy for informing themarket has to be carefully formulated to managethe financial statement impact arising fromFRS 103. Organisations should recognise theneed to prepare the market for any anticipateddilutions in earnings as a result of new intangibleassets identified in the new transactions – whichmay result in more amortisation in the future –combined with the impact of new treatments forrestructuring costs and ‘the excess of fair valueover cost of business combinations’.

Disclosures are intended to allow users to assessthe reasonableness of management’s decisionsand assessment. However, in light of theincreased transparency of disclosure, analysts,shareholders and other users of the financialstatements will have access to more informationabout the nature and consequences ofmanagement decisions on acquisition thanbefore. Thus, senior management should beprepared to handle the more informed group ofanalysts and other parties as a result of thesignificantly expanded disclosure requirements.

Post-acquisition transaction

In FRS 103, the annual disclosures required ongoodwill impairment review are detailed andonerous. At the outset, details for the acquisitioncost and the financial implications, i.e. goodwill or‘excess of fair value over cost of businesscombination’, are required to be disclosed. Post-acquisition, management should be aware of therequirements for impairment reviews of goodwillas well as intangible assets with indefinite useful

lives and consider the impact of those reviews.There is also a need to ensure that the market isalso prepared for any anticipated impairmentcharges. With the impairment charges, earningscould be more volatile and unpredictable.Therefore, it is crucial to prepare the market for any(expected) volatility of the earnings as a result ofimplementation of FRS 103.

Next steps

It is important to remember that these changes inthe accounting treatments under FRS 103 do notaffect the cash flow of the acquisition transaction.However, we must recognise that these changesmay have an adverse effect on companies’ perform-ances if the measurements are based on earningsper share due to the additional charges in theincome statement.

In the light of increased risks and complexity ofFRS 103, we encourage senior management toassess all potential acquisition transactions toachieve their business, economic and accountinggoals.

It should also be of interest that FRS 103encompasses phase I of the business combinationsproject embarked by the International AccountingStandards Board. Phase II of the businesscombinations project is currently being discussedby the Board and the following issues are beingconsidered:

• rename ‘purchase method’ to ‘acquisitionmethod’;

• definition of a business;

• deferred tax; and

• operating leases.

It is expected that revisions to FRS 103,incorporating issues arising from Phase II of thebusiness combinations project, should beforthcoming in 2005.

Peter Low can be contacted attel • (65) 6236 3348e-mail • peter.low@sg.pwc.com

14 PWC EDGE

Some key issues management should consider at each stage of the acquisition process

Structure

• Identify whichparty is theacquirer; this maynot be obvious in acomplextransaction

• Consider how thetarget fits into theorganisation

• Which part of thebusiness might beat risk fromimpairment?

• Plan an appropriatestructure forconsideration

Evaluation

• Consider the compositionof the opening balancesheet and impact of newrules on key ratios

• Identify and value allintangible assets andcontingent liabilities ofthe target

• Carry out detailedanalysis of all potentialassets and liabilities(including those above)to determine impact onthe group balance sheetand income statementpost-acquisition

• Consider purchaseaccounting implicationsof variable share pricesin non-cash deals

• Consider impact ofimpairment reviews ofgoodwill and intangibleassets with indefiniteuseful lives

Communications

• Early identification of thekey issues is vital andrequires an understandingof the accounting anddisclosure requirements

• Stakeholdercommunications mustclarify impact of FRS 103on particular aspects ofthe deal, e.g. profit impactof intangible assetamortisation

• Formulate communicationsstrategy for informing themarket in the light ofincreased transparency ofdisclosure

• Prepare seniormanagement for moresearching questions thatmay be raised by analystsand others

• Prepare market for anyanticipated earningsdilution

• Prepare market foranticipated impairmentcharges

Impacts

• Determine the likelycomplexity of the purchaseaccounting

• Plan early communicationto stakeholders on thelikely financial impact ofthe transaction

• Identify additionalresources needed tocomply with recognition,valuation and disclosurerequirements

• Poor definition of CGUsmight result in animpairment charge

• Make good use ofopportunities (onlyavailable at the time of thetransaction) to minimisethe risks of futureimpairment

• Carry out more detaileddue diligence to complywith recognition anddisclosure requirements

• Assess risk of impairmentcharges

• The estimated value of allcontingent considerationis included in the cost ofthe acquisition andallocated over the assetsand liabilities acquired

• Impairment charges createearnings volatility

Planning

Assessing

Closing

Post-deal

Source: PricewaterhouseCoopers, April 2004, Acquisitions: Accounting and transparency under IFRS 3

Goodwill = Goodbuy or Goodbye?Following the recent introduction of Financial Reporting Standards (FRS) 103Business Combinations coupled with the revised FRS 36 (2004) Impairment ofAssets and FRS 38 (2004) Intangible Assets, companies are required tocomply with these requirements when accounting for business combinationsfor annual periods commencing on or after 1st July 2004.

