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Original Article value, standards, and : ‘‘The Moribund Effect’’

Received (in revised form): 28th January 2017

Roger Sinclair (deceased) was a greatly admired and respected specialist in brand and accounting for . He was the designer of the globally recognized Brandmetrics valuation tool, which was bought in 2009 by Prophet Brand Strategy. In 2011, he was commissioned by the ANA to draft a set of principles for brand valuation in the USA. He earned his Ph.D. from the University of the Witwatersrand in Johannesburg, South Africa, where he was professor of for a decade.

Kevin Lane Keller is the E. B. Osborn Professor of Marketing at the Tuck School of at Dartmouth College. Keller’s academic resume includes degrees from Cornell, Duke, and Carnegie-Mellon Universities, award-winning research, and faculty positions at Berkeley, Stanford, and UNC. His textbook, Strategic Brand , in its 4th edition, has been adopted at top business schools and leading firms around the world and has been heralded as the ‘‘bible of branding.’’

ABSTRACT ‘‘TheMoribund Effect’’is defined as an accounting phenomenon by which the value of a brand that is acquired, measured, and added to the by a remains unchanged no matter how well the brand might perform for that company over time. We describe accounting conventions for brands in mergers and acquisitions and explain the role of brand value. Our main contention is that the subsequent performance and value of an acquired brand should be reported annually in the Management Dis- cussion and Analysis (MD&A) section of a company’s . If the intangible value of the acquired brand has declined, an explanation should be provided to financial markets as to why this occurred. If there is a gain in asset value, it should be announced and explained to those same financial markets. We also review methodological issues in making such calculations, putting some emphasis on understanding the intangible value from brands and versus customer-related relationships, and we underscore the importance of marketing in guiding and driving these disclosures. Journal of (2017). doi:10.1057/s41262-016-0025-1

Keywords: brand value; brand ; mergers and acquisitions; intangible asset value; accounting standards Correspondence: Kevin Lane Keller, Tuck School of Business, Dartmouth College, 100 Tuck Hall, Hanover, NH 03755, USA. E-mail: [email protected]

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management

www.palgrave.com/journals Sinclair and Keller

INTRODUCTION for a full explanation of the relevant During 2015, a record US$3.8 trillion accounting standards). worth of mergers and acquisitions occurred One particular set of standards, which (Baigorri, 2016). The largest completed deals with business combinations or mergers deal was Pfizer Inc. and Allergan Plc’s and acquisitions, contains a requirement blockbuster US$160 billion deal. Two regarding the accounting treatment of other noteworthy deals announced that acquired and intangible that year were the proposed by AB have the potential to suppress important InBev of SABMiller for US$106 billion information that should know. and ’s merger with data storage com- We call this phenomenon, where the value pany EMC for US$67 billion. It would of acquired brands is unchanged for seem that the growth of mergers and accounting purposes and remains at their acquisitions is set to continue. transaction measurement over time, ‘‘The Mergers and acquisitions have a number Moribund Effect.’’ of business implications for marketing, In this article, we will explain how it strategy, finance, -- and came about, its effect on the company’s virtually all areas of business. Our interest is market value, and how it can be seen as in the implications of mergers and acquisi- conflicting in spirit with the Efficient tions for accounting, and from an account- Market Hypothesis and the manner by ing standards perspective in particular. which information is absorbed by financial Accounting standards play a vital role in markets. We will explain how this apparent allowing investors and providers of to conflict deprives users of the annual understand the financial workings of these or financial reports of information they should any other . The canon of stan- have if the price of a company’s is to dards, of which there are many, guide those be fully priced. We finish by proposing who prepare financial statements in what to how the Moribund Effect can best be dealt say and how to say it (see www.fasb.org and with, emphasizing how marketing can play www.iasb.org). In particular, they provide a key role to bring this change about. guidance as to how financial accounts should be organized and presented. Many of these deals will have been carried BACKGROUND out by companies that are subject to the In the late 1990s, both the FASB in the accounting standards issued by the Financial USA and the IASC (it was a committee at Accounting Standards Board (FASB) in the that stage and only became a board in USA and the International Accounting 2001) for the rest of the world issued Standards Board (IASB) elsewhere in the accounting standards dealing with intangi- world. Specifically, the acquiring company ble assets. The FASB standard was SFAS will be required to comply with the appro- 142 Intangible Assets; the IASC standard was priate accounting standards that deal with IAS 38 Intangible Assets. These standards business combinations and the impairment prevail to this day. of assets. The FASB version is Accounting The standards contain a line which is Standards Codification (ASC) 805 Business unambiguous about how internally gener- Combinations issued in 2001, and the IASB ated brands should be treated in annual version is International Financial Reporting financial reports: Standards (IFRS) 3 Business Combination Expenditure on internally generated issued in 2005 (see Sinclair and Keller (2014) brands … cannot be distinguished from

