Recently there has been an increase in the categories of intangible assets being identified and claimed by companies as part of their strategies to minimize ad-valorem taxes.¹ Several of the items that are now being included for the first time on ad-valorem tax returns relate to identifiable intangible assets that can be increasingly difficult to appraise/value.

Identifiable intangible assets, such as engineering drawings, blueprints, technical documentation, lab notebooks, maps, operating manuals, computer software, databases, operating permits and other assets have to primarily rely on the asset/cost approach and methods to estimate their value. Such items are creating issues in the administrative and judicial property tax appeals process because they are not easy to value. Further, the estimated values that some valuation analysts determine are also making it difficult for the taxing authorities to understand from a logic standpoint.

Real Life Example

A good example of this conundrum is a case in which a valuation analyst determines the fair market value of engineering drawings to be approximately $300 thousand and the tangible assets that the drawings relate to have a comparable estimated value for the same purpose. That is like saying that if you buy a used car for $10 thousand you’re going to pay the owner another $10 thousand for the manual! There is something logically wrong with the conclusion of value in the used car analogy. Sure it might cost the car manufacturer $10 thousand to recreate the manual, but I doubt if the market would pay that asking price. This scenario can also be alluded to in the words of some notable valuation analysts — “In other words, value is not necessarily equal to cost, at least not to cost as measured in the historical accounting sense.”²

Why is it difficult for valuation analysts to estimate the value of these types of identifiable intangible assets — because many of these items do not allow for the use of all three commonly accepted approaches (the income, market and the asset/cost approaches) to determine the property valuation? The valuations of these subject intangible assets generally require the appraiser to estimate values³ using the asset/cost approach to determine their market value for the relevant taxing authority.

Cost Formula Approach

Left with having to rely on the asset/cost approach to value the aforementioned identifiable intangible assets, the CPA valuation analyst generally will follow the common cost formula⁴ to quantify the asset values:

Base:	Reproduction cost new
Less:	(Incurable functional and technological obsolescence)
Equals:	Replacement cost new
Less:	(External obsolescence, including location and economic obsolescence)
	(Curable functional and technological obsolescence)
Indicates:	Fair market value

For most valuation analysts, determining the base (reproduction cost new) won’t be overly difficult. The determination of obsolescence reductions (functional,⁵ technological and external) can become more complex. Many steps are necessary to develop a solid basis for the different categories of obsolescence. It can involve significant interview time with management, specialists or other representatives as well as the application of various analytical methods. In addition, it can mean that the valuation analyst has to comply with Statement on Standards of Valuation Services (“SSVS”) No. 1 and obtain and review enough information to fully understand the subject interest (the intangible asset) being valued.⁶

Okay, so you do all the developmental work and determine a value for the obsolescence — are you finished? That’s a nice try! It’s now time to consider sanity checks⁷ before you make your valuation conclusion. A couple of quick answers may be found in the following sanity checks.

The Total Enterprise Value (“TEV”)

If the valuation assignment(s) also valued the total enterprise value (a/k/a Total Business Enterprise Value or “BEV”)⁸ using the income approach, the valuation analyst may be able to unbundle the assets to analyze the amounts estimated for obsolescence (and the net indicated fair market value of the intangible assets).

For example, let’s suppose the estimated TEV of an entire industrial business was $4 billion. The value of the asset components have been reduced by everything except economic obsolescence. The value of the components yield:

• Net working capital, fair market value of $2.5 billion
• Tangible fixed assets (using the cost approach) before economic obsolescence has a fair market value of $1.5 billion (economic obsolescence is estimated at $600 million)  
• The intangible assets has a fair market value (using the cost approach) before economic obsolescence of $1 billion (economic obsolescence is estimated at $500 million)

The sum of the above asset values exceed the TEV by $1 billion ($2.5 billion for net working capital + $1.5 billion for tangible assets + $1 billion for intangible assets = $6 billion). Obviously, the sum of the parts exceeds the whole — the TEV of $5 billion as illustrated in Table 1 below.

The net working capital items generally are not subject to economic obsolescence (at least for this example). For sanity check purposes, the tangible assets and intangible assets can be looked at for their pre-economic obsolescence values. The sum of the tangible assets and the intangible assets (pre-economic obsolescence) equal $2.5 billion and for them to reconcile with the TEV one or both of them have to be reduced by $1 billion. The pro rata portion of the tangible assets is 60 percent and the intangible assets are 40 percent of the combined $2.5 billion value before economic obsolescence (see Table 2 below). This would indicate that the economic obsolescence for the tangible and intangible assets would be $600 million (60%) for the tangible assets and $400 million (40%) for the intangible assets.

