January 5, Dear Scott:

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1 January 5, 2006 Mr. Scott Taub, Acting Chief Accountant Office of the Chief Accountant U.S. Securities & Exchange Commission 100 F Street, NE Washington, DC Dear Scott: The Committee on Corporate Reporting ( CCR ) of Financial Executives International ( FEI ) and the Financial Reporting Committee ( FRC ) of the Institute of Management Accountants ( IMA ) ( the Committees ) are writing to provide their views on the recent speech by Pamela R. Schlosser, a U.S. Securities & Exchange Commission ( SEC ) Professional Accounting Fellow, regarding valuing customer relationship intangibles 1. Specifically, we wish to provide further information regarding the applicability of a marketplace participants approach under existing GAAP. Both Committees were very involved in the Financial Accounting Standards Board s ( FASB or the Board ) due process leading up to issuance of FAS 141 and 142 as well as subsequent discussions with members of the Board and Staff, which provides us with a perspective on this issue that may be helpful to the SEC Staff in giving this matter further consideration. During the early stages of the broad project on Business Combinations, the Board recognized that it needed to segment the project into phases to facilitate completion of the most urgent issues on a timely basis. One of the matters that was determined to be more appropriate for Phase II of the project was the application of purchase methods and procedures (this conclusion is affirmed in paragraph B100 of FAS 141). Accordingly, the exposure drafts that were issued did not change existing practices under APB 16 and did not seek comment on a new methodology for determining fair value commonly referred to as the marketplace participants approach. We do not take a position on whether some value should have been recognized under the existing fair value methodologies in the case cited by the SEC Staff in the speech. Rather, we wish to obtain clarity on this issue and to identify other matters that would need to be addressed in order to appropriately and consistently apply a marketplace participants approach. 1 Remarks before the 2005 AICPA National Conference on Current SEC and PCAOB Developments, December 5, 2005.

2 2 Shortly after the FASB completed Phase I of the business combinations project, FEI and IMA jointly sponsored a conference to discuss the implementation issues related to the new standards 2. At that conference, a major point of discussion was whether a marketplace participants approach was required in applying purchase accounting requirements of FAS 141. FASB Board Member Michael Crooch, a panelist at the conference, stated that the Board had chosen not to deliberate those issues in Phase I and that it had carried forward the guidance in APB 16 without reconsideration. When this issue resurfaced in 2005, the IMA FRC wrote the attached letter to the FASB seeking affirmation of the earlier conclusion (Appendix A). The FASB staff confirmed that application of the marketplace participants approach was a Phase II issue. Subsequent to that discussion, FEI and IMA wrote to the Board requesting clarification as to whether the issuance of a final standard on fair value measurements would amend FAS 141 to require a marketplace participants approach. The FASB staff responded that the final standard would not amend FAS 141 and that this change would be effected through finalization of the Business Combinations ED. We understand that there are references in FAS 141 that could convey a different view of this issue. We understand that paragraph B174 of the standard appears to endorse a marketplace participants view in determining what assumptions should be used. We cannot explain the apparent contradiction between this paragraph and paragraph B100. However, it is a fair observation that Board members often peek ahead at the implications of decisions they make on issues they will inevitably face later in a multi-phase project. While there is little doubt that at least some members on the Board at that time would have supported application of a marketplace participants approach to assigning purchase price to intangibles, it would not have been possible under the Board s Rules of Procedure, to incorporate such a fundamental change in the final standard without first going through due process. Assuming the Staff continues to hold the view that application of a marketplace participants approach is required, we note that there are many unresolved issues associated with that approach as applied to non-financial assets. These include but are not limited to: how to determine the appropriate market and the nature of the potential buyer, how to incorporate tax benefits when the tax treatment of an acquired asset varies by tax jurisdiction, and how to account for the asset on day 2. In the context of the fair value measurements ED, the FASB has yet to consider the role of practicability in applying the marketplace participants approach in a level 5 measurement, even though that accommodation is provided in other standards where a fair value measure is required based on marketplace participant assumptions (e.g., FAS 143). We also observe that the auditing literature has yet to address this concept and that it is more than a remote likelihood that initial judgments made in applying the approach could be overturned upon further review by regulators. Both FEI and IMA have written to the Board to request clarification and additional guidance on these issues prior to finalization of the fair value measurements standard. 2 FEI IMA Conference on Business Combinations, Sheraton New York Hotel, December 12, Julie Erhardt was a panelist at this conference.