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Brand value, accounting standards, and mergers and acquisitions

the cost of developing the business as a feasibility of adding brands to the balance whole. Therefore, such items are not sheet. The commission was headed by recognized as intangible assets. (see Sin- Patrick Barwise, a marketing professor clair and Keller, 2014, p. 288) from the London Business School (LBS). To understand what happened to bring this After 3 months of deliberation, the Barwise state of affairs about, it is useful to trace the Commission concluded that the account- relevant history of brand accounting. ing profession was right and that ‘‘brand In 1989, the Accounting Standards valuation was contradictory to the Committee of the Institute of Chartered accounting framework’’ (Sinclair, 2002). As of England and Wales issued a result, in most jurisdictions, brands could an unprecedented instruction to its mem- no longer be considered to be assets under bers to ‘‘cease and desist’’ the practice of conditions of acquisition or internal valuing brands and adding them to the development. assets in the balance sheet. This instruction was confirmed the following year in an Exposure Draft (ED) titled Accounting for FOUR KEY QUESTIONS Goodwill (Power, 1990). Over the 10 years of the IFRS standard and This practice of valuing brands and add- the 14 years of the FASB standard, many ing them to the assets in the balance sheet thousands (perhaps hundreds of thousands) arose during the 1980s when there was a of mergers and acquisitions transactions spate of high-value of companies have taken place. By extension, there that owned brands. The accounting con- would have been innumerable intangible vention at the time was to apply the assets recorded in balance sheets in terms of acquired goodwill to shareholder equity these standards. and thus make it vanish. But, when one Four key brand-related questions arise in company made a bid for another at a price considering the accounting implications of that would have all but decimated share- these mergers and acquisitions transactions: holder wealth, the CEO took a different route. He asked his graphic design com- 1. Purchase price What propor- pany, Interbrand, if it could create a model tion of the purchase price is a pre- to value brands. mium in excess of the net asset value John Murphy, founder of Interbrand, of the company? The net asset value said he could, and he then assembled a team of a company can be defined as the to turn the promise to reality. The original fair-market value of its total assets Interbrand brand valuation methodology minus its total liabilities. was used to value the brands that were to be 2. Intangibles and goodwill allocation How acquired, and instead of deducting the value much of the premium arising from from shareholder equity, the new assets the Purchase Price Allocation and were added to the balance sheet. Thus, Post-Purchase Price Allocation dif- shareholder equity was preserved, and the ference, as required by the business value of the company reflected the acqui- combination standards, is allocated to sition of a new set of assets. intangibles assets and goodwill? The This new practice did not sit well with standards leave no doubt as to what the accounting leadership who, having intangibles might be identified and issued their order to cease and desist, measured. Goodwill is what remains established a commission to examine the of the premium paid once the

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Sinclair and Keller

intangibles have been identified and identified, and we are able to use these measured. insights to help answer, at least in part, our 3. Nature of intangibles The standards list four questions. over 60 intangibles that might com- prise the premium. In reality, only two or three intangibles are typically Purchase price premium selected. What are these intangibles, For more than 10 years, the studies suggest and what is the relative importance that the portion of the purchase price allo- of each? cated to goodwill and intangibles is regu- 4. Lifetime of assets The standards require larly over 50 per cent and often exceeds 70 the preparers of annual financial per cent. Recent examples indicate that this statements to determine whether the trend is set to continue. AB InBevs initially useful life of the acquired intangible offered a price of US$106 billion for SAB asset is finite or the opposite, which Miller plc, which had net assets of in the language of the standard setters US$19.95 billion at the time. The premium is indefinite, not infinite. As is being offered to acquire the business was explained in greater detail below, therefore approximately US$86 billion (81 finite lifetime of assets implies there is per cent). In February 2015, a finite duration for which it will bought WhatsApp for US$19 billion. provide economic benefits; indefi- According to a later filing by Facebook nite lifetime of assets implies that the with the SEC, the acquired company had exact duration cannot be determined only US$45 million in assets at the end of at the time of the transaction. What 2013, so that the purchase price was close to is the balance between these two 100 per cent intangible. Dell’s initial offer lifetimes, and how is it determined if to buy EMC was for a reported US$67 the intangible has a finite or indefi- billion. The balance sheet value of EMC’s nite useful life? net assets at the time was US$21.9. The premium would therefore have been Because of the large numbers of transac- US$45.1 (67.3 per cent). tions that have been concluded since the Summary In general, studies find that the business combinations standards were portion of the premium initially allocated issued (FASB: 2001; IFRS: 2005), there is to goodwill and intangibles is regularly over no complete database that would allow a 50 per cent and often exceeds 70 per cent comprehensive, conclusive answer to these or more. four questions. Several companies have sampled balance sheets, however, and one firm has even established a database of over Intangibles and goodwill allocation 7500 valuations extracted from In terms of the business combination post-transaction balance sheets. To provide standards, the acquiring company must some indication of what the answers to the identify the intangible assets that were four questions posed above might be, we bought. These are measured after the highlight some of the findings of the most transaction is completed and listed on the prominent of these surveys (summarized in balance sheet as intangible assets. The bal- Table 1). ance of the premium paid for the company While the data in Table 1 allow nothing is listed as goodwill. From Table 1, a clear more than generalized conclusions, some picture emerges as to what the breakdown important trends and patterns can be is between intangibles and goodwill. A

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Brand value, accounting standards, and mergers and acquisitions