Using the above analysis, the economic obsolescence for the tangible fixed assets is right on target. The estimate for the intangible assets is off by $100 million from the valuation analyst’s detailed results ($500 million detailed analysis v. $400 million sanity check = $100 million difference). These results may require the valuation analyst to reevaluate the detailed analyses of economic obsolescence on the intangible assets before making his/her conclusion of value.

Market Approach Indications

As part of the information that the valuation analyst gathers in performing his or her market transactions, he/she may be able to obtain pertinent qualitative information related to the identifiable intangible asset values. Let’s suppose the valuation analyst has seven to 10 comparables that indicate that the total fair values⁹ of intangible assets of the reported transactions were within six to 12 percent of the total purchase price (TEV). That would mean that the value of the intangible assets in the above scenario would range between $240 million (six percent of the TEV of $4 billion) to $480 million (12% of the TEV of $4 billion). The indicated value of the intangible assets after being reduced for detailed economic obsolescence analysis above was $500 million. That would be at the high end of the results from the market approach indicators. Thus, the market indications (sanity check) may also suggest that the valuation analyst re-evaluate the economic obsolescence analyses on the intangible assets before making his/her conclusion of value.

The sanity checks described above are just some of the valuation tools that a valuation analyst should consider when determining the obsolescence related to intangible assets. Sanity checks are rules of thumb and should never be used as the primary measure of value for intangible assets. However, sanity checks can be excellent tools for appraisers to use when determining, finalizing or testing credible conclusions of value. We suggest you consider them as part of your analyses in order to avoid hearing “That’s a nice try” from your client, attorneys or the trier of fact.

Note: This article was written in honor of Walker John Roby.

Robert P. Gray, CPA/ABV, CFE, FACFEI, has an extensive background in financial/accounting analyses, business valuation, economic damages, forensic investigation and litigation. He is a member of the AICPA’s Forensic & Litigation Services Committee, which provides professional guidance to CPAs who perform fraud investigations and determine economic damages.

-------------------------

¹ Identified intangible assets in many taxing jurisdictions can be excluded from ad-valorem taxes. Valuing a Business, The Analysis and Appraisal of Closely Held Companies, Fifth Edition, Shannon P. Pratt with Alina V. Niculita, 2008.

² Valuing Intangible Assets, Robert F. Reilly and Robert P. Schweihs, 1999.

³ “The most common basis for assessing real estate and personal property in the United States is market value. The market-derived property assessment basis is often referred to in state statutes, in judicial opinions, and in property tax literature by such terms as fair cash value, fair value, cash value, true value, true cost value, economic value, and other similar terminology. Notwithstanding these local statutory phrases, all these definitions have generally come to mean the most likely price at which a property will sell from a willing seller to a willing buyer, both cognizant of all pertinent facts and neither being under duress … Nonetheless, when either a cost approach or an income approach is used to value special purpose assessable property — because a lack of recent transactional data regarding such special purpose properties does not allow the effective use of the market approach — the objective of the analysis is still to estimate the market value of the subject property.” Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Fifth Edition, Shannon P. Pratt with Alina V. Niculita, 2008.

⁴ Ibid.

⁵ Includes allowances for incurable and curable functional obsolescence.

⁶ SSVS No. 1, Valuing a Business, Business Ownership Interest, Security, or Intangible Asset, American Institute of Certified Public Accountants (“AICPA”), Issued by the AICPA Consulting Services Executive Committee, “In analyzing the subject interest, the valuation analyst should consider nonfinancial and financial information. The type, availability, and significance of such information vary with the subject interest." Paragraph 26, 2007.

⁷ “Consequently, rules of thumb rarely, if ever, should be used without reference to other, more reliable valuation methods.” Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Fifth Edition, Shannon P. Pratt with Alina V. Niculita, 2008.

⁸ CPA valuation analyst may encounter situations where he or she is not the primary appraiser of the TEV but is only engaged to estimate the value of the intangible assets.  In these situations, if the identifiable intangible appraiser uses this sanity check, it is recommend that the valuation analyst sufficiently review the analyses of the TEV (income approach) and disclose such information appropriately in his or her report (including the assumptions and limiting conditions.

⁹ For financial reporting purposes only, the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Source: Financial Accounting Standards Board definition in Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, as used in the context of Generally Accepted Accounting Principals (GAAP).