accounting theory case 7.2

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Accounting Theory

CASE STUDY

Prepared by

Lutfiana Hermawati

023091076

Excellent Class Program

Faculty of Economy

Trisakti University

May 2012



Lutfiana Hermawati / Trisakti University

A c c o u n t i n g T h e o r y : C a s e S t u d y

Case 7.2

Intangible AssetConsider the following four valuation methodologies

1. Cost approach : the after tax cost which be incurred in reproducing the asset.

2. Market transaction : actual transaction value for identical or similar asset based on an arm’s

length market transaction.

3. Income method : excess earnings transaction value of future earnings generated by the

intangible asset net of a reasonable return on other assets contributing

to the stream of earnings.

4. Income method : relief from royalty approach the present value of the likely future

royalty stream which be earned from licensing out the intangible asset

to third party.

Which of the above approaches are appropriate for each intangible asset listed below?

Give the explanations.

a) Brands and Trade Marks

the most common general approaches to brand valuation is cost approach. The cost approach

method is based on the putative cost of creating the brand, for example the amount spent on

marketing and advertising it. It is considered to be the most conservative method in terms of the

value which results. Not surprisingly, it is sometimes deployed in trade mark cases, when the issue

of damages is at stake. When applied to an acquired brand, it will assume that the value of the

asset will decline from the time of acquisition. It has been argued that this fails to take account of

the fact that brand values may increase over time. Another commonly adopted approach is the

market value or comparables approach, which bases the value of the brand on what it might bring

in the open market. The obvious bench mark for such an approach would be to compare the brand

with other similar brands in the market which have been sold. Clearly problems would arise if there were no other brands available for comparison.

b) Patents

Patent valuations are needed for a variety of matters including to support the transfer of

ownership (licensing or assignment) of the business or patent, collateralized financing, financial

reporting and taxation matters. A valuation of patents may also be needed to support litigation

matters, such as quantifying patent infringement damages. The most common approach to

valuation of patents is the income approach. In this approach, an appraiser identifies the profit

attributed to a patent by calculating the premium pricing associated with the sale or the patented

products and/or the money savings associated with the use of the patent. Alternatively, anappraiser may examine the projected income stream derived from the royalties earned under

licensing. Or the appraiser may calculate the net present value of the income stream with the

patented technology and without, and then compare the two as another means of valuation. The

income based approach is perhaps the most commonly deployed method of brand valuation. This

approach is designed to arrive at the value that the brand produces in after tax income Its

attraction no doubt lies in the fact that it combines several different indicators of brand value.

These may include the relief from royalty measures, as well as market and cost based assumptions

of brand value.

c) Customer Contract



Lutfiana Hermawati / Trisakti University

A c c o u n t i n g T h e o r y : C a s e S t u d y

Income approach. Customer contract can refer to a base contract to share the terms and

conditions from the base contract. Income approaches are based around the concept that an

asset's worth is equal to the present value of the future returns the asset is expected to generate.

This involves forecasting the entity or asset's ability to generate cash and adjusting the future

income streams to today's value by discounting for risk. Successful businesses are skilled at

managing their customers profitably. After all, customers are the reason for the businesses'

existence.

d) Internally Generated Computer Software

One or a combination of three main approaches are normally used in order to calculate the market

value of software – the Income Approach, the Market Approach and the Cost Approach:

The Income Approach indicates the market value of the software based on the value of the

cash flows that the software might reasonably be expected to generate.

The Market Approach indicates the market value of the software based on a comparison of

the software to comparable software transactions in the market.

The Cost Approach indicates the market value of the software based on the concept of replacement cost. The premise of the Cost Approach is that a prudent investor would pay no

more for the software than the amount for which he could replace the software with a new

one having the same utility to the investor as the existing software.

The Market Approach is typically difficult to apply to software since rarely are transactions of

truly comparable assets readily available. In addition, the Cost Approach is inappropriate for most

software as it fails to capture expected returns on the asset. However, it may be appropriate for

certain software packages for internal use.

The Income Approach is the most common technique used to value software, because it both

captures expected future returns to the owner and it is able to estimate value for unique assets

when market transaction data is not available. Market data may often be obtained to estimate theincome stream that might reasonably be expected to be generated from a particular software asset.

Broadly speaking, there are two main categories into which the Income Approach can be

classified; namely, Direct and Indirect methods:

Direct Income Approach: the cash flows, or earnings, generated by a technology or brands,

or expenses saved through the ownership of the asset, are estimated directly by reference to

market benchmarks.

Indirect Income Approach: the value is estimated from the residual earnings after fair returns

on all other assets employed have been deducted from the business’s after -tax operating

earnings.

Our preferred approach, where possible, is to have primary reference to the relief from royalty

method (a Direct Income Approach) for software market value determinations. This method

measures the after-tax royalties or licence fees saved by owning the asset.

However, in other circumstances the multi-period excess earnings methodology, or another

valuation technique, may prove more appropriate, depending on the specific circumstances of the

case.

Key stages to a valuation employing the relief from royalty methodology are:

Isolating forecast sales that are associated with the software

Determining an appropriate arm’s length royalty rate, based on comparable market data

Cross-checking the affordability of the selected royalty rate

Determining an appropriate discount rate that reflects the risk of the software

accounting theory case 7.2

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