Table 1: Summary of some M&A analyses by select

Source Data Key findings

Houlihan Lokey (2013) USA M&A only; sample of 511 companies Average to intangibles = 34% (31%) Average to goodwill = 38% (39%) Total intangible premium = 70% of purchase price Ratio of trademarks with indefinite to finite useful lives = 23:77% Main intangibles: customer-related assets, trademarks, and developed technology Ernst and Young (2009) Global M&A activity for 2007 covering Total premium as percent of purchase 709 transactions price = 70% 47% = goodwill 23% = identified intangibles Customer-related assets = 44% Brands and trademarks = 31% KPMG (2010) Analysis of M&A in previous year (2008) Allocation of purchase price to goodwill exceeds 50% European Securities and Markets A sample of 56 EU issuers of IFRS 3 The allocation to goodwill was 54% Authority (ESMA) (European compliant financial statements No figure for intangibles Securities and Market Authority, 58% of sample that had allocated to 2014) specific intangibles identified customer- related intangible assets In 54% of cases the identified intangible was brand Markables (2015) Based on a database of more than 7500 The database shows that in exactly 50% files of purchase price allocation of cases, intangible assets are allocated information from M&A activity from an indefinite life and the other half are 2003 to 2015 allocated finite lives scrutiny of balance sheets of companies Summary The European Securities and which have undergone this process con- Markets Authority (ESMA) sample found firms that goodwill tends to be the larger of that in 54 per cent of cases, brands were the two numbers. identified as intangible assets and measured. Summary The study findings imply that Customer-related intangibles were higher as much as half of the acquired goodwill is at 58 per cent. Between them, these two typically allocated to identified intangibles, represent roughly half of the initially allo- as described in more detail below. The cated goodwill and intangibles. The other balance remains as goodwill. half remains goodwill.

Nature of intangibles Lifetime of assets A consistent conclusion from the various A major feature of the business combination analyses is that two intangibles -- from a list standards is the need to specify the useful life of over 60 possibilities set out in the stan- of intangibles included in the transaction. dard -- are most frequently identified and The useful life can be either finite (i.e., it has a included: (1) Customer-related relation- finite duration after which it will no longer ships and (2) trademarks or brands. Tech- produce the economic benefits that were nology is the next most frequently selected generated at the time of the purchase) or intangible, but it is far behind the two not. Intangibles with finite lives are amor- leaders (Bahadir et al, 2008). tized over their remaining lifetime.

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Sinclair and Keller

The opposite of finite (in accounting Acquired brands with finite lives are language) is not infinite; it is indefinite. This amortized over the remaining number of distinction makes it clear that brands, for years. Brands with indefinite lives are example, are unlikely to live forever, but added to the assets in the balance sheet, the duration of their remaining useful life is against the intangible asset line item label. not known at the time of the transaction. They are not amortized, but tested each Intangibles that are given indefinite lives year for impairment. are measured at the time of the transaction, If the asset is impaired -- the new valu- and the value is added to the assets in the ation is less than the carrying amount -- the balance sheet as trademarks (brands) with impairment loss is transferred to the income indefinite lives. The asset is re-measured statement as an . Goodwill, which each year as a test for impairment. It is not is the difference between the premium paid amortized and could be carried on the in the transaction and the sum of the balance sheet for many years. intangible assets, is treated as an asset, and it Summary In this case, the survey results too is tested annually for impairment. The are conflicting, with the Markables data- consequences of impairment are resisted by base indicating that the split is 50/50 but companies because the loss is transferred to saying the split is 23--77 the , thus increasing per cent in favor of finite. The Markables and reducing profit. sample (7500) is far bigger and might There is no allowance in the standard for therefore be more reliable. Regardless, the the opposite of impairment which is findings suggest that at least half, and pos- accretion (or gain in value). In business sibly more, are allocated a finite useful life. combination accounting, gains in value are not acknowledged. This practice arises in part from historic reason and the fact that IMPAIRMENT AND ACCRETION the value of assets used to be almost To summarize, from a brand point of view, exclusively tangible and would be stated at the accounting implications for mergers their cost. They were then depreciated and acquisitions were (and remain) clear over time in order to reflect their gradual and, for marketing, extremely important. consumption. When a merger or acquisition takes place Some assets were carried in the accounts, and a premium over net asset value is paid, and the principle that most assets depreciate the premium may no longer be fully allo- in value over time continued. Hence, each cated to goodwill. The acquiring company year the value of assets was tested and if the has to examine the purchase price and value was less than the carrying amount, a allocate the premium to identifiable loss was charged to the income statement. intangible assets. Typically, these have been To add accretion to this annual test would customer-related intangible assets, such as introduce complex decisions about how customer relationships and brands (see the gain should be treated. Reading the Table 1). opinions of the standard setters and those Once identified, these intangibles must who use them, there was no interest in be assigned either finite or indefinite useful attempting this change. lives. In the table above, we show that the The valuation of the acquired asset is proportion of each can vary from 23 to 50 carried on the balance sheet until it is dis- per cent in favor of a finite life. The dis- posed of or fully impaired. This prospect, tinction determines how the acquired assets full impairment and the subsequent hit to will be treated in the financial accounts: the company’s profits, might explain why