BY KEOY SOO EARN Transactions – Valuation & Strategy

PWC EDGE 15

16 PWC EDGE

Effective date of implementation

1 July 2004 1 January 2005 30 June 2005 31 December 2005

Application of FRS 103 for entities with December financial year end

Opening Balance Sheet First financial statements according to FRS 103

First time application of FRS 103

Impact of the news standards at aglance

• All business combinations are acquisitions

• An acquirer must be identified for everycombination

• More intangible assets will be identifiedand recognised on acquisition – some willbe intangible assets with indefinite usefullives

• Goodwill is not amortised but subject to anannual impairment test

• Negative goodwill is recognisedimmediately in income

• Restructuring costs are charged to income

• Contingent liabilities are recognised at fairvalue

• Detailed disclosures about transactionsand impairment testing are required

Key implications of FRS 103

FRS 103 requires the purchase price ofacquisitions to be allocated across all identifiableassets (separately from goodwill), as well asrecognise the liabilities and contingent liabilitiesassumed. Accordingly, with the requirement tojustify the remaining amount allocated to goodwill,it will prove increasingly more difficult todemonstrate value in the form of goodwill. In thisrespect, companies will have to undertake a morerigorous analysis of the goodwill amount that isstated, or to be stated in their financial statements.

FRS 103 also prescribes that goodwill no longerneeds to be amortised. Instead, it will be subjectedto annual impairment tests and ad-hoc testingswhenever there are indications of impairment. Thisis likely to result in irreversible impairment chargeson poor-performing acquisitions at a very earlystage. Thus, it is apparent that the application ofthe new standard will give a more immediateindication of whether companies have overpaid fortheir acquisitions. One can then tell if goodwill isreflective of a good buy. With this in mind, it isimportant for acquirers to carry out more stringentevaluations of target firms in the acquisitionprocess. Thorough evaluations will also ensurethat the deal is able to withstand greater marketscrutiny.

The new standard also means that structuringdeals as ‘pooling of interests’ will no longer beallowed. In practice, although it has been difficult

Application of FRS 103 for entities with June financial year end

17PWC EDGE

to qualify for merger accounting due to the strictqualifying criteria, the benefits of mergeraccounting however, have provided companiesan incentive to structure deals to meet thequalifying crtieria wherever possible. Under thenew requirements, an acquirer must be identifiedand thus companies may want to carefullyconsider which party will be the acquirer incomplex transactions.

Concept of Fair Value

Fair value as defined in FRS 103 is the amountfor which an asset could be exchanged, or aliability settled, between knowledgeable willingparties in an arm’s length transaction. Theconcept of fair value is a fundamental underlyingprinciple in FRS 103 and is key to the purchaseprice allocation process.

Purchase Price Allocation

Purchase price allocation has not changedradically but has been made more rigorous bythe new standards. All intangible assets of theacquired business that are identifiable andseparable must be recorded at their fair values.This means that any intangible asset that wouldhave been subsumed within goodwill previouslymust be separately identified and valued.

Explicit guidance is provided for the recognitionof such intangible assets; clarification is alsomade to categorise an asset as identifiable whenit arises from contractual or other legal rights, oris deemed separable. An asset is consideredseparable if it could be sold, either on its own orbundled with other assets.

The new requirements will result in therecognition of many more intangible assets thanpreviously. These are set out in FRS 38 (2004)and FRS 103 which prescribe the recognition ofidentifiable intangible assets separately fromgoodwill.

Examples of intangible assets to berecognised and valued separately fromgoodwill

Marketing-related

• Trademarks, trade names, service marks,collective marks, certification marks,internet domain names, trade dress,newspaper mastheads, non-competitionagreements

Customer-related

• Customer lists, order or productionbacklog, customer contracts and relatedrelationships, non-contractual customerrelationships

Artistic-related

• Copyrights, plays, operas, ballets, books,magazines, newspapers, musical works,pictures, photographs, videos, films,television programmes

Contract-based

• Licensing, royalty and standstillagreements, contracts for advertising,construction, management, service orsupply, lease agreements, constructionpermits, franchise agreements, operatingand broadcasting rights, rights to water, air,mineral, timber cutting and route authority,servicing contracts, ‘favourable’employment contracts

Technology-based

• Patented and non-patented technology,computer software, databases, tradesecrets, special formula, processes orrecipes

Purchase price allocation has

not changed radically but has

been made more rigorous by

the new standards.

Challenges of identifying and fair valuingintangible assets

Along with the need to recognise intangible assets,their identification becomes a pertinent issue – anda challenging one – as it involves the attribution ofthe value drivers of a business to specific intangibleassets. For instance, it is difficult to distinguish andquantify profit contributions attributable to acompany’s brand and those attributable to itsstrong customer relationship.

18 PWC EDGE

In addition, the useful life of such an intangibleasset is difficult to determine as renewal periodscan be taken into account under specificcircumstances. This may result in the useful lifedeviating from the contractual duration of thecustomer relationship.

This is precisely where a valuation expert’sexperience and insights matters and makes adifference. The ability to use industry knowledgeto identify the factor, of which the success of thebusiness depends on, is of critical importance forthe accurate identification of the business’intangible assets. Accurate identification laysthe foundation for the accurate attribution of anintangible asset’s profit contribution.

