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Ouch! A US$2.9 Billion Write-Off Tuesday 16 May 2017

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Impairment testing of capitalised intangibles assets is an important financial reporting requirement. Companies that have acquired high-risk, early-stage R&D programs can be particularly vulnerable to write-offs if the fair value of these assets drops below carrying value.

A recent example is Merck’s eye-watering US$2.9 billion write-off of a single clinical development program (for the hepatitis C drug uprifosbuvir). The new carrying value of this R&D program is a modest US$240 million.

While the size of this impairment is unusual, it highlights issues that are relevant to a wide variety of companies that either have intangible assets on their balance sheets, or those planning M&A.

What’s the impact of an asset impairment?

Merck’s bottom line is US$2.9 billion lighter as a result of the impairment. Net balance sheet assets have been reduced by a similar amount. Although the write-off has no cash flow impact, the damage to its income statement and balance sheet may be of concern to analysts and investors.

Big pharmaceutical companies have a portfolio of products and R&D projects, and are able to absorb impairment shocks. Small cap R&D companies that are reliant on a small number of development programs are far more vulnerable. Asset write downs often trigger investor concerns about management and the R&D pipeline - resulting in further dips in market capitalisation.

What are the implications for M&A planning?

Intangible assets - such a technology, brands and customer relationships – are pivotal to the success of most corporate transactions. Yet the metrics gauging the strength and value of intangibles are usually hopelessly inadequate. In transactions, meaningful assessment of intangible assets often falls through the gaps between commercial and legal due diligence. Although it is possible to rigorously assess the earnings potential and risk profile of early stage technology, this is seldom done. Why? Few due diligence providers have the integrated capability to evaluate the legal, functional and economic characteristics of this complex asset category.

What are the lessons for purchase price allocations and impairment reviews?

Although the hard work in asset evaluations should be done before an acquisition, the allocation of the purchase price to acquired assets has important tax and financial reporting implications.
Purchase price allocations are often carried out by business valuers without an appreciation of the intellectual property rights supporting intangible assets. This results in crude allocations of value to assets described as ‘brands’ or ‘technology’ which leads to lost tax amortisation opportunities.

In Australia, listed companies now have to disclose Key Audit Matters. Thus, the processes and assumptions used to test asset values will receive greater scrutiny. This increases the need to plan early, understand key impairment triggers and, where appropriate, consult valuers with a deep understanding of the asset category.

Any chance of recognising asset ‘enhancements’?

Unfortunately, changes in asset value are one-way traffic. Accounting standards don’t allow for increases in the value of intangible assets to be capitalised. Should the fair value of Merck’s uprifosbuvir program surge beyond US$240 million is future years, the increase will not be reflected on its balance sheet.

The general rule is that it is only acquired intangible assets (and some tech development costs) that can be capitalised. So the bulk of internally generated assets are not visible to users of financial reports. This explains the substantial gap between net balance sheet assets and enterprise value in stock markets around the world.

In Short: Better Visibility is a Good Thing

Understanding the value and risk profile of your intangible assets reduces the likelihood of stumbling over poor investment decisions.

To find out more about how our experts can help you with intangible asset valuations, visit our IP Economics Valuations page and contact one of our valuations experts.

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