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Brand value, accounting standards, and mergers and acquisitions

some companies are shifting their identifi- more emphasis on the ‘‘back end’’ of mar- cation and measurement of acquired keting programs and the realized value of intangibles from brands to customer rela- marketing activities to reinforce and capi- tionships (see for example Binder and talize on loyalty of the existing customer Hanssens, 2015). The marketing function base. can play a valuable role with another major Nevertheless, the two concepts theoret- accounting decision that also needs to be ically go hand-in-hand: Customers need made with mergers and acquisition -- when and value brands; but a brand ultimately is to classify acquired intangibles as - only as good as the customers it attracts. As marks or brands (TB) versus customer-re- evidence of this duality, consider the role lated relationships (CRR). Consequently, of the retailer as ‘‘middleman’’ between it is helpful to provide some perspectives as firms and consumers. Retailers clearly to how value arising from brands versus recognize the importance of both brands from customer relationships is related and customers. A retailer chooses to sell (Keller, 1993, 2013). those brands that are the best ‘‘bait’’ for those customers it wants to attract. Retailers essentially assemble brand port- Brand and customer relationships folios to establish a profitable customer in theory portfolio. Manufacturers make similar There is no question that the intangible decisions, developing brand portfolios and asset value created by customer-related hierarchies to maximize their customer relationships versus by trademarks or brands franchises. is related. In theory, both concepts can be Effective brand management is critical, expanded to incorporate the other point of and despite the growing interest in cus- view, and they are clearly inextricably tomer relationship management, it would linked. Customers drive the success of be a mistake to ignore its important role in brands, but brands are the necessary developing -term profit streams for touchpoint that firms have to connect with firms (Madden et al, 2006). Some market- their customers (Fournier, 1998; Moor- ing observers have perhaps minimized the house, 1990). Many of the actions that will challenge and value of strong brands to increase brand value will increase the value overly emphasize the customer relationship of customer relationships and vice versa perspective, for example, maintaining that (Keller and Lehmann, 2003; Srivastava et al, ‘‘our attitude should be that brands come 1998; Epstein and Westbrook, 2001). The and go -- but customers must remain’’ two concepts are highly related and in (Rust et al, 2004). Yet, that statement can many ways, ‘‘two sides of the same coin.’’ easily be taken to the logical, but opposite, Yet, in practice, CRR value and TB value conclusion: ‘‘Through the years, customers are often complementary notions in that may come and go, but strong brands will marketers focusing on one or the other can endure.’’ tend to emphasize different considerations. Perhaps the main point is that both are Marketers focusing on creating brand value really crucial, and the two perspectives can tend to put more emphasis on the ‘‘front help to improve the marketing success of a end’’ of marketing programs and intangible firm and may both be crucial intangible value potentially created by marketing pro- assets to identify and measure as a part of a grams to attract customers and increase their merger or acquisition. One important dis- loyalty; marketers focused on creating value tinction between the two is that CRR through customer relationships tend to put focuses on existing customers, while TB

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Sinclair and Keller

additionally accounts for future yet-to-be- For example, it has been speculated that acquired customers. Moreover, there would now that the AB InBev acquisition of seem to be some situations where the value SABMiller has been finalized, the new from customer relationships may be a more company may have already selected its next important intangible asset than the value target: The Coca-Cola Company. If such a from brands. deal were to occur, the post-transaction For example, one could make the case that value that would be included on the bal- CRR may often be more important than TB ance sheet for the Coca-Cola brand could for service companies than for product be in the region of US$83 billion. That companies, especially in the era of ‘‘bigdata.’’ number is the average assigned to the brand With service companies, such as firms by both Interbrand (81.5) and Millward offering financial, legal, and accounting Brown (83.8) in their respective 2015 lists services, much relationship management of valuable brands. occurs and a robust and healthy customer Had the Coca-Cola Company been franchise and well-populated database may bought 10 years ago (2005), at the time be critical. Similarly, CRR may also be more that Proctor and Gamble (P&G) bought important than TB for more mature or the Gillette Company, the brand would established where much has been have been entered on the balance sheet at a learned about customers and when they value of US$54.5 (again, the average of the have developed strong ties directly to the values assigned by Interbrand (67.5) and company. In that regard, CRR may be more Millward Brown (41.4) in their respective important than TB in any situation where 2005 lists of valuable brands). Over barriers to exit exist for customers and where 10 years, these brand values for Coca-Cola an entrenched customer franchise is a huge show a gain in value of US$28.2 billion. asset. That is a very significant addition to shareholder wealth, and although the addition of the Gillette brand may have led Brand and customer relationships to greater profits for the company during in practice this time, the business combination stan- The value created by brands and customer dards do not allow the underlying accretion relationships is thus closely intertwined, in brand value to be shown in the accounts. especially when it comes to famous brands. In Table 2, we provide a second example If SABMiller had not spent over 100 years based on the purchase of the Gillette building a famous portfolio of beer brands, Company by P&G in 2005. As Table 2 it would not today have built such a loyal shows, the brand was valued at the time at and profitable customer franchise and US$24 billion. It has been carried in the would not have been the target of a P&G balance sheet since then at that value. US$106 billion takeover bid by AB InBev. The number ($24 billion) has not been as Some of its lesser brands will eventually be consistent as this implies due to other discarded, no doubt, but brand leaders in acquisitions and divestitures and possible many markets will continue to provide the modifications to the Gillette brand portfolio new owners with abundant brand-gener- over the period. However, a careful reading ated flows. We argue therefore that of the notes to the accounts implies that powerful brands still exist, and while their Gillette remained the dominant unit within importance relative to customer relation- the section: ‘‘Brands with indefinite lives’’ at ships can be explored and even re-aligned, about $24 billion. During this period, the they will remain powerful and strong. world economy suffered weak economic