All assets acquired and liabilities, includingcontingent liabilities assumed, have to berecognised at fair value. This can be a complexand time-consuming process and expertvaluation assistance can be enlisted to assistmanagement in establishing their fair values andto ensure compliance with FRS 103. There arevarious methods to ascertain fair value; the mostappropriate of which to apply requires anevaluation of the business and itscircumstances.

Furthermore, as the valuation of intangibleassets tends to attract some degree ofscepticism and reservation, an independentexpert report on the valuation of intangibleassets will lend credibility to the assessment. Itis advisable to seek an expert valuer who isfamiliar with generally accepted accountingprinciples and the requirements of FRS 103.Otherwise, companies may find themselveshaving to justify and reconcile the treatment withauditors who are required to attest to the valuesstated on the financial statements.

Common valuation approaches

The ‘market’ approach is based on a premise thatprices paid for comparable intangible assets incurrent or prior transactions can serve as a guidein the valuation of the subject asset. While this isa reliable estimate of the fair value of anintangible asset, due to the uniqueness of manyintangible assets acquired and the lack ofinformation about prior transactions, theapplication of the market approach is oftenlimited.

The income approach is most commonly used inthe valuation of intangible assets. This methodestimates the fair value of an intangible assetthrough the calculation of the present value ofeconomic benefits that it is expected to generate.The challenge in using this approach lies in theability to identify and project the expected cashflows attributable to the asset, the determinationof an appropriate discount rate, and thedetermination of the remaining useful life of theasset.

The cost approach is relatively intuitive inapplication, as it is based on the premise that abuyer would pay no more than the amount forwhich it would cost to reproduce the asset. Usingthis method, the valuer must consider all coststhat would be incurred to replicate the asset, suchas materials, labour, amortisation anddepreciation.

Will earnings increase as amortisationends?

The end of goodwill amortisation will enhanceearnings of companies with significant goodwillbalances. The transition rules do not requirerestatement of past transactions, so there may bean immediate positive impact on earnings.

A study1 performed on the top 10 listedcompanies by market capitalisation on theSingapore Stock Exchange showed that on theaverage, net profit will increase by 15.1% andearnings per share will increase by 7 cents, uponthe application of the new standard.

However, more intangible assets identified in newtransactions may result in more amortisation inthe future, not less. Combined with the impact ofnew treatments for restructuring costs and

1 The study was performed based on information extracted from Bloomberg as at 31 August 2004.

...an independent expert

report on the valuation of

intangible assets will lend

credibility to the assessment.

19PWC EDGE

negative goodwill, earnings may well decrease.In addition, earnings may potentially be morevolatile as impairments are most likely to occur inyears of already poor economic performance,thereby depressing profits in difficult years.

Impairment testing

The annual impairment test on goodwill andintangibles with indefinite useful lives has to beperformed at the cash-generating unit (CGU)level, being the lowest level at which goodwill ismonitored for internal management purposes. ACGU is by definition the smallest identifiablegroup of assets that generates cash inflowslargely independent of the cash inflows fromother assets of the group. This essentiallymeans that CGUs with impairment cannot be‘subsidised’ by CGUs with no impairment.

In addition, disclosure of key assumptions and asensitivity analysis on the key assumptions isrequired. This will demonstrate the range withinwhich the assumptions may change before thecarrying amount of the CGU exceeds itsrecoverable amount. Users of financialstatements can thus understand the assumptionsbehind the calculations and their impact on thefinancial statements.

The new requirements also stipulate that therewill not be impairment if the carrying value of theCGU is lower than the fair value or value in useof the CGU. To determine the fair value or valuein use of a CGU, an appropriate valuation modelhas to be identified, a job that is perhaps best leftto the valuation specialists.

Increased deal transparency

Without doubt, the increased disclosurerequirements will provide analysts andshareholders with more information. This may inturn elicit more pertinent questions. It istherefore essential that CEOs and CFOs have anin-depth understanding of the issues and are in aposition to explain the details to the market aswell as to the wider investment community. Timespent on considering the financial impact toproposed acquisitions can reap benefits in theform of confidence and trust from shareholdersand analysts, through accurate and well-prepared disclosures at annual general meetingsand analysts’ briefings.

Conclusion

So is goodwill reflective of a good buy? Or shouldwe impair and bid goodbye? The intrinsic value ofgoodwill, if any, will increasingly become moreapparent when acquirer companies adopt thestandard. The more stringent impairment test willhighlight the success or otherwise of these dealsand any loss of value will be immediately expensedoff to the profit and loss. This would result in amore immediate indication of whether companieshave overpaid for their acquisitions.

As the real value of a deal becomes moretransparent, it is critical for investors, analysts andCEOs to carefully consider whether a particulartransaction is indeed a good deal. For this reason,rigorous evaluation of target companies during theacquisition process is necessary. Thoroughevaluation will also identify and ensure that thedeal is able to withstand greater market scrutiny,and that it will enhance shareholders’ value.