3 We would appreciate the opportunity to earliest convenience. 3 discuss this issue further with the Staff at its Sincerely, Lawrence J. Salva Chair, Committee on Corporate Reporting Financial Executives International Teri List Chair, Financial Reporting Committee Institute of Management Accountants cc: Robert H. Herz, Chairman FASB

4 APPENDIX A 4 July 5, 2005 Mr. Robert H. Herz, Chairman Mr. Donald T. Nicolaisen, Financial Accounting Standards Board Chief Accountant 401 Merritt 7 Office of the Chief Accountant P. O. Box 5116 U.S. Securities & Exchange Commission Norwalk, CT Washington, DC Gentlemen: The Financial Reporting Committee of the Institute of Management Accountants is writing this letter to raise an emerging accounting issue related to the allocation of purchase price under Financial Accounting Standards Board ( FASB ) Statement of Financial Accounting Standards ( SFAS ) No 141, Business Combinations, (SFAS141) and SFAS No 142, Goodwill and Other Intangible Assets ( SFAS 142 ) to certain elements of an acquisition that do not provide significant incremental value to the acquirer. We are concerned that there is divergence developing among certain accounting and valuation firms, particularly with respect to customer relationships where the customer base of the acquired company overlaps with that of the acquirer. Specifically, it is our understanding that the emerging view is that all customer relationships result in assets that must be recognized under SFAS 141 and Emerging Issues Task Force Issue No , Recognition of a Customer Relationship Intangible Asset Acquired in a Business Combination ( EITF ). This conclusion leads to an application of valuation methodologies prescribed by SFAS 142 that require incorporation of the assumptions marketplace participants would use. The result is recognition of an intangible asset that is not consistent with the economics underlying the purchase transaction. Some believe the issue addressed in this letter is symptomatic of the broader issues companies are facing with increasing frequency as a result of the push towards the fair value model, particularly when faced with the requirement to utilize a marketplace participant approach to valuation. In our view, the move toward identifying and valuing additional theoretical identifiable intangibles, combined with the requirement to use a marketplace participant approach to value such assets is accelerating the divergence of the economics of purchase transactions from the financial reporting effects. We are very concerned about the risk that the underlying economic reality from the acquirer s perspective will not be reflected in the financial reporting. For an acquirer, the entire acquisition analysis, including the acquisition economics and ultimate acquisition decision, is based on a set of assumptions and estimates that are very specific to their own set of circumstances. This includes an analysis of which acquired assets will be utilized and the overall cash flows that will be generated from the pool of acquired assets. We believe an accounting model that forces companies to disregard their own modeling, strategy, assumptions and estimates when accounting for the impacts of such acquisitions would not faithfully represent the transaction it purports to represent and would provide users of financial statements with information that is less useful for evaluating the extent to which management s strategy has been successful or for measuring the post-acquisition performance of the combined enterprise.

5 Consider the following example that illustrates the issue pertaining to overlapping customer relationships: 5 A manufacturing company (A) acquires another manufacturing company (Target) in a business combination. A and Target manufacture a variety of products, some overlapping and some complementary. A and Target are both leading manufacturers and marketers of brand-name products. The sales for both companies are executed through purchase orders that is, sales are not made pursuant to a contractual relationship. Both companies sell to retail companies. Target s customers have a 90% overlap with A s customer base. A has excellent relationships with its customer base, including the customers that overlap with Target. A s integration plans with respect to Target s sales and distribution of products will be to manage them through A s existing sales and distribution organization, post acquisition. Because of its existing relationships and integration plans, A did not ascribe any value to Target s overlapping customer relationships when evaluating the merits and economics of the acquisition. The Target relationships are non contractual and are not capable of being separated from the Target and sold, transferred, licensed, rented or otherwise exchanged for something of value, as they have no value to a buyer on their own. Asset Recognition Based on the specific facts presented above, other than with respect to the 10% of Target s customer base that does not overlap with A s existing base, we do not believe the acquisition should result in a customer-related intangible that should be recognized. Although EITF would indicate that in this type of a situation, one might have two different types of customer relationships (one being a contractual-relationship intangible and the other being a non-contractual customer relationship intangible); we do not believe there is a customer relationship intangible in this instance that meets the separable criteria of SFAS 141. Beyond that, we would question whether the overlapping customer relationships in the above situation meet the definition of an asset in FASB Statement of Financial Accounting Concepts ( Concepts Statement ) No. 6, Elements of Financial Statements. Some may argue that an asset results because the acquirer gains control over the relationships as a result of a past transaction (two of the three elements of an asset in paragraph 25); however, the acquisition of the overlapping relationships will not provide an incremental future economic benefit to the acquirer. Further, requiring A to recognize an asset for the overlapping customer relationships in the above situation would be totally inconsistent with the economics of the transaction. A had the existing customer relationships, did not ascribe any value to such relationships in its assessment of the acquisition economics, and did not/would not have paid for such relationships, either as part of the acquisition or separately. While another marketplace participant may have been able to attribute specific value to the customer relationship, it may have attributed less value to other assets otherwise its overall value would have exceeded the offer made by A. We would be troubled, as we believe would most users of financial statements, with an accounting presentation that is inconsistent with the economic reality of the underlying transaction. It is becoming apparent that certain accounting and valuation firms would reach a different conclusion in applying the purchase price allocation guidance to this example. Certain firms believe all acquired customer relationships should be recognized, regardless of overlap with existing customers. We understand that this view is emerging partially in response to a speech made by a Professional Accounting Fellow ( PAF ) at the December 2003 AICPA National Conference on Current SEC and PCAOB Developments, wherein issues related to customer-related intangible assets