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Brand value, accounting standards, and mergers and acquisitions

Table 2: Illustrative example of the moribund effect in action: P&G purchase of the Gillette Company in 2005 (2005--2015) (numbers are in US$ billions)

Years 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

P&G market capitalization 190.4 202.8 226 181.2 176.1 180.2 183.7 185.5 220.7 218 185.6 Gillette brand value in 2005 24 24 24 24 24 24 24 24 24 24 24 (carried on balance sheet at transaction value as per accounting standard) Carrying amount as % of 12.6% 11.8% 10.6% 13.2% 13.6% 13.3% 13.1% 12.9% 10.9% 11.0% 12.9% Market Capitalization Nominal brand value gain of 24 24.48 24.97 25.47 25.98 26.50 27.03 27.57 28.12 28.68 29.26 2% per annum since 2005 Carrying amount grown 12.6% 12.1% 11.0% 14.1% 14.8% 14.7% 14.7% 14.9% 12.7% 13.2% 15.8% annually at 2% as % of Market Capitalization growth and the 2008/2009 financial crisis. of dying,’’ the sense in which we use the Thus, the illustration is less dramatic than it word. The accounting standard would might have been otherwise. require that the post-transaction value be Nevertheless, we cannot believe that the carried on the balance sheet and tested historically successful marketing skills of the annually for impairment. As a result, in P&G Company would have not resulted in 2015, the value of the Coca-Cola brand some degree of growth for the famous would still be the 2005 value of US$54.5 Gillette brand. Even at a nominal growth billion. rate of 2 per cent per annum, the gradual The Moribund Effect reflects the fact divergence between the percent of market that brand value remains unchanged, giving capitalization represented by the brand can the impression to those who use annual be seen. At that growth rate, the brand financial reports that acquired brands, once would have been worth $29.3 billion by bought, are in effect placed on a shelf and the end of 2015. But, more significant is ignored. They do not grow in absolute the absolute brand value difference of terms or in relationship to the performance US$5.6 billion between actual brand value of the company. If the company grows assuming a nominal growth rate of $29.3 over time, because the value of these and the recorded brand value of $24 bil- acquired brands remains at their transaction lion. Because this growth (accretion) is not measurement, their relative weight or reported in the accounts, this information is percentage of the marketing capitalization not communicated to the investment of the firm actually decreases. community, inaccurately implying an This vivid loss of weight underscores the inactive brand. use of the term ‘‘moribund.’’ Logic would suggest that they should, at least, move in step with the company growth rate. In THE MORIBUND EFFECT some cases even, where successful market- These two examples and the principles they ing has lifted brand and profit illustrate are instructive, and we have above the historic trend, they should grow coined the term, the ‘‘Moribund Effect,’’ to faster than the company. All of these pos- describe this strange phenomenon. sibilities are ignored because of the way the According to Miriam Webster Collegiate business combination standards are worded. Dictionary, moribund can mean, ‘‘in a state Value ignored is value lost.

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Sinclair and Keller

In large, highly successful companies methodologies: cost, market, and income. such as P&G, PepsiCo, AB Inbev, Mon- The first two are often discarded because: delez, Vodafone, IBM, Unilever, and many (a) the task of researching the historic costs more that do acquire brands, the brands associated with a brand, especially one that they buy will be placed under the care which might be decades old, is simply too of a marketing team whose task will be to daunting; (b) there are no markets for learn about the new brand and ensure that brands and therefore no comparable the brand continues to at least generate cash transactions that can be used as a proxy for flows as it did for the previous owner, if value. The income valuation approach, not reach even higher levels of growth. which is based on the time value of There are very rare exceptions when a money, is most frequently used, and the company might buy a competitor to specific technique most normally remove it from the marketplace, but in the employed is called the Relief from Roy- vast majority of cases, the objective for the alty method (e.g., see PWC, 2013;Grant firm will be to use the new acquisition to Thornton, 2013;IVSC,2011). improve category and as an The notion behind this methodology is additional source of . that a royalty would have to be paid to the We would argue that when this is the owner of the trademark if it were owned by case, the users of the annual financial a third party. Since the trademark is owned accounts would want to know how suc- by the company conducting the valuation, cessful the company has been in maximiz- the value is the present value of the royalties ing the financial return of this acquisition that are saved through , i.e., the and leveraging the value of this brand asset. royalties the owner is relieved from paying. As it is, all they would have available to See Table 3 for a sample calculation. make that determination would be the In addition to being simple (as the balance sheet and the static number sitting example in Table 3 illustrates), it has the there, unaffected by events around it, in a virtue of requiring few inputs: gross rev- state of apparent moribundity. In these enues, a rate of growth, the royalty rate and companies, the Management Discussion a discount rate. Yet, from the marketing and Analysis (MD&A) part of the annual point of view, the Relief from Royalty report has sections devoted to the activities method is inadequate because it has no and efforts of the marketing function. brand strength input. It does not take Brand segments and sometimes specific account of an often critical source of brand brands are discussed. Depending on the cash flows: the customers. Nor does it stance taken by the company in any one incorporate the contribution of other year, these may or might not provide stakeholders of the brand, an especially insights into how the acquired brands have important consideration, for example, with performed (as suggested in Gregory and corporate brands. Moore, 2013). Its common use by many companies and its ubiquitous appearance in post-transac- tion financial reports, however, makes it A POSSIBLE SOLUTION impossible to ignore. It is, at this stage, the How might the changing and often de facto method of valuing acquired brands. increasing value of these acquired brands Given its practical importance, we suggest be measured? Three categories of valua- the following modifications to make it tion procedure are usually mentioned more suitable for use as a marketing when discussing possible measurement measurement:

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Brand value, accounting standards, and mergers and acquisitions

Table 3: Simple example of Relief from Royalty

y1 y2 y3 y4 y5 y6

Sales 100,000 105,000 110,250 115,763 121,551 127,628 Royalty rate = 4% 4,000 4,200 4,410 4,631 4,862 5,105 Less @ 40% 2,400 2,520 2,646 2,778 2,917 3,063 Present value Y1-- Y5 10,511 Discount factor 0.627 Annuity () 24,007 1921 Brand value 34,518

In addition to a royalty rate of 4% and a tax rate of 40%, Table 3 assumes a growth rate of 5% per annum and a discount rate of 8%. The brand value in this table, using the Relief from Royalty method, is calculated by first calculating the present value of the after-tax royalty proceeds of years 1--5, using the 8% discount rate, and then adding the annuity or terminal value of the year 6 discounted proceeds in perpetuity.

• The standard setters warn against fore- Relief from Royalty, a gain will occur casting long periods such as 10 years due through a lowered discount rate or an to the inherent risks involved in such increase in revenue. If it is the latter, a shift long projections. A 5- or maximum in revenue growth above the trend will 7-year projection is recommended. likely be the result of . • It is clear from the example in Table 3 Our contention is that the marketing that the terminal value (dividing the function could make a valuable contribu- discount rate into the nth year after tion by adding a section in the MD&A part allowing for the discount factor) adds too of the annual report with a measurement large a number to the valuation. This is update to reflect any accretion and a sum- an infinite value; not indefinite. To mary of the marketing strategy of the past replace the infinite life approach with year which was deemed as leading to the one more suitable for business combi- increase in value. The actual measurement nation post-transaction accounting, we could follow the guidelines proposed by propose that the step down approach, this section. described in ‘‘Appendix,’’ be used. Besides providing informational value • A value that conformed to these externally to the investment and financial requirements could be updated each year communities, a disclosure of this kind would by inserting the actual number in year also help to validate the importance of the one and changing the growth rate for the marketing function internally within the subsequent years to whatever macro- (Germann, 2015; Whitler et al, and microeconomic circumstances at the 2015). Ensuring that marketing leadership time suggest. Thus, a moving annual has a ‘‘seat at the table’’ for top management valuation can be produced to show how decision making has been an important the brand has performed. concern and priority for many top marketing As we have noted, measurement of strategists (Rao, 2012; Welch, 2013). acquired intangible assets is conducted In assembling this section, management annually for the impairment test. The would also want to recognize the contri- accountants’ only interest is in impairment bution of other non-marketing areas of the of value. They are not required to measure business that might have led to enhanced gain in value, nor recognize it anywhere in brand value, e.g., new technologies or new the accounts. If the asset is being measured, licenses. Although challenging, identifying then the result will be either a gain or a all the drivers behind the cash flows loss. With a simple procedure such as attributed to a brand would ultimately

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Sinclair and Keller

provide the most complete and diagnostic value ascribed to the acquired brand in the view of brand performance and value. balance sheet at its transaction value. In the examples for Gillette and Coca-Cola above, however, we have shown that CONTRIBUTING TO AN EFFICIENT investors might be deprived of information MARKET critical to placing an accurate value on the There is also solid economic grounding for company. the proposal to recognize accretion as We are suggesting that this omission much as impairment. The importance of should be overcome and that, accepting this (missing) information is implicit in the that the standard setters are unlikely to idea introduced in the 1960s by Chicago allow for accretion, the work of marketing University professor and Nobel in supporting acquired brands with the award winner Eugene Fama (Fama 1970). same vigor and expertise they apply to the The Efficient Market Hypothesis (EMH) company’s own brands, should be reported affirms the efficiency of financial markets annually in the MD&A part of the annual by maintaining that stock prices are set at report. If the asset is impaired, marketing their current level because markets are in will need to explain why this occurred. If possession of all available knowledge and there is a gain in value, it should be information about the stock. As new announced to the financial markets which, information becomes available, all market in keeping with the strong EMH, will participants become aware of it, and the incorporate the added value into the stock price will immediately absorb the new price as it becomes known. information, i.e., markets are ‘‘informa- tionally efficient.’’ In the 1970s and 1980s, there was con- troversy about the EMH which resulted in SUMMARY AND CONCLUSION the definition of three phases or levels: We conclude by offering some perspectives and conclusions to our analysis. When we • The weak level Stock prices incorporate wrote our initial paper on the financial historic information about the company. interplay of branding and accounting (Sin- • The semi-strong level Market participants clair and Keller, 2014), we covered two dis- add current information from financial tinct -- but related -- accounting anomalies: journals, newspapers, and press releases that change the value of the stock. All • The main thrust of the paper was to participants have access to the same encourage the accounting standard set- information and the price response is ters to review the omission that brands immediate. which are acquired are identified as • The strong level Market participants are assets, but brands which are internally able to gain information that might be generated are not. considered private or inside information. • We also drew attention to the business There is clearly a fine line between what combination requirement that acquired this private information is and what brands are measured at their transaction might be considered insider trading -- a value and tested annually for impair- criminal offense. ment. There is no recognition of the opposite; a gain in value or accretion. Under normal circumstances, investors We have since given this phenomenon a and lenders would know only about the name: ‘‘The Moribund Effect.’’ This is the

