Changes in accounting rules affect agency acquisitions
By Wayne A. Walkotten, CPA
In the summer of 2001, the Financial Accounting Standards Board (FASB) issued two statements regarding acquisitions and intangible assets that have confused many agency owners. Basically, these pronouncements did two things. The first, FASB 141, requires that all acquisitions be accounted for as an acquisition, which eliminated the previous option of accounting for the acquisition as a pooling of interests. The second, FASB 142, specified how companies must account for intangible assets. In the case of business acquisitions, intangible assets are created when the price paid is more than the book value of the company acquired. This article will discuss both of these topics, as they will impact any agency in the acquisition mode.
Most pooling transactions were insurance agencies acquired by public companies, typically national brokers or banks. Previous to FASB 141, pooling transactions allowed an acquirer to treat an acquisition for financial reporting purposes as if it had always been owned. In those cases, the balance sheets were simply combined and the acquirer did not record any intangible assets, such as goodwill.
With the elimination of the pooling method, all acquiring companies must utilize the purchase method of accounting. Under purchase accounting, the acquirer uses the residual method and records the assets purchased at fair market value; and any excess over fair market value is allocated to intangible assets. First, all liquid assets such as cash, marketable securities, and accounts receivable are valued at market value. Second, all tangible assets such as furniture, equipment, and computers are valued at their fair market values. Finally, the value of the amount paid for the acquisition that is in excess of the total of the fair market value is allocated to intangible assets and goodwill.
In the future, all companies, regardless of whether they previously used the purchase or pooling method of accounting, will be required to account for intangible assets in the same way. The purpose of FASB's 141 and 142 is to more accurately and consistently account for the value of assets purchased. Subsequent to the year of acquisition, the value of intangible assets must be assessed annually. Any material deterioration of the value of intangible assets must now be realized for financial statement purposes.
It is important to note that this discussion is related to the financial statement reporting of transactions and does not impact the tax accounting methodologies, past, present, or future. For tax purposes, except in the case of tax-free mergers or the purchase of the stock of another entity, all intangible assets continue to be amortized on a straight-line basis over 15 years. As such, do not be concerned that you will need to adjust tax returns--past, present, or future--as a result of this new rule.
Prior to the current focus on intangible assets and goodwill, businesses were required to value identifiable intangible assets under APB Opinion 17. Identifiable assets, other than goodwill, should have been amortized over lives not exceeding 40 years. Many small businesses that did not prepare financial statements, often did not worry about the allocation between expiration lists, goodwill, and other intangible assets. In addition, for simplicity, they may have used the same accounting for book and tax purposes. Technically, however, they should have allocated a purchase price under the residual method described above. Specifically identified assets often included covenants not to compete.
Prior financial statements could have reflected several different treatments. Under the new standards:
* If an intangible asset had been separately identified, but included in the same account as the goodwill, the identifiable intangible asset will have to be reclassified.
* If the useful lives do not agree with the lives determined under FASB 142, an adjustment should be made to the useful life and the financial statements restated.
* Many small businesses, even though they may have called it goodwill, books of business, or expiration lists, were using 15-year, straight-line amortization for book and tax purposes. Now, under FASB 142, identifiable intangible assets have been defined. In an insurance agency, the most common allocation is to the book of business purchased. Other possible allocations are to employment agreements, software and technology developed, and trade names.
Tax returns are not impacted by the changes in FASB 141 and 142, but the change in book treatment will undoubtedly create a difference between book and tax.
Prior financial statements should be restated and balances should be compared to the accounting guidance provided under FASB 141 and 142. The first step is to go back to the original accounting entries that were used to record the transaction. Compare your accounting to the following.
Process for valuing intangible assets:
1. Isolate the fair market value of tangible assets and marketable securities.
2. Identify intangible assets that are valued in the purchase agreement, including covenants not to compete.
3. Identify and value intangible assets that qualify for recognition apart from goodwill. In an insurance agency, the following items are likely to be included based on the guidance offered in paragraph A14 of FASB 141:
a. Book of Business or Customer Relationships--These relationships are based on the contractual relationship of the insurance policy between the agent, the insurance company, and the customer. Their value can be estimated using the factors of agency profitability, historical attrition, and inflation.
b. Employment Agreements--A contractual relationship with employees, that includes non-compete or non-piracy provisions, leads one to examine whether value should be assigned to the employment contracts of the producers of the agency.
i. Regardless of the presence of an employment contract, the agency loses the new business production of the departing producers. This producer talent may have a value. However, the existence of an employment agreement does not guarantee a flow of new business.
ii. A non-compete or non-piracy agreement protects the existing business of the agency. This protection impacts the attrition rate assumption on the existing book of business. The attrition rate reflects an agency protected from loss due to agents changing employers.
c. Trade Name--There are royalty calculations that can be done on the value of a trade name. However, in the situation of a seller taking on the name of the buyer after a short transition, there is likely to be limited value to the seller's trade name.
d. Technology and Software--Most agencies utilize software from one of the primary suppliers of agency management software. The original cost of the software has probably been amortized over a useful life. In the event that an agency has expensed the software or has developed proprietary software, there may be some value that should be assigned as an identifiable intangible asset.
e. Goodwill--The balance of the intangible value is assigned to goodwill. Goodwill is not amortized under the new pronouncements, but is subject to the impairment testing.
Impairment is an overstatement of the identifiable or goodwill values shown on a company's balance sheet, compared with their fair value. Impairment is an event or series of events after which the balances of identifiable intangible assets and goodwill are overstated. FASB 142 requires that a business test for impairment on an annual basis, as well as between annual tests if an event or circumstances change that more likely than not reduce the fair value of assets, below their carrying value.
Impairment testing is a two-step process. First, compare the fair value of a reporting unit to its carrying value. If the fair value of the reporting unit is less than its carrying value, the value of the intangible assets and goodwill is potentially impaired, and impairment is then measured.
Impairment is the amount that the reporting unit's intangible assets or goodwill carrying value exceeds the "implied" fair value of the goodwill or identifiable intangible assets. If impairment is suspected, it is calculated using an approach similar to the original valuation method.
Impairment losses recognized as a result of adopting the new provisions, this year, are reflected as an adjustment to the intangible asset balance and a cumulative effect of a change in accounting principle, with a related charge to retained earnings. Future impairment losses will be charged to operations as incurred.
Impairment between annual tests occurs when events significantly and negatively impact the agency. Those events could include the loss of an important market, resulting in attrition of business due to a lack of market for rolling the book; loss of a major producer, or group of producers, triggering a loss of business; or loss of a major account, or group of accounts, of the agency if they generated greater than 5%-10% of agency's business. These events do not mandate an impairment loss. They only should lead the agency to test for impairment.
This article is an attempt to simplify a complex topic. It is important that agencies active in the acquisition arena address these issues. In summary, an agency must:
* Value intangible assets
* Amortize them over the appropriate time periods
* Be aware of events that may impair the carrying value on their books, and
* Test annually for the impairment. *
The author
Wayne Walkotten is a vice president and senior consultant at Marsh-Berry & Company, where his focus is merger and acquisition activities involving insurance agencies, or bank acquisitions of insurance agencies. His agency management background includes merger and acquisition activities. His consulting activities include the valuation of insurance agencies and brokers, financial and operational management, business perpetuation and compensation planning. He is a certified public accountant and has a master's degree in management from Aquinas College.