Keoy Soo Earn can be contacted attel • (65) 6236 3898e-mail • soo.earn.keoy@sg.pwc.com

So is goodwill reflective of a

good buy? Or should we

impair and bid goodbye?

20 PWC EDGE

Valuation of IntangiblesFRS 38 defines an ‘intangible asset’ as ‘an identifiable non-monetary assetwithout physical substance’. Intangible assets include intellectual propertysuch as patents, trademarks, copyrights, trade secrets and industrial know-how as well as customer lists, software license, franchise agreements, trainedworkforce, networks, etc. These assets are rapidly becoming a core source ofwealth creation in many sectors of the economy.

BY LUCY GWEE Transactions – Valuation & Strategy

21PWC EDGE

PWC EDGE22

Intangibles Make Up More Than Half OfMarket Capitalisation For SomeCompanies

A company’s overallmarket value takes intoaccount the value of itsintangible assets.According to an articlepublished in August 2003in Business Week, theCoca Cola brand is worthUS$70.5bil. Thecombined total brand value

of the top ten brands in Singapore is worth onlyabout 10% of Coca-Cola’s brand value!

At times, the value of intangibles may contributeto more than half of its market capitalisation. Letus take a look at a sample of local companies.For example, the ‘implied’ intangible value of EuYan Sang and UOB is about 53% of their marketcapitalisations (See Figure 1). Eu Yan San’sbrand value constitute about 60% of its impliedintangible value. On the other hand, the brandvalue of UOB is assessed to be S$1.2bil,representing 10% of its implied intangible value.The rest of UOB’s intangible value can beattributed to its marketing-related intangiblessuch as its customer relationship, branchnetwork, customer list and database, etc.

Figure 1: Implied Value of Intangibles of Singapore Companies

1 Based on last traded share price as at 8 October 20042 Source: Bloomberg3 Source: International Enterprise Singapore “Singapore Brand Awards 2003”

Mar

ket

Val

ue o

f C

ompa

ny

Unidentifiableintangibleassets

Identifiableintangibleassets

Nettangibleassets

Capitalising on your Intangibles To CreateWealth

Intangibles, as we have seen, are keycontributors to the earning power of a company.Yet many companies often fail to leverage andcapitalise on the opportunities to exploit itsintangibles. Like any other revenue-generatingtangible asset, intangibles can provideopportunities for commercial exploitation. Thiscan range from an outright sale to licensing, togaining a competitive edge in the marketplacewith specialised trade secrets.

Often, companies fail to identify all the intangibleassets they own and/or control. Hence, it iscritical for every organisation to put in place asystem to manage its intangible assets. Effectivemanagement of intangible assets involvessystematically identifying and protecting theseassets, assessing their potential value, devisingand executing appropriate strategies to exploitthese assets. In this article, we will focus onassessing the value of intangible assets.

Although the commercial value of intangibleassets, including intellectual properties, is widelyacknowledged and frequently transacted, thevaluation of these intangible assets generallyattracts a degree of skepticism and reservation.This arises primarily because there is doubt as towhether the value of intangibles can be reliably

measured.

There are many methodsof valuing intangibleassets, some of which aremore robust than others.Unfortunately, there is alack of general consensusas to which methods arepreferred. Variousaccounting standardsetting bodies around theworld are beginning toindicate what they believeto be acceptable methodsof valuation for financialreporting purposes.

Approaches to Valuing Intangible Assets

The fair value of an intangible asset is defined asthe amount that a party would pay for the asset,at the acquisition date in an arm’s lengthtransaction between knowledgeable and willingparties, based on the best information available.

Companies

(Figures inSGD mil)

UOB

Asia PacificBreweries

SingaporeAirlines

OSIM

Eu Yan Sang

MarketCapitalisation1,2

(a)

21,543

1,929

13,156

447

109

Net TangilbleAssets (NTA)2

(b)

9,816

764

11,454

93

51

Value ofintangibles?(c) = (a) - (b)

11,727

1,165

1,702

354

58

Brand Value(Ranking)3

1,211 (2)

943 (4)

304 (7)

95 (12)

35 (15)

PWC EDGE 23

There are three basic approaches used todetermine the fair value of an asset. These arethe cost, market and income approaches.Although in practice many methods are used, allsuch methods can be categorised as variationsof one of the three approaches.

It is generally accepted that the determination ofthe fair value of an intangible is as much ascience as it is an art. As such, it is verycommon for the results of one valuation methodto be corroborated with the results of one ormore other methods in the determination of thefair value of an intangible.

Cost Approach

The cost approach values an intangible asset byaccumulating the costs that would currently berequired to replace the asset. The underlyingpremises of the cost approach is that the cost ofthe intangible asset is commensurate with theeconomic value of the usage that the propertycan provide during its life, and that an investorwould not pay more than the cost to reproduceor acquire the asset.

Whilst this approach is suitable for some assets,particularly for easily replicable assets like simplesoftware, care should be exercised in choosingthis approach as cost is often not a reliable guideto value. The cost approach tends to lookbackwards in time, which is seldom the waybuyers and sellers view assets or transactions.