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management Brand value, accounting standards, and mergers and acquisitions

phenomenon under which, no matter how ask that company management be more a company performs over time, the value of forthcoming in their MD&A section in the brand that was acquired, measured, and their annual reports by providing more added to the balance sheet remains information of material importance to unchanged. It is carried at its transaction decision making (Securities and value. Any relationship it might have to Exchange Commission, 2003). enterprise wealth (e.g., as a contributor to Accounting standard setters recognize the the market premium), or any gain in function and value of accounting to ‘‘use the absolute terms, is hidden from view. language and algebra of valuation to convey This has special implications for investors information’’ (Christensen and Demski, and lenders (identified by the standard 2003, p. 121), but they must make decisions setters as the main users of annual financial as which information they wish for compa- statements) and for the marketing function, nies to convey. Here, their might be whose governance of the acquired brand or that accounting systems were never intended brands, could appear deficient. The first to record every event that could affect the group is not provided with full and proper market value of the firm as an asset. Their information about the assets within the position might also be that brand value is no company that drive cash flows and growth; different than R&D findings, human , any successes the marketing function has etc., in that they are part of the economic achieved in further building the acquired value of the firm, but not the book value of brands are ignored. the firm. They believe that many events fail Our view is that companies should adopt the test of recognition -- whether an event the strong version of the Efficient Market can be measured with sufficient reliability to Hypothesis and, voluntarily, publish a sec- inclusion (Christensen and Demski, tion in the MD&A of the annual report in 2003, pp. 304--305). which the performance of acquired brands is In other words, accounting standard setters tracked to show accretion as well as maintain that accountants have a comparative impairment. Our examples earlier are advantage in recording certain events, but hypothetical, but they are based on real not others. Accounting systems thus reflect brands and numbers, and they show just how those events over which accounting has a the Moribund Effect can mask true value. It comparative advantage and deliberately leave is a marketing function to build brands, and others outside the system. As a part of that it is the marketing function that should take reasoning, they additionally maintain that command of this situation to ensure that the thoughtful investors know to combine value of brands under their is prop- accounting information with other sources of erly and fully measured and reported. information when making judgments Our appeal is not to the accounting regarding valuation. They would categorize standard setters (although we hope they brand value estimates from published sources find our ideas interesting), but to the many such as Interbrand and Millward Brown as companies that are, or have been, involved examples of non-accounting sources of in mergers and acquisitions and who are information that investors could use. sitting with moribund brands on the bal- We recognize too that a case could be ance sheet. Our exhortation for companies made that investors can learn about specific to be more informative about their brands financial valuations of brands from one (or is shared by the SEC leadership. They also more) of these many published sources.

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This analysis and reporting, however, only ACKNOWLEDGEMENTS addresses a very small percentage of the The authors thank the JBM editorial and many brands that may be participants in review team, as well as Richard Sansing mergers and acquisitions. Different and Daniel McCarthy, for insightful and methodologies make different assumptions, constructive comments. and brand valuations from the different published sources may not agree. Man- agement may feel more comfortable with a REFERENCES particular methodology that they could Bahadir, S., Bharadwaj, G. and Srivastava, R. (2008) publically identify and put forth if brand Financial value of brands in mergers and acquisi- valuation were discussed in the MD&A. tions: Is value in the eye of the beholder? Journal of Marketing 72(6): 49--64. Another argument might be made that it Baigorri, M. (2016) 2015 was best-ever year for M&A; would not necessarily be in the self-interest This year looks good too. Bloomberg BusinessWeek. of top management to provide valuations of January 5, 2016. ‘‘home-grown brands’’ as there may always Binder, C. and Hanssens, D.M. (2015) Why strong customer relationships trump powerful brands. Har- be a risk of impairment at some point, vard Business Review. April 14, 2015. resulting in criticism or even termination of Christensen, J. and J. Demski (2003) Accounting Theory: top management. In today’s increasingly An Information Content Perspective. : McGraw-Hill Irwin. transparent world, however, interest from Epstein, M.J. and Westbrook, R.A. (2001) Linking investors, the media, or even consumers in actions to profits in strategic decision making. MIT learning more about the internal workings Sloan Management Review (Spring): 39--49. Ernst & Young (2009) Acquisition Accounting— and various financial indicators of compa- What’s Next for You? February 2009. nies is likely to remain high if not even European Securities and Market Authority (2014) further increasing. Review on the Application of Accounting Require- In summing up our main contention, the ments for Business Combinations in IFRS Financial Statements. June 2014. IFRS conceptual framework contains this Fama, E. (1970) Efficient capital markets: A review of phrase: theory and empirical work. Journal of Finance 25(2): 383--417. The scope of financial statements is Fournier, S. (1998) Consumers and their brands: Devel- determined by their objective, which is oping relationship theory in consumer research. to provide information about an entity’s Journal of Consumer Research 24(September): 343--373. assets, liabilities, equity, income and Germann, F. (2015) Do CMOs really add value? Harvard Business Review. October: 32. expenses that is useful to users of financial Grant Thornton (2013) Intangible Assets in Business statements in assessing the prospects for Combinations. November 2013. future net cash inflows to the entity and Gregory, J. and Moore, M. (2013) Aligning marketing in assessing management’s stewardship of and finance with accepted standards for valuing the entity’s resources. IFRS (2015) brands. Capco Institute Journal of Financial Transforma- tion 38(October): 41--48. We suggest that, under the circumstances Houlihan Lokey (2013) Purchase Price Allocation Study. October 2014. discussed in this paper, companies are IFRS (2015) The Conceptual Framework for Financial forced by this unintended accounting con- Reporting. Exposure Draft. London: IFRS Foundation. sequence to mislead readers of the annual International Valuation Standards Council: IVSC (2011). IVS 210. Intangible Assets. accounts. The Moribund Effect denies Keller, K.L. (1993) Conceptualizing, measuring, and investors and lenders ‘‘the scope’’ promised managing customer-based brand equity. Journal of in the standard setters own conceptual Marketing 57(1): 1--22. framework. If the standard setters cannot Keller, K.L. (2013) Strategic Brand Management, 4th edn. Upper Saddle River, NJ: Pearson Prentice-Hall. or will not correct this anomaly, then Keller, K.L. and Lehmann, D.R. (2003) How do brands marketers must. create value? (May/June): 26--31.