6 6 were discussed. 3 In that speech the PAF, in discussing EITF 02-17, indicated that customer related intangible assets exist in a wide variety of situations, even if such assets are not considered separable from the acquired entity or if no contracts exist at the date of the acquisition. The PAF further stated that the valuation method employed in assessing fair value must take into account the view of a marketplace participant and that entity-specific assumptions may not be appropriate. Our reading of that speech would not lead us to believe there is a presumption that overlapping customer relationships must be recognized. Nonetheless, this approach appears to be emerging as a leading view. Valuation Considerations Marketplace Participants We note that FAS 141 carries forward without reconsideration the purchase accounting guidance in APB 16, and all other relevant citations in that standard support continued application of traditional approaches to fair value. In the absence of an active market with observable values, those approaches have historically tended to be entity specific and not based on marketplace participants. In fact, the notion of market participants is only mentioned once in SFAS 141 (paragraph B174 in the background information and basis for conclusions section) and that reference is in the context of an intangible asset arising from contractual and other legal rights. We do not believe it is appropriate to interpret this relatively innocuous reference as a requirement that all intangibles must be valued using only a marketplace participant approach. None-the-less, some apparently have. The consequences of the asset recognition issue described above are compounded and exacerbated by the application of a marketplace participant approach. For example, such an approach would exclude the synergies that the acquiring company with an existing relationship might realize if such synergies were not available to a market participant acquirer that did not have an existing relationship. We believe the application of marketplace participant approach to valuing this type of asset is not required under SFAS 141, nor operational given the number of variables involved. Often times, a marketplace participant would not have the level of overlapping customers that may exist for an actual acquirer. In the case of a financial buyer marketplace participant, there would likely be no overlap. Thus, depending on the definition of the marketplace participant, the resulting value could vary significantly for the same transaction. In the above example, should marketplace participants be limited to industry peers? When should financial buyers be considered marketplace participants? Does the magnitude of the purchase price impact the determination of a marketplace participant such that there is only one or a very limited number of marketplace participants (i.e., for a very significant transaction, the purchase price is oftentimes based on buyerspecific synergies that only one or a few other marketplace participants could replicate)? We are currently observing diversity in views regarding such questions among accounting and valuation firms. We also believe requiring the valuation of overlapping customer relationships using marketplace participant assumptions would result in an accounting impact that is directly contradictory to the Board s very reasoning in support of using market-participant based fair value measures. Specifically, paragraph 33 of Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, provides the principal rationale for fair value (utilizing marketplace participant assumptions): If the entity measures an asset or liability at fair value, its comparative advantage or disadvantage will appear in earnings as it realizes assets or settles liabilities for amounts different than fair value. The effect on earnings appears when the advantage is employed to 3 Speech by Chad A. Kokenge on December 11, 2003.