Historical costs may not account for theincremental profits that an asset may generate.Conversely, not all costs are efficiently andeffectively incurred. For instance, the vastamounts of investment on pharmaceuticalresearch projects may yield minimal value.

Market Approach

The market approach values the asset based oncomparison with sales of similar assets. Thetransaction price, as a ratio of an asset attributesuch as sales, is used to derive a marketmultiple. This market multiple is then applied tothe attribute of the asset being valued to obtainan indicative value of the subject asset. Onemay use sales, EBITDA, EBIT, net income,operating cash flow, revenue, etc to derive themarket multiple. In an efficient market, this isdeemed the best method because the marketrepresents the economic environment wherearm’s length transactions occur between thebuyer and seller.

However, in practice it is difficult to identifyintangible assets with ‘similar’ characteristics. Theavailability of any information relating to thetransaction details as well as the lack of an activemarket place exacerbate the problem. Even if theprice is available, the other problem is thatintangible assets are often ‘bundled’ with otherassets, so the price paid for an individual intangibleasset is not observable with certainty.Nonetheless, this approach is most straightforward,easily understood and usually applied as a counter-check to other methods of valuation.

Income Approach

This is the most common approach for valuingintangible assets. The principal notion supportingthe income approach is that it views value asarising from the expectation of future incomestream(s) and cash flows.

There are several variations to the incomeapproach. We examined four commonly usedmethods for valuing intangible assets:

• Excess profits method

• Premium pricing method

• Cost savings method

• Royalty savings method

1. Excess profits method

The excess profits method determines the valueof the intangible asset by capitalising theadditional profits generated by the businessowning the intangible asset over and abovethose generated by similar businesses, whichdo not have the benefit of the intangible asset.

The basic theoretical premise is that the tradename and/or other intangible assets will allowthe owner to earn a profit that is greater thanwhat a competitor would earn without thebenefit of the trade name.

There are various ways in which the excessprofits may be calculated. For example, someways would be by reference to a margindifferential or comparing the return on capitalemployed earned by the business owning theintangible asset with that earned by companieswithout such benefits. The calculated excessprofits expected to be earned over the life of theintangible asset in question are then discountedto the present day to arrive at an estimatedvalue of the intangible asset.

24 PWC EDGE

Under this method, it is important to ensurethat the excess profits identified arespecifically attributable to the intangible assetin question and not some other factors (suchas an efficient production facility or distributionnetwork) that relate to the business as awhole.

Another important consideration of thismethod is that the comparable company maylack the subject company’s intangible assetbut it could benefit from other intangibleassets of its own. In this scenario, thecomparable company’s operating marginswould also include returns from its ownintangible assets, and the inference is that theexcess profit of the subject company must behigher.

2. Premium pricing method

The premium pricing method is a variation onthe excess profits method and is often used tovalue brands in the consumer products sectorwhere it is common for a branded product tobe more expensive than a non-brandedequivalent.

The value of this additional revenue projectedover the life of the brand, net of marketing andother brand support costs expected to beincurred to achieve this revenue, is thendiscounted to the present day to provide avalue of the brand.

A drawback of this method is that is verydifficult to find a truly generic, non-brandedproduct. In the food sector, where storesoften sell both branded and their ‘own label’ or‘no-frills’ products, the store’s own brand itselfcarries certain value.

3. Cost savings method

The cost savings method values the asset bycalculating the present value of the costsavings that the business expects to make asa result of owning the intangible. This isusually a result of an efficient process orsecret technology.

Whilst a business can usually calculate thecosts it has saved since it introduced the newprocess, it can be more difficult to estimatewhether a third party would save more or lesscosts if they introduced the same technologyto their own business.

4. Royalty savings method

The royalty saving method is based on theprinciple that, if the business did not own theasset, it would have to in-license it in order toearn the returns that it is earning.Alternatively the business could out-licensethe asset if it did not wish to use it. Under thismethod, the value of the intangible isestimated by capitalising the royalties saveddue to the company’s ownership of theintellectual property. In other words, theowner realises a benefit from owning theintangible asset rather than paying a rent orroyalty for the use of the asset.

Royalty savings are typically determinedbased on the application of an arm’s lengthroyalty rate to the future revenues expectedfrom the sale of the product or serviceassociated with the intangible, and the valueis determined based on the present value ofthe royalty stream that the business is savingby owning the intangible. Trade names andtrademarks are typically valued using thismethod.

Determining an appropriate royalty rate is a keypart of a valuation using this method. Oneapparent and simple way would be to find anexact comparable transaction between unrelatedparties. Yet the existence of an ‘exact’comparable may be elusive. In the absence ofthe exact comparable, justification for anappropriate royalty rate often defaults to weak or‘inexact’ comparables. This is one of the majordifficulties of this approach.

...value brands in the

consumer products sector

where it is common for a

branded product to be more

expensive than a non-

branded equivalent.

PWC EDGE 25

Choosing the Appropriate ValuationMethod

When assessing the value of your intangibleassets, no one single method can be sufficientlyconclusive. A good practice is to use a fewmethods to substantiate one’s initial findings.Some of the above methods are more suitablefor certain assets than others and there is alwaysthe practical limitation of what information isavailable.