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KPMG (2010) Intangible assets and goodwill in the determinable life time. The distinction is context of business combinations: An study. that these intangibles, which are mainly White paper. www.kpmg.com. Madden, T.J., Fehle, F. and Fournier, S. (2006) Brands acquired brands, do not have infinite lives. matter: An empirical demonstration of the creation In the language of M&A accounting, these of shareholder value through branding. Journal of the economic lives are described as indefinite Academy of Marketing Science 34(2): 224--235. Markables (2015) http://www.markables.net/. and not the antonym of finite: infinite. It is Moorhouse, M. (1990) The case for capitalising brands. a vital distinction because the infinite ver- In: Power, M. (ed.) Brand and Goodwill Accounting sion distorts the recorded value. Strategies. New York, NY: Woodhead-Faulkner. Depending on the methodology used, Power, M. (1990) Brand and Goodwill Accounting Strate- gies. Special Report. London: Woodhead-Faulkner valuers will construct a discounted cash Ltd. flow table projecting earnings from the PWC (2013). Brands: What’s in a Name? March 2013. asset for 5, 7, or 10 years. The duration is Rao, V. (2012) Great CEOs Must be Either Technical or Financial. Forbes Tech. March, 3, 2012. largely dependent on the nature and history Rust, R.T., Zeithaml, V.A. and Lemon, K.N. (2004). of the brand that has been acquired. To Customer-centered brand management. Harvard discount to infinity (a common practice), Business Review (September 2004): 110--118. Securities and Exchange Commission (2003) Interpre- the nth year (6, 8, or 11) is projected, a tation: Commission guidance regarding manage- present value discount factor is applied and ment’s discussion and analysis of financial condition then the discounted nth year is simply and results of operations. 17 CFR Parts 211, 231 and divided by the discount rate. This produces 241. Sinclair, R. (2002) Recognizing and Evaluating Brand the so-called terminal value, growing per- Equity in South African Business to Gain Financial petuity or annuity. As the Relief from and Operational Benefits. Doctoral thesis. University Royalty example shows in Table 3 the of the Witwatersrand, Johannesburg, South Africa. Sinclair, R. and Keller, K.L. (2014) A case for brands as effect invariably is to add a number to the assets: Acquired and internally developed. Journal of initial present value that distorts the total Brand Management 21(4): 286--302. because it is typically a very large number Srivastava, R.K., Shervani, T.A. and Fahey, L. (1998) Market-based assets and shareholder value. Journal of and becomes the dominant component of Marketing 62(1): 2--18. the transaction value. Welch, G. (2013) How can CMOs get positions serving Our solution is to decay the nth year on a corporate board? Age. October 15, value, over a period (typically the same as 2013. Whitler, K.A., Krause, R. and Lehmann, D.R. (2015) the initial DCF period), and step it down When and How Does Board-Level Marketing over that period by equal reductions. This Experience Impact Firm Performance? MSI work- is a well-known technique used in property ing paper: 15--109. valuation. If the initial cash flow period is 7 years, the nth year value is reduced sys- APPENDIX: CALCULATING ECO- tematically by 1/7th segments until it meets NOMIC LIFE the base line. The value is therefore the The standards setters make a distinction sum of the initial present value of 7 years between intangible assets that have finite plus the stepped down present value. The lives ( and copyright with specified sum is the value of a brand with an indef- lifetimes) and intangibles that have no inite life.

ª 2017 Macmillan Publishers Ltd. 1350-231X Journal of Brand Management