7 7 achieve cost savings or the disadvantage results in excess costs. In contrast, if the entity measures an asset or liability using a measurement other than fair value, its comparative advantage or disadvantage is embedded in the measurement of the asset or liability at initial recognition. If the offsetting entry is to revenue or expense, measurements other than fair value cause the future effects of this comparative advantage or disadvantage to be recognized in earnings at initial measurement. (Emphasis added) Inherent in the above rationale is the assumption that the asset will be utilized in operations and the cost of utilizing that asset should be reflective of market conditions, such that other synergies (or inefficiencies) will be reflected in post-acquisition operations, rather than in the asset value. Some may continue to debate the merits of this rationale. However, irrespective of which side of the debate one is on relative to this rationale, the facts in the example presented above clearly indicate that the asset will never be utilized in operations. Thus, requiring an acquirer to value the asset using marketplace participant assumptions may actually mask the acquirer s relative efficiencies by forcing them to record a cost for an asset that will not be utilized. A separate, but related, issue exists on valuation. Some accounting firms would require the use of an excess earnings/residual income approach in performing the valuation. In the opinion of many valuation specialists, this approach produces valuations that are completely inconsistent with the underlying transaction. In addition to the marketplace participants dilemma discussed above, the contributory charges assessed against the future revenues produced by the asset is systematically underestimated in many of the models used today. The combination of these factors may result in inflated customer relationship values that do not reflect economic reality they do not equate to real values that would be observed in exchange transactions. We believe that including such assets in financial statements does not provide decision-useful information concerning the current or future cash-flow-generating capabilities of an enterprise and could even be misleading with respect to such capabilities. Subsequent Accounting Finally, we struggle with the day two accounting that would need to be addressed if overlapping customer relationships are assigned a value in a business combination. The most logical answer would seem to be an immediate write off of the asset in the circumstances presented above. Given that the asset will not be utilized and delivers no incremental value to the acquirer, and could not be separated and sold to another party, there are no cash flows to support the assigned basis. Thus, the asset effectively is impaired upon establishment. While some may suggest periodic amortization of such assets over some period, we do not believe there is a conceptual rationale for such an approach when applied to an intangible asset that a company never intended to use and that can be expected to contribute no incremental cash flows to a company s operations. Amortizing an underlying asset in such circumstances would, in addition to masking the relative efficiencies of the acquiring entity, be inconsistent with the cumulative body of generally accepted accounting principles. Related Examples While we have focused on overlapping customer relationships for illustrative purposes, the issue also applies to other situations. For example, consider software and other technology. If the acquired entity s software and technology are inferior to that of the acquirer and will not be utilized and cannot be sold, should the software and technology be assigned some portion of the purchase price, simply because they would have value to a less sophisticated acquirer? Also, consider an acquired brand or trademark that will not be used by the acquirer. For example, an acquirer may purchase a company with a portfolio of brands, including a brand that competes with one of the acquirer s

8 8 existing brands. For efficiency or other strategic reasons, the acquirer decides to discontinue the competing acquired brand and has no intent to sell or license it to a competitor. Even though this brand may have a value to a marketplace participant, we do not believe any significant portion of the purchase price should be allocated to the brand. In addition, it would appear to us that any value ascribed to that brand by the acquirer would be immediately impaired based on the acquirer s plans. If the conclusion on these and other related examples is that an intangible asset must be recognized and valued by referencing other marketplace participants, we are concerned that the resulting accounting will not provide decision-useful information to financial statement users. Summary We believe the practices for asset recognition with respect to overlapping customer relationships, acquired software systems, discontinued brands and the other matters discussed herein should be determined primarily by the specific facts and circumstances underlying an acquisition. Importantly, we do not believe there should be any presumption or bias toward recognizing an asset in situations where no significant incremental value is provided to the acquirer. Based on the emerging interpretations discussed above and the resulting diversity that is developing in practice, we recommend that the FASB or SEC issue interpretative guidance that confirms that assets should only be recognized and valued when they represent incremental value or benefit to the acquiring entity. Further, in situations in which an asset is determined to exist, we believe the Board has a responsibility to demonstrate the superior decision-usefulness of the information that would be produced by a rigorous application of the market participants concept to these situations before adopting it as an absolute requirement. As we indicated previously, FAS 141 carries forward APB 16 purchase accounting without reconsideration and therefore mandates traditional approaches to developing fair value measures. We observe that the broader issue of whether purchase accounting should incorporate valuations based on the marketplace participants approach was, at the time FAS 141 was issued, intended to be the subject of further study in the context of phase II of the business combinations project. While we recognize the need to comment separately on that project, we would encourage the Board to consider the comments included herein in their deliberations. We appreciate your consideration of our comments. We would welcome an opportunity to personally discuss these issues with you. If you have any questions, please do not hesitate to call me. Sincerely, ****** Teri L. List Chair, Financial Reporting Committee Institute of Management Accountants