Perhaps the most important guide to your choiceof valuation method is to consider how the assetcreates value for its owner:

• Does it generate additional revenue? If so,then a method based on revenue is probablymost appropriate.

• Does it save costs? If so, then a methodbased on costs saved could be used.

• Does it give a competitive advantage withoutdirectly generating additional revenues orsaving costs? In this case, a method basedon replacement costs may be the answer.

Figure 2 shows you some common methodsused to value various classes of intangibleassets.

Dealing with Uncertainty and Risk

One of the reasons that many people areskeptical about placing a value to an intangible isthat there is usually a greater level of uncertaintyand risk(s) associated with the potentialrevenues from the exploitation of an intangible

asset than from a tangible asset. How can theseuncertainty and risks be dealt with in the valuationso that it is reasonable, robust and reliable enoughfor financial reporting purposes?

To a certain extent, the income approach whichuses the Discounted Cash Flow (DCF) method ofvaluation accounts for the time value of money, andto a certain degree, the riskiness of cash flows. Itis possible to use a risk adjusted discount rate todiscount the cash flows, or to adjust cash flows toreflect riskiness, or changing riskiness over time.

For instance, one way to deal with the uncertaintythat the future cash flows will not materialise,particularly where there is a higher than usual levelof risk, is to use expected cash flows rather thanthe simple discounted cash flow approach. In the

expected cash flow approach, the principal riskassociated with the future cash flows are identifiedand dealt with using a probability approach andoption techniques. Thus, for example, whenestimating the probability of certain eventsoccurring, we can factor in the impact of the totalmarket being larger or smaller than expected ortake into account the impact of competition. This

A good practice is to use a

few methods to substantiate

one’s initial findings.

Figure 2: Common methods for valuing frequently encountered intangible assets

Excess profit

•

•

•

Premiumpricing

•

Cost Saving

•

•

•

Royalty relief

•

•

•

•

Income approachMarketapproach

•

•

•

•

Costapproach

•

•

•

•

Assets

Brands

Patents

Know how

Customer lists

Franchises

PWC EDGE26

makes the valuation more robust. Thesetechniques have particular relevance inevaluating portfolios of products or applicationsunder development, for example in thepharmaceutical industry. An example of thistechnique is shown in Figure 3.

Under a probabilistic DCF approach, the situationis usually such that all the information involved inmaking a decision about the intangible is highlyuncertain, and the best that can be done is toconsider the costs and revenue probabilistically.The end result being a frequency distribution ofNet Present Value (NPV) values. However sucha method, and other so-called ‘Monte Carlo’simulations can be time-consuming and areconstrained by the difficulties in establishing theprobability distributions needed.

The DCF method is, and will remain, the primarytool in valuation. Yet it can difficult to use DCF tojustify the market values of start-ups or someother companies heavily centred on intangibleassets since many may not even have positivecash flow and/or revenue. Their market valuetoo may not reflect the various strategic optionsthat it is currently exploring. For instance, acompany could be deciding whether to invest inthe prototype of its technology, or it could in themidst of a critical licensing deal for its intangibleswith a global player. If materialised, it could yielda substantial leap in its cash flow. The standardDCF does not include the value of such optionsin its calculations.

Hence in valuing such companies, other decisiontree analysis or options pricing theory could beused to complement and supplement thetraditional DCF method. The three most commonways include decision tree analysis (DTA), Black-Scholes and binomial analysis.

The advantage of suchmethods over the traditionalDCF method is that it builds inthe value of ‘flexibility’encountered in a patent or anyother intangibles. For example,it takes into account to someextent the ability to abandonthe patent.

Each method is appropriate fordifferent situations and requiredifferent inputs. Suchmethodologies are becomingpopular, especially in thepharmaceutical, and oil and gasindustry. There are manyfactors to consider whenassessing value under differentscenarios and industry/regional

profiles. Separate discussions will be required toexpound the detailed methodology and examplesin valuing intangibles under uncertainty.

Conclusion

So, can an intangible asset be reliably measured?The answer is yes, provided that the appropriateapproach and methodology is selected andproperly applied.

It is equally important to add that a keen sense ofbusiness acumen combined with rationaljudgment are critical inputs to the valuationprocess.

Valuation is both an art and a science.

Lucy Gwee can be contacted attel • (65) 6236 4079e-mail • lucy.slk.gwee@sg.pwc.com

dg

Figure 3: Probabilistic Discounted Cash Flow

Cost=-10

Failp=0.85

p=0.15Succeed

Cost=-75

Failp=0.25

Lowp=0.70p=0.75

Succeed

p=0.30High

Post-launchNPV = 650

Post-launchNPV = 1020

Commercial outcome

Phase III

Phase II

Probability-weighted present value is $64

27PWC EDGE

Benefits-in-kind Reap Benefits inTaxTax is often one of the key considerations when companies evaluatethe value of starting an operation in a new country. Yet, one of thecrucial components of tax planning may inadvertently be overlookedin the rush to expand. And this tends to form a large chunk ofexpenses, especially for the professional or consultative servicesindustry.

28

BY JENNY GOH Human Resource Services – International Assignment Solutions

PWC EDGE

29PWC EDGE

Remuneration is crucial in sourcing foremployees. It is no secret that it is the peoplewho make or break an organisation, even in therealm of managing and improving systems andhardware. Attractive remuneration packages giveemployers an edge in the available pool ofsuitable employees. This does not necessarilymean that the cost to the company has toincrease correspondingly. Simply restructuringhow your company offers benefits to employeesand educating employees on how the benefitsstructured by your company actually reduces theirtax – thereby increasing their disposable income– may already reap you unexpected results.

Sometimes, certain benefits may also beperceived to be more appealing than outrighthigher cash remuneration.

Isn’t it time to take a closer look at the benefitsyou have been missing out? Time to relook atways of attracting employees who may potentiallyfurther grow your business?

Structuring the remuneration package

One of the personal tax minimisation strategies inSingapore lies in the structuring of theremuneration package. Generally, all cashremuneration is taxable in full. Certain fringebenefits, if properly structured, are givenfavourable tax treatment.

Fringe benefits that save you money

Do you know how you can enjoy tax-free fringebenefits? Here’s a quick run-through of suchpotential benefits.

• AccommodationHousing allowance provided to the employeeis taxable in full. Where the employerprovides housing accommodation to theemployee. The taxable benefit is the lower of10% of the employee’s total remuneration orrent on the unfurnished premises paid by theemployer, less the housing contribution paidby the employee. In most cases, 10% of thetotal remuneration works out to be the lowerfigure. Furniture and fittings provided by theemployer or landlord are taxed at nominalrates prescribed by the IRAS.

To enjoy this concession, the employer mustclearly state its intention to provideaccommodation to the employee, enter intothe tenancy agreement with the landlord andpay the rent directly to the landlord.

• Home leaveCash in lieu of home leave passage is taxable infull. However, where the employer pays forleave passage to home country, concessionarytax treatment is available – only 20% of the costof air-tickets paid by the employer for theemployee and his family members to go back totheir home country (limited to one trip foremployee and spouse and two trips perqualifying dependent child in a year) is taxable.Full tax remission for home leave passages isallowed if the employer enjoys certain taxincentive status (e.g. pioneer, OperationalHeadquarters status, etc) and the employee isinvolved in those activities. Costs of additionalhome leave passages, passages to otherdestinations, and other expenses incurredduring the eligible leave passage (e.g. hotel,meals, etc) are fully taxable.

The above concessionary treatment is notapplicable to Singaporeans and Singaporepermanent residents and where the tax incentivestatus is granted to the company after 1 January2004.

• CarInstead of paying the employee a car allowance,the employer may choose to provide acompany-owned car or a leased car (where thelease agreement is signed between theemployer and the leasing company). Under thisarrangement, the employee is taxed on thebenefit derived from the private use based onthe IRAS’ prescribed formulae. The taxablevalue to the employee depends on whether thecar is company-owned or leased, and whetherthe employer bears the cost of petrol, but isgenerally lower than the taxable value of a carallowance.

It is important to note that the employer cannotclaim any corporate tax deduction for expensesincurred on private plated cars, regardless ofwhether it is company-owned or leased.Although the above arrangement results in lowertax liability to the employee as compared toreceiving car allowance, it may result in a highercash outlay to the employer if the company ispaying tax at the full corporate tax rate since thelatter is tax deductible. CPF implications of carallowance versus car benefit should also betaken into consideration.

PWC EDGE30

• Club membershipWhere the employer provides a corporatemembership, the entrance fee paid by theemployer is not taxable on the employee. Onthe other hand, entrance fee paid by theemployer for an individual membership isgenerally taxable on the employee. Monthlysubscriptions paid by the employer whetherfor corporate or individual membership aretaxable on the employee only to the extentthat the employee uses the club facilities fornon-business purposes.

• Employer’s contributions to overseaspension fundEmployees usually prefer to remain on theirhome country pension scheme, if possible,during their assignment in Singapore.Employer’s contributions made in respect ofan employee to any provident or pension fund(including social security) constituted outsideSingapore are taxable on employees in theyear the contributions are made.

As a concession, mandatory contributions arenot taxable if certain conditions are met.Individuals who are tax residents and qualifyfor the Not Ordinarily Resident (NOR) status,may claim tax exemption on employer’scontributions to non-mandatory pension fund/social security, subject to limitations. TheNOR scheme applies to an individual who is atax resident in the current tax year but non-resident in the 3 preceding tax years.

• Stock options/ share awardsGains on stock options or share awardsarising from Singapore employment aretaxable. However, partial tax exemption onoption gains is available under theEntrepreneurial Equity-Based RemunerationScheme (EEBR) and Company EmployeeEquity-Based Remuneration Scheme(CEEBR).

Under the EEBR scheme, 50% of the optiongains, up to a cap of S$10 million over a10 year period is exempt, while the CEEBRexempts 100% of the first S$2,000 and 25%of the remainder, up to a cap of S$1 millionover a 10-year period.

Tax rules on stock option/ share award gainsare usually complex and an individual’s taxsituation can be influenced by changingpersonal circumstances, laws and regulations.

Individuals who move into or out of Singaporebetween the grant of their options and theirvesting and/or exercise could be taxable inseveral locations. Thus, it is important forindividuals to take particular care in assessingtheir tax requirements.

• Interest subsidy/interest-free loans

Where an employer provides an employeewith a loan, either interest-free or at a ratebelow that of the market rate, a benefit isderived by the employee and such deemedbenefit is taxable to the employee. However,as an administrative concession, suchbenefits would not be taxable to the individualif he does not have substantial shareholdingsor control or influence over the company. Thisconcession may be extended to a director,subject to meeting certain criteria.

Where an employer pays interest, in full or inpart, on loans obtained by the individual, suchbenefit does not fall within the scope of theabove administrative concession and is thustaxable.

• Education subsidy/scholarshipsGenerally, where the employer provides anemployee with an education subsidy/ scholar -ship, the IRAS may agree to a non-taxableposition if the training/course leads to anacquisition of knowledge or skills which arerelated to the employment, and/or theemployee concerned would be bonded to thecompany for a certain period of time.

• Long service awardAs an administrative concession, the IRASwill not tax non-cash awards if they have littleor no commercial value.

• Life insurance premiumsPremiums paid by an employer on aninsurance policy where the employee and/orhis nominee is the beneficiary, are taxable onthe employee. However, insurance premium(s)paid by the employer is exempt from tax if theemployer is the owner and beneficiary of thepolicy, even if it is intended that proceeds willbe given to the affected employee or theemployee’s family.

PWC EDGE 29

• Dental/medical, hospitalisation andsurgical benefits

Basic medical benefits (including dental)provided by the company to its employees arenot taxable for Singapore tax purposes byconcession.

• Free/subsidised food and drinks, andfree transport between pick-up pointsand the location of employmentWith effect from 1 January 2004, free orsubsidised food and drinks provided byemployers to employees (e.g. coffee/tea/snacks provided in the pantry, companysponsored meals etc) and free transportservices between pick-up points and thelocation of employment, will no longer betaxable for Singapore tax purposes byconcession.

Conclusion

It is clear that employers can reduce employees’tax costs significantly by judiciously providingcertain benefits-in-kind instead of cash, withoutincreasing costs to themselves. Employers reapthe benefits where as part of the remunerationpackage, they bear the employees’ taxes.Obviously other details such as the administrativecosts of delivering such benefits and corporatetax implications should also be given aptconsideration when assessing at the overall cost-benefits.

Jenny Goh can be contacted attel • (65) 6236 3638e-mail • jenny.goh@sg.pwc.com

Basic medical benefits

(including dental)

provided by the company to

its employees are not

taxable for Singapore tax

purposes by concession.

32 PWC EDGE

Illustration of tax benefits from tapping on benefits-in-kind

1Overseas allowance repackaged as:1) Housing accommodation of S$48,000 (S$4,000 x 12)2) Home leave passage of S$8,0003) Leased car charges of S$18,000 (S$1,500 x 12)4) Term club membership of S$5,0005) Employer’s contributions to overseas pension fund of S$10,0006) Dental and medical care of S$1,000

2 Lower of 10% of total remuneration or rent paid by employer = 10% (S$200,000 + S$50,000 + S$1,600 + S$7,714 + S$2,500) or S$48,0003 S$8,000 x 20%4 3/7 x (S$1,500 x 12)5 The individual qualifies for NOR status and enjoys full exemption on the employer’s contributions to overseas pension fund.6 Assuming that company is paying corporate tax rate @ 20%: S$340,000 x 80% (net of corporate tax deduction @ 20%)7 Due to non-deductibility of leased car charges: (S$340,000 – S$18,000) x 80% + S$18,0008 Assuming that employee is entitled to self relief of S$1,000, wife relief of S$2,000 and child relief of S$4,000

Base salary

Bonus

Overseas allowance

• Housing accommodationRent paid by employer on an unfurnishedapartment @ S$4,000/month x 12 = S$48,000

• Home leaveOne home leave passage for self @ S$8,000

• Leased carLeased car charges @ S$1,500/month x 12 =S$18,000, petrol borne by employee

• Club membershipTerm club membership @ S$5,000 per year,50% business usage

• Overseas pension fundEmployer’s contributions to home countryretirement plan @ S$10,000/year

• Dental and medical care@ S$1,000/year

Total

Cost to employer (net of tax deduction) S$275,6007

Tax payable by employee8 S$39,589

S$272,0006

S$49,860

Cost differential of S$3,600

Tax differential of S$10,271

}}Taxable income (S$)

With cashremuneration only

200,000

50,000

90,000

NA

NA

NA

NA

NA

NA

340,000

With benefits-in-kind

200,000

50,000

NA1

26,1812

1,6003

7,7144

2,500

